Monetary Policy

Monetary Policy

It is concerned with the changing the supply of money stockand rate of interest for the purpose of stabilizing the economyat full employment or potential output level by influencingthe level of aggregate demand. At times of recessionmonetary policy involves the adoption of some monetarytools which tends to increase the money supply and lowerinterest rate so as to stimulate aggregate demand in theeconomy. At the time of inflation monetary policy seeks tocontract aggregate spending by tightening the money supplyor raising the rate of return.

Objectives

• To ensure the economic stability at fullemployment or potential level of output.

• To achieve price stability by controllinginflation and deflation.

• To promote and encourage economic growth inthe economy.

Tools of Monetary Policy

• Bank rate policy

• Open market operations

• Changing cash reserve ratio

• Undertaking selective credit controls

Bank Rate Policy

• Bank rate is the minimum rate at which thecentral bank of a country provides loan to thecommercial bank of the country.

• Bank rate is also called discount rate becausebank provide finance to the commercial bank byrediscounting the bills of exchange.

• When general bank raises the bank rate, thecommercial bank raises their lending rates, itresults in less borrowings and reduces moneysupply in the economy.

Limitations

• Well organized money market should exist inthe economy. It is not present in India

• It is use full during the times of inflation but itdoes not full fill its purpose during the time ofrecession or depression.

Open Market Operations

• It means the purchase and sale of securitiesby central bank of the country.

• It is useful for the developed countries.

• The sale of security by the central bank leadsto contraction of credit and purchase there ofto credit expansion.

Limitations

• When the central bank purchases the securities thecash reserve of member bank will be increased andvise versa.

• The bank will expand and contract credit according toprevailing economic and political circumstances andnot merely with reference to their cash reserves.

• When the commercial bank cash balance increase thedemand for loan and advance should increase. Thismay not happen due to economic and politicaluncertainty.

• The circulation of bank credit should have a constantvelocity.

Changing Cash Reserve Ratio

• The bank have to keep certain amount of bank money with them selves as reserves against deposits.

• The increase in the cash rate leads to the contraction of credit only when the banks excess reserves.

• The decrease in the cash rate leads to the expansion of credit and banks tends to make more available to borrowers.

Expansionary Monetary Policy

Problem: Recession and unemployment Measures: (1) Central bank buys securities through open

market operation (2) It reduces cash reserves ratio (3) It lowers the bank rate

Money supply increases

Investment increases

Aggregate demand increases

Aggregate output increases by a multiple of the increase in investment

Tight Monetary Policy

Problem: Inflation Measures: (1) Central bank sells securities through open market operation

(2) It raises cash reserve ratio and statutory liquidity (3) It raises bank rate (4) It raises maximum margin against holding of stocks of goods

Money supply decreases

Interest rate raises

Investment expenditure declines

Aggregate demand declines

Price level falls

Sources of Monetary Mismanagement

• Variable time lags concerning the effect of money supply on the national income.

• Treating Interest rate as the target of monetary policy for influencing investment demand for stabilizing the economy.

Role of Monetary Policy in Economic Growth

• Monetary policy and savings.

• Monetary policy and investment.

– Cost of credit..

– Monetary policy and public investment.

– Monetary policy and private investment.

• Allocation of investment funds.

Monetary Policy of RBI

• In recent years starting from the mid-nineties promoting economic growth is being given greater emphasis in monetary policy of RBI.

• Three sub-periods:

– Monetary policy of controlled examination(1951-1972).

– Monetary policy in the pre-reforms period(1972-1991) .

– Monetary policy in the post-reforms period(1991-2000).

Monetary policy of controlled examination(1951-1972)

• Reserve bank’s responsibility in the circumstancesis mainly to moderate the expansion of credit andmoney supply in such a way as to ensure thelegitimate requirements of industry and tradeand curb the use of credit for unproductive andspeculative purposes.

• To ensure controlled expansion, RBI used theinstruments:– Changes in bank rate – Changes in cash reserve ratio – Selective credit control

Monetary policy in the pre-reforms period(1972-1991)

• Price situation worsened during the years of1972-1974 to contain inflationary pressuresRBI further tightened its monetary policy.

• It is similar to tight monetary policy.

Easy and Liberal Monetary Policy(1996)

• Liberal monetary policy adopted for encouraging private sector since 1996.

• Two instrument for monetary management BY RBI since 1996:

– Reactivation of bank rate.

– Repo rate system .

Repo Rate System

• It is introduced through which RBI can add toliquidity in the banking system. Through reposystem RBI buys securities from the bank and thereby provide funds to them.

• Repo refers to agreement for a transaction betweenRBI and banks through which RBI supplies fundsimmediately against government securities andsimultaneously agree to repurchase the same orsimilar securities after a specified time which maybe one day to 14 days.

Liquidity Adjustment Facility

• It is the another instrument of monetary policyfrom June 2000 to adjust on a daily basisliquidity in the banking system.

• Through LAF, RBI regulates short-term interestrates while its bank rate policy serves as asignaling device for its interest rate policy in theintermediate period.

4th Bi-monthly Monetary Policy• The Reserve Bank of India (RBI) presented its 4th Bi-monthly

Monetary Policy review on 30 September 2014.• RBI kept the major rates unchanged as the central bank kept

its focus on tackling inflation. Following are the major ratesand projections coming out of this review:– GDP growth rate projected at 5.5% for current fiscal.– The high growth rate during Q-1 (Apr-June 2014) may not be

sustained in Q-2 and Q-3.– Consumer Price Index (CPI)-based inflation projected to remain at

8% by Jan 2015 and 6% by Jan 2016.– Repo rate (short term lending rate) unchanged at 8%.– Cash Reserve Ratio (CRR) unchanged at 4%.– Statutory Liquidity Ratio (used for unlocking banking funds)

retained at 22%.– The liquidity rate under Export Credit Refinance (ECR) reduced

from 32% to 15% (w.e.f. 10 October 2014).

International Capital Market

International Capital Markets

• International capital markets are a group of markets (inLondon, Tokyo, New York, Singapore, and other financial cities)that trade different types of financial and physical capital(assets), including

– stocks

– bonds (government and corporate)

– bank deposits denominated in different currencies

– commodities (like petroleum, wheat, bauxite, gold)

– forward contracts, futures contracts, swaps, options contracts

– real estate and land

– factories and equipment

Gains from Trade

• How have international capital markets increased the gains from trade?

• When a buyer and a seller engage in a voluntary transaction, both receive something that they want and both can be made better off.

• A buyer and seller can trade– goods or services for other goods or services

– goods or services for assets

– assets for assets

Gains from Trade Cont…

Gains from Trade

• The theory of comparative advantage describes the gains from trade of goods and services for other goods and services:

– with a finite amount of resources and time, use those resources and time to produce what you are most productive at (compared to alternatives), then trade those products for goods and services that you want.

– be a specialist in production, while enjoying many goods and services as a consumer through trade.

Cont…

• The theory of inter-temporal trade describes the gains from trade of goods and services for assets, of goods and services today for claims to goods and services in the future (today’s assets).

– Savers want to buy assets (future goods and services) and borrowers want to use assets (wealth) to consume or invest in more goods and services than they can buy with current income.

– Savers earn a rate of return on their assets, while borrowers are able to use goods and services when they want to use them: they both can be made better off.

Cont…

• The theory of portfolio diversification describes the gains from trade of assets for assets, of assets with one type of risk with assets of another type of risk.– Many times in economics (though not in Las Vegas) people

want to avoid risk: they would rather have a sure gain of wealth than invest in risky assets.

– Economists say that investors often display risk aversion: they are averse to risk.

– Diversifying or “mixing up” a portfolio of assets is a way for investors to avoid or reduce risk.

Portfolio Diversification

• With portfolio diversification, both countries could always enjoy a moderate potato yield and not experience the vicissitudes of feast and famine.

– If the domestic country’s yield is 20 and the foreign country’s yield is 100 then both countries receive: 50%*20 + 50%*100 = 60.

– If the domestic country’s yield is 100 and the foreign country’s yield is 20 then both countries receive: 50%*100 + 50%*20 = 60.

– If both countries are risk averse, then both countries could be made better off through portfolio diversification.

Classification of Assets

Claims on assets (“instruments”) are classified as either

1. Debt instruments

Examples include bonds and bank deposits

They specify that the issuer of the instrument must repaya fixed value regardless of economic circumstances.

2. Equity instruments

Examples include stocks or a title to real estate

They specify ownership (equity = ownership) of variable profits or returns, which vary according to economic conditions.

International Capital Markets

The participants:

1. Commercial banks and other depository institutions:

– accept deposits

– lend to governments, corporations, other banks, and/or individuals

– buy and sell bonds and other assets

– Some commercial banks underwrite stocks and bonds by agreeing to find buyers for those assets at a specified price.

Cont…

2. Non bank financial institutions: pension funds, insurance companies, mutual funds, investment banks

– Pension funds accept funds from workers and invest them until the workers retire.

– Insurance companies accept premiums from policy holders and invest them until an accident or another unexpected event occurs.

– Mutual funds accept funds from investors and invest them in a diversified portfolio of stocks.

– Investment banks specialize in underwriting stocks and bonds and perform various types of investments.

Cont..

3. Private firms:

– Corporations may issue stock, may issue bonds or may borrow from commercial banks or other lenders to acquire funds for investment purposes.

– Other private firms may issue bonds or borrow from commercial banks.

4. Central banks and government agencies:

– Central banks sometimes intervene in foreign exchange markets.

– Government agencies issue bonds to acquire funds, and may borrow from commercial or investment banks.

Cont…

• Because of international capital markets, policy makers generally have a choice of 2 of the following 3 policies:

1. A fixed exchange rate

2. Monetary policy aimed at achieving domestic economic goals

3. Free international flows of financial capital

Cont…

• A fixed exchange rate and an independent monetary policy can exist if restrictions on flows of financial capital prevent speculation and capital flight.

• Independent monetary policy and free flows of financial capital can exist when the exchange rate fluctuates.

• A fixed exchange rate and free flows of financial capital can exist if the central bank gives up its domestic goals and maintains the fixed exchange rate.

Introduction to Credit Rating Agencies

Credit Rating

• A credit rating estimates the credit worthiness of an a financialsecurity, a corporation, local government or even a country.

• It is an evaluation made by credit reporting agency of a risk ofbuying into a specific security offering and based on a numberof factors.

• Credit ratings are calculated from financial history and currentassets and liabilities.

• Typically, a credit rating tells a lender or investor theprobability of the subject being able to meet paymentrequirements for interest and principal repayment.

What is a credit rating?

• An opinion on the issuer's capacity to meet its financialobligations on a particular issue in a timely manner, forexample long-term bonds:

Credit Rating Agency

A Credit Rating Agency (CRA) is a company thatis responsible for assessing the financialstrength of a company or government entity.This includes domestic and foreign companies.The main area that a credit rating agencyfocuses on is the ability of the company orgovernment entity to meet the interest andprinciple payments on their debts and bonds.

Functions of Credit Rating Agency• Provide easy to understand information: Rating agencies gather

information, then analyze information to interpret and summarize

complex information in a simple and readily understood manner.

• Provide basis for investment: An investment rated by a credit rating

enjoys higher confidence from investors. Investors can make an

estimate of the risk and return associated with a particular rated issue

while investing money in them.

• Healthy discipline on corporate borrowers: Higher credit rating to

any credit investment makes the financial instrument (bond, mortgage

security) more attractive to investors. Corporations can borrow money

more cheaply if they maintain high credit ratings on their debt.

• Formation of public policy: Once the debt securities are rated

professionally, it would be easier to formulate public policy guidelines

as to the eligibility of securities to be included in different kinds of

institutional portfolios.

How ratings are established?

Rating Agencies

• International:

– Moody’s Investment Services

– Standard and Poor’s

– Fitch Rating

• National

– Fitch Ratings

– CRISIL (

– CIBIL (Credit Information Bureau (India) Limited)

Rating Scales used by Major Credit Raters

International Monetary System

International Monetary System

• International monetary systems are sets ofinternationally agreed rules, conventions andsupporting institutions, that facilitate internationaltrade, cross border investment and generally thereallocation of capital between nation states.

• International monetary system refers to thesystem prevailing in world foreign exchangemarkets through which international trade andcapital movement are financed and exchange ratesare determined.

Cont..

• The International Monetary System is part ofthe institutional framework that bindsnational economies, such a system permitsproducers to specialize in those goods forwhich they have a comparative advantage,and serves to seek profitable investmentopportunities on a global basis.

Features that IMS should possess

• Flow of international trade and investmentaccording to comparative advantage.

• Stability in foreign exchange and should bestable.

• Promoting Balance of Payments adjustments toprevent disruptions associated with temporaryor chronic imbalances.

• Providing countries with sufficient liquidity tofinance temporary balance of paymentsdeficits.

• Should at least try avoid adding furtheruncertainty.

• Allowing member countries to pursueindependent monetary and fiscal policies.

Stages in IMS

• Classic Gold Standard (1816 – 1914)

• Interwar Period (1918 – 1939)

• Bretton Woods System (1944 – 1971)

• Present International Monetary System (1971

Classical Gold Standard(1816 – 1914)

Classical Gold Standard

• 22nd June 1816, Great Britain declared the goldcurrency as official national currency (Lord Liverpool’sAct). On 1st May 1821 the convertibility of PoundSterling into gold was legally guaranteed.

• Other countries pegged their currencies to the BritishPound, which made it a reserve currency. Thishappened while the British more and more dominatedinternational finance and trade relations.

• At the end of the 19th century, the Pound was used fortwo thirds of world trade and most foreign exchangereserves were held in this currency.

• Between 1810 and 1833 the United States hadde facto the silver standard. In 1834 (CoinageAct of 1834), the government set the gold-silverexchange rate to 16:1 which implemented a defacto gold standard.

• In 1879 the United States set the gold price toUS$ 20,67 and returned to the gold standard.With the “Gold Standard Act” of 1900, goldbecame an official instrument of payment.

• From the 1870s to the outbreak of World War I in1914, the world benefited from a well integratedfinancial order, sometimes known as the First ageof Globalization. Money unions were operatingwhich effectively allowed members to accepteach others currency as legal tender including theLatin Monetary Union and Scandinavianmonetary union

• In the absence of shared membership of a union,transactions were facilitated by widespreadparticipation in the gold standard, by bothindependent nations and their colonies

Rules of the System

• Each country defined the value of its currencyin terms of gold.

• Exchange rate between any two currencieswas calculated as X currency per ounce ofgold/ Y currency per ounce of gold.

• These exchange rates were set by arbitragedepending on the transportation costs of gold.

• Central banks are restricted in not being ableto issue more currency than gold reserves.

Arguments in Favour of Gold Standard

• Price Stability:-

By tying the money supply to the supply of gold,central banks are unable to expand the moneysupply.

• Facilitates BOP adjustment automatically:-

The basic idea is that a country that runs a currentaccount deficit needs to export money (gold) tothe countries that run a surplus. The surplus ofgold reduces the deficit country’s money supplyand increases the surplus country’s money supply.

Arguments against Gold Standard

• The growth of output and the growth of goldsupplies needs to be closely linked. For example, ifthe supply of gold increased faster than the supplyof goods did there would be inflationary pressure.Conversely, if output increased faster thansupplies of gold did there would be deflationarypressure.

• Volatility in the supply of gold could cause adverseshocks to the economy, rapid changes in thesupply of gold would cause rapid changes in thesupply of money and cause wild fluctuations inprices that could prove quite disruptive

• In practice monetary authorities may not be forced to strictly tie their hands in limiting the creation of money.

• Countries with respectable monetary policy makers cannot use monetary policy to fight domestic issues like unemployment.

Interwar Period (1918 – 1939)

Interwar Period

• The years between the world wars have beendescribed as a period of de-globalization, as bothinternational trade and capital flows shrankcompared to the period before World War I.During World War I countries had abandoned thegold standard and, except for the United States.

• The onset of the World Wars saw the end of thegold standard as countries, other than the U.S.,stopped making their currencies convertible andstarted printing money to pay for war relatedexpenses.

• After the war, with high rates of inflation and alarge stock of outstanding money, a return to theold gold standard was only possible through adeep recession inducing monetary contraction aspracticed by the British after WW I.

• The focus shifted from external cooperation tointernal reconstruction and events like the GreatDepression further illustrated the breakdown ofthe international monetary system, bringing suchbad policy moves such as a deep monetarycontraction in the face of a recession.

Conditions Prior to Bretton Woods

• Prior to WW I major national currencies were on asystem of fixed exchange rates under theinternational gold standards. This system had beenabandoned during WW I.

• There were fluctuating exchange rates from theend of the War to 1925. But it collapsed with thehappening of the Great Depression.

• Many countries resorted to protectionism andcompetitive devaluation. But depressiondisappeared during WW II

BRETTON WOODS (1945-1971)

• British and American policy makers began to planthe post war international monetary system in theearly 1940s.

• The objective was to create an order thatcombined the benefits of an integrated andrelatively liberal international system with thefreedom for governments to pursue domesticpolicies aimed at promoting full employment andsocial wellbeing.

• The principal architects of the new system, JohnMaynard Keynes and Harry Dexter White

• Bretton Woods is a little town in New Hampshire,famous mostly for good skiing. In July 1944, theInternational Monetary and Financial Conferenceorganized by the U.N attempted to put together aninternational financial system that eliminated the chaosof the inter-war years.

• The terms of the agreement were negotiated by 44nations, led by the U.S and Britain. The main hope ofcreating a new financial system was to stabilizeexchange rates, provide capital for reconstruction fromthe war and foment international cooperation.

Features of Bretton Woods System

• The features of the Bretton Woods system can bedescribed as a “gold-exchange” standard ratherthan a “gold-standard”. The key difference wasthat the dollar was the only currency that wasbacked by and convertible into gold. (The rateinitially was $35 an ounce of gold

• Other countries would have an “adjustable peg”basically, they were exchangeable at a fixed rateagainst the dollar, although the rate could bereadjusted at certain times under certainconditions.

• Each country was allowed to have a 1% bandaround which their currency was allowed tofluctuate around the fixed rate. Except on therare occasions when the par value was allowedto be readjusted, countries would have tointervene to ensure that the currency stayed inthe required band.

• The IMF was created with the specific goal ofbeing the multilateral body that monitored theimplementation of the Bretton Woodsagreement.

• Its role was to hold gold reserves and currencyreserves that were contributed by the membercountries and then lend this money out to othernations that had difficulty meeting their obligationsunder the agreement.

• The borrowing was classified into tranches, eachwith attached conditions that becameprogressively stricter. This enabled the IMF to forcecountries to adjust excess fiscal deficits, tightenmonetary policy etc, and force them to be moreconsistent with their obligations under theagreement.

The Demise of the Bretton Woods System

• In the early post-war period, the U.S. government had toprovide dollar reserves to all countries who wanted tointervene in their currency markets. Lead to problem of lack ofinternational liquidity.

• The increasing supply of dollars worldwide, made availablethrough programs like the Marshall Plan, meant that thecredibility of the gold backing of the dollar was in question. U.S.dollars held abroad grew rapidly and this represented a claimon U.S. gold stocks and cast some doubt on the U.S.’s ability toconvert dollars into gold upon request.