Wednesday, November 19, 2008

Monetary Policy

The responsibility for the control of money supply, bank credit, and interest rates lies with the central bank of the country, viz. the Reserve Bank of India.

The money in circulation with the public cossets of currency and coins issued by the central bank plus deposits with banks and some other depository institutions. Depending upon which deposits are being included we get different monetary aggregates which are termed M1, M2, M3 and so forth. M3 is the so called broad money and includes demand and fixed deposits along with currency and coin. Bank credit is also a measure of liquidity in the economy since banks’ ability to extend credit depends upon their ability to mobilize deposits and the cash reserves they have to maintain against these deposits. The stock of currency together with the reserves maintained in the banking system of the central bank constitutes the monetary base or high powered money. Changes in this are magnified and lead to changes in the total money stock or bank credit.

The central bank can use a variety of policy instruments to regulate the volume and cost of credit in the economy. It can lower or raise the cash reserve ratio (CRR) within specified limits to make it easier or more difficult for banks to extend credit. By engaging in open market purchases or sales of securities from its portfolio it can inject or suck out reserves enabling banks to expand or contract credit as also lowering or raising the cost of credit. It can use the discount rate – the rate it charges banks for refinancing facility and discretionary limits on refinancing facilities to influence the volume of bank credit. At times it can impose administrative controls to alter the volume and select oral composition of outstanding bank credit. Lately, the Reserve Bank of India has more or less dispensed with such administrative controls on credit and interest rates and has been relying more on open market operations and the market mechanism.

The RBI has adopted inflation control as the primary objective of monetary policy. From time to time it must also deploy the policy tools under its control to address other targets such as exchange rate and employment. Often, these objectives can conflict with each other. Thus massive capital inflows into the economy which is already awash with liquidity pose a dilemma for the central bank. If the central bank does nothing, the exchange rate would appreciate which may hurt exports; if it intervenes and buys foreign exchange to prevent this, it would have to inject additional liquidity into the system. At such times, it must trade off one target against another.

The degree of autonomy enjoyed by the central bank is an important determinant of its ability to conduct effective monetary policy and achieve credibility with financial markets. If it has to play second fiddle to the Finance ministry and accommodate government’s borrowing requirements irrespective of the resulting impact on money supply, interest rates and inflation, it loses its ability to conduct effective monetary policy. Similarly, excessive reliance on opaque administrative control mechanisms reduces its credibility with financial markets and makes it difficult to implement anti-inflationary policies or appropriate exchange rate policies. In recent years, there has been a gradual move towards granting more and more operational independence.

Some financial terms:

Macroeconomics focuses on aggregate variables such as Gross National Product, aggregate investment and saving, total employment wholesale and consumer price indices money supply and bank credit and key financial variables like interest rates and exchange rates.

Gross Domestic Product (GDP) and Gross National Product (GNP) are two widely used measures of the level of economic activity.

Per capita GDP is widely used as a measure of living standards. The World Bank classifies countries into: ‘Low Income, ‘Middle income’ and ‘High Income’. The low income countries are often referred to as the Third World.


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