Monetary Policy & Inflation
PGDM – Semester -II
What is Money Supply?

Money supply is one of the important indicator of
macroeconomic environment

This refers to the total volume of money circulating in the
economy at a point in time.

Money supply in an economy determines liquidity
conditions in the market, which in turn impacts interest rate
structure and hence the cost of capital to the firms.
Contd..

Money supply is basically determined by the central bank of
a country (e.g. Reserve Bank of India) and the commercial
banking network.

RBI has adopted four measures of money supply viz.-Ml,
M2, M3 and M4 .

M3 (broad money) is most popular from operational point of
view. M3 includes time deposits (fixed deposits), savings
deposits with post office saving banks and all the components
of M1.
What cause increase in money supply?
gulated?
 RBI has the power to print notes, they can hence release more
money into the economy.
However it is only partly true. Such a process cannot be sustained
as more notes for the same quantity of physical goods in the
economy will only bring down the value of the currency and hence
will not benefit anyone.

 After
all increase in money supply should be done with an
objective to benefit the economy as a whole by protecting the
value of the currency. So, a government has to exercise restraint in
printing notes.
Factors affecting Money supply
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Bank credit
Deficit financing
Foreign exchange reserves
Government Expenditure
FII inflows
Why Is Money Supply Important?

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An increase in the supply of money works both through interest
rates, which spurs INVESTMENT, and through putting more
money in the hands of consumers, making them feel wealthier,
and thus stimulating spending.
Business firms respond to increased sales by ordering more raw
materials and increasing production. The spread of business
activity increases the demand for labor and raises the demand for
capital goods.
In a buoyant economy stock market prices rise and firms issue
equity and debt. If the money supply continues to expand, prices
begin to rise, especially if output growth reaches capacity limits
What is Inflation??


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A sustained increase in the general level of prices so that a
given amount of money buys less and less.
In the Keynesian sense True inflation begins when the
elasticity of supply of output in response to increase in
money supply has fallen to zero or when output is
unresponsive to changes in money supply.
Opinion survey conducted in India, USA and many other
countries reveal that inflation is the most important concern
of the people as it badly affects their standard of living.
Important terms related to Inflation


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Deflation: is the opposite of inflation when fall in
prices occurs.
Disinflation: is process of bringing down prices
moderately from their high level.
Stagflation: is a term in macroeconomics used to
describe a period of high inflation combined with
low incomes, unemployment, or economic
stagnation.
Types of Inflation

Demand pull inflation:
This represents a situation where there is increase in
Aggregate Demand for resources either from the
government or the entrepreneurs or the households.
Result of this is that the pressure of Demand can’t be
met by the Currently available Aggregate Supply which
result in Aggregate Demand > Aggregate Supply which
is bound to generate inflationary pressure in the
economy.
Types of Inflation

Cost Push inflation: This is because of large increases in
the cost of important goods or services where no suitable
alternative is available. This may happen if the costs
especially wage cost rise.

Hyperinflation: Hyperinflation is also known as runaway
inflation or galloping inflation. This type of inflation
occurs during or soon after a war
Causes of Inflation

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Inflation due to Monetary expansion
(Monetary inflation)
Inflation due to rise in real aggregate demand
(Real inflation)
Inflation due to contraction in Aggregate
Supply
Monetary inflation
It was Milton Friedman who famously
quipped, “Inflation is always and everywhere
a monetary phenomenon.” If the quantity of
money grows at a pace greater than warranted
by the growth of the economy, then the excess
money supply drives up prices.
Remedies – Monetary Inflation
 If
the cause of inflation is instead monetary
expansion, aggregate supply should still be
stimulated, but the focus of effort should be
constraining further monetary expansion.
Remedies - Real Demand Inflation
It involves inflation rising as the real gross domestic
product rises and unemployment falls
 If inflation is caused by strong real demand, the best
response may be to support aggregate supply growth. Part
of the solution may be to let prices rise. Suppliers need
incentives to invest in new capacity.
 Stimulating aggregate supply include encouraging
business investment; reducing input costs; and increasing
competitive intensity.

Remedies - Real Demand Inflation


If aggregate supply is sufficiently stimulated, inflation may
be converted into balanced economic growth:
If instead money supply is tightened in the face of strong
real demand, the result will be a surge in interest rates,
which may be counterproductive in this case, as it will be
harder for aggregate supply to expand when borrowing
costs are high.
Real v/s Money Inflation
To distinguish real demand inflation from
monetary inflation is to look at interest
rates. When inflation is caused by strong
real demand, interest rates will tend to be
high. When inflation is caused by excessive
monetary growth, in contrast, interest rates
will tend to be low.
Measurement of Inflation

Inflation is measured by the
 Wholesale
Price Index (WPI)
 Consumer Price Index (CPI)
A Wholesale Price Index (WPI) is the price of a
representative basket of wholesale goods.
 Some countries use the changes in this index to
measure inflation in their economies, in particular
India – The Indian WPI figure is released weekly

WPI as a measure of inflation in India

WPI is preferred to CPI
 wider
commodity coverage
 available on weekly basis
 computed at all-India basis

WPI Inflation is divided into three broad
categories
 Primary
Articles
 Fuel Products and
 Manufacturing Items.
Headline inflation
Headline inflation is a measure of the total inflation
within an economy and is affected by certain
components which may experience sudden
inflationary spikes such as food or energy. As a
result, headline inflation may not present an accurate
picture of the current state of the economy.
 WPI is the measure of headline inflation in India

Core inflation

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Core inflation has emerged as an alternative for
measuring inflation. In this, volatile items like food
prices and fuel items are excluded.
The first two categories include food articles and fuel
items which can be excluded. The third category –
Manufacturing also includes food products which tends
to be volatile as well and moves in line with prices of
primary articles. So after excluding food products from
manufacturing sector, we get non-food manufactured
products inflation. This can also be called as core
inflation for India
Consumer Price Index
 CPI,
also retail price index is a statistical
measure of a weighted average of prices of a
specified set of goods and services purchased
by wage earners in urban areas. It is a price
index which tracks the prices of a specified set
of consumer goods and services, providing a
measure of inflation.
CPI in India based on different economic
groups.
 CPI
UNME (Urban Non-Manual Employee)
 CPI AL (Agricultural Labourer)
 CPI RL (Rural Labourer)
 CPI IW (Industrial Worker).
 While the CPI UNME series is published by
the Central Statistical Organization, the others
are published by the Department of Labor.
Effects of inflation
Wealth costs – inflation affects those on fixed incomes
and redirects wealth to other (physical) assets
 Planning costs – businesses uncertain about future price
changes may be reluctant to invest – hits economic growth
 Competitiveness – inflation at a higher rate in the UK than
elsewhere hits domestic competitiveness and affects the
balance of payments
 Social stability - At very high rates, confidence in the
currency is eroded and production and exchange can be
stifled – can lead to food riots, looting and violence

Real & Nominal Interest rates
Interest Rate = Nominal Interest Rate –
Inflation
 Real interest rate, is one where the effects of
inflation have been factored in. A nominal
variable is one where the effects of inflation
have not been accounted for.
 Real
Monetary Policy
What is Monetary Policy??
It is the process by which the central bank
or monetary authority of a country regulates
(i) the supply of money (ii) availability of
money and (iii) cost of money or rate of
interest in order to attain a set of objectives
oriented towards the growth and stability of
the economy
Monetary policy
Monetary policy is one of the tools used to
control the supply and availability of money, to
influence the overall level of economic activity in
line with its political objectives. Usually this goal
is "macroeconomic stability" - low
unemployment, low inflation, economic growth,
and a balance of external payments. Monetary
policy is usually administered by a Government
appointed "Central Bank“.
What is Monetary Policy??



It is concerned with the changing the supply of money
stock and rate of interest for the purpose of stabilizing
the economy by influencing the level of aggregate
demand.
At times of recession monetary policy involves the
adoption of some monetary tools which tends to increase
the money supply and lower interest rate so as to
stimulate aggregate demand in the economy.
At the time of inflation monetary policy seeks to contract
aggregate spending by tightening the money supply or
raising the rate of return.
Monetary policy provides
a) an overview of economy
b) specifies measures that RBI intends to take
to influence such
 key
factors like…money supply….interest
rates….inflation
c) lays down norms for financial institutions
like banks, financial companies etc. relating
to CRR, capital adequacy
Monetary policy & Inflation
 When
inflationary pressures build up:
raise the short-term interest rate (the policy
rate)
 which squeezes consumption and
investment.

TYPES OF MONETARY POLICY

Cheap money policy : Followed in
periods of slums & depression

Dear money policy: Followed in
periods of boom & inflation.
Monetary Policy Instruments
 Open
Market Operations
 Bank rate
 Cash Reserve Ratio
 Statutory Liquidity Ratio
 Repo rate
 Reverse Repo rate
Open Market Operations
OMOs are the means of implementing
monetary policy by which a central bank
controls the nation’s money supply by
buying and selling government securities,
or other financial instruments
What is the outcome on account of OMO?

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When the RBI buys bonds from the market and infuses
liquidity, the consequences are:

It tends to soften the interest rates
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It enables corporate to borrow at favorable interest rates

It may tend to increase inflation
Consequently… If the RBI were to sell bonds
instead and suck in liquidity, the effect
would exactly be the opposite!!
Bank rate
Rate at which Central Bank lends money to commercial
Banks
The bank rate signals the central bank's long-term outlook on
interest rates. If the bank rate moves up, long-term interest
rates also tend to move up, and vice-versa.
Any increase in Bank rate results in an increase in interest rate
charged by Commercial banks which in turn leads to low
level of investment and low inflation
Cash Reserve Ratio


It refers to the cash which banks have to maintain with
RBI as certain percentage of their demand and time
liabilities
An increase in CRR reduces the cash with commercial
banks which results in low supply of currency in the
market, higher interest rate and low inflation
Statutory Liquidity Ratio


It is the percentage of total deposits commercial banks
have to invest in government bonds and other approved
securities. RBI in November cut the SLR for banks by
one percentage point and it now stands at 24% of their
total demand and time deposit liabilities
Objectives of SLR
 To restrict expansion of Bank credit
 To augment bank’s investment in government
securities
 To ensure solvency of banks
Meaning of Repo

The term Repo is used as an abbreviation for
Repurchase Agreement.

Repo rate is the interest rate at which the central bank
lends funds to banks against pledging securities

It enables collateralized short term borrowing and
lending through sale/purchase operations in debt
instruments
Repo Rate

In current review of monetary policy Repo rate 6.5% and
reverse repo is 5.5%

If the RBI wants to make it more expensive for the banks
to borrow money, it increases the repo rate; similarly, if
it wants to make it cheaper for banks to borrow money, it
reduces the repo rate.
Reverse Repo
The rate at which RBI borrows money from the banks (or
banks lend money to the RBI) is termed the reverse repo
rate.
 If the reverse repo rate is increased, it means the RBI will
borrow money from the bank and offer them a lucrative rate
of interest. As a result, banks would prefer to keep their
money with the RBI (which is absolutely risk free) instead
of lending it out (this option comes with a certain amount of
risk)

Reverse Repo
Consequently, banks would have lesser funds to lend to
their customers. This helps stem the flow of excess money
into the economy
 Reverse repo rate signifies the rate at which the central
bank absorbs liquidity from the banks, while repo signifies
the rate at which liquidity is injected.

Importance of Repo & Reverse Repo

It helps borrower to raise funds at better rates
An SLR surplus and CRR deficit bank can use the Repo
deals as a convenient way of adjusting SLR/CRR
positions simultaneously.

RBI uses Repo and Reverse repo as instruments for
liquidity adjustment in the system

Reverse Repo is undertaken to earn additional income
on idle cash.
Major Players in Repo/Reverse Repo market

The major players in the repo and reverse repurchase market tend
to be banks who have substantially huge portfolios of government
securities as approved by RBI (Treasury Bills, Central/State
Government securities).

Besides these players, primary dealers who often hold large
inventories of tradable government securities are also active
players in the repo and reverse repo market.

DFHI is very active in the Repo Market. It has been selling and
purchasing on repo basis T-Bills and eligible dated Government
Securities.
Discount and Finance House of India
(DFHI)
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The DFHI was set up in April 1988 by the Reserve Bank with
the objective of deepening and activating the money market.
It has commenced its operations from July 28, 1988.
DFHI is also an authorized institution to undertake repo
transactions in treasury bills and all dated government
securities to impart greater liquidity to these instruments.
Since November 13, 1995, DFHI is an accredited primary
dealer. With this accreditation, its role has undergone a
transformation. Now it acts as a market maker, giving twoway quotes and takes large positions on its account in
government securities.
Call Rate – Short term Inter bank rate
Call rate is the interest rate paid by the banks for
lending and borrowing for daily fund
requirement. Since banks need funds on a daily
basis, they lend to and borrow from other banks
according to their daily or short-term
requirements on a regular basis.
Liquidity Adjustment Facility

A tool used in monetary policy that allows banks to borrow
money through repurchase agreements. This arrangement allows
banks to respond to liquidity pressures and is used by RBI to
assure basic stability in the financial markets.

Liquidity adjustment facilities are used to aid banks in resolving
any short-term cash shortages during periods of economic
instability or from any other form of stress caused by forces
beyond their control.
banks use eligible securities as collateral through a repo
agreement and use the funds to alleviate their short-term
requirements, thus remaining stable.

Liquidity Adjustment Facility
Objective : The funds under LAF are used by the banks for their day-today mismatches in liquidity.
Tenor :Under the scheme, Reverse Repo auctions (for absorption of
liquidity) and Repo auctions (for injection of liquidity) are conducted on a
daily basis (except Saturdays).
Eligibility : All commercial banks (except RRBs) and PDs having current
account and SGL account with RBI.
Minimum bid Size : Rs. 5 cr and in multiple of Rs.5 cr
Eligible securities: Repos and Reverse Repos in transferable Central
Govt. dated securities and treasury bills.
Objectives of Monetary Policy

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To ensure the economic stability at full employment
or potential level of output.
To achieve price stability by controlling inflation
and deflation.
To promote and encourage economic growth in the
economy
Mid-Quarter Monetary Policy Review: December
2010
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by RBI
Monetary Measures: It has been decided to:
retain the repo rate at 6.25 per cent and the reverse repo rate at 5.25 per
cent under the Reserve Bank’s liquidity adjustment facility (LAF);
retain the cash reserve ratio (CRR) at 6.0 per cent of net demand and time
liabilities (NDTL) of scheduled banks.
Liquidity Measures: It has been decided to:
reduce the statutory liquidity ratio (SLR) of scheduled commercial banks
(SCBs) from 25 per cent of their NDTL to 24 per cent with effect from
December 18, 2010;
conduct open market operation (OMO) auctions for purchase of
government securities for an aggregate amount of ` 48,000 crore in the
next one month, the schedule for which is being issued separately.
The above two measures are expected to inject liquidity on an enduring
basis of the order of ` 48,000 crore.
Contd.. Dec -10
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Inflation
Though inflation has moderated, inflationary pressures persist
both from domestic demand and higher global commodity
prices. The pace of decline in food price inflation has been
slower than expected due largely to structural factors.
There is a risk that rising international commodity prices will
spill over into domestic inflation. Going forward, rising
domestic input costs for the manufacturing sector combined
with aggregate demand pressures could weigh on domestic
inflation. The risk to the Reserve Bank’s projection of 5.5 per
cent inflation by March 2011 is on the upside.
Contd.. Dec -10
Liquidity


While the overall liquidity in the system has remained in deficit consistent
with the policy stance, the extent of tightness has been beyond the comfort
level of the Reserve Bank. In addition, the liquidity deficit has been
accentuated by structural factors such as relatively sluggish growth in
bank deposits even as the credit growth accelerated in 2010-11. While the
liquidity deficit improved transmission of monetary policy signals with
several banks raising deposit and lending interest rates, excessive deficits
induce unpredictability in both availability and cost of funds, making it
difficult for the banking system to sustain credit delivery.
As the economy expands, it needs primary liquidity, which will have to be
provided in a manner consistent with the monetary policy stance. Such
provision of liquidity should not be construed as a change in the monetary
policy stance since inflation continues to remain a major concern. The
measures taken in this review need to be appreciated in that context.
Analyst comments for 25th Jan Review of credit
policy
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The vast majority of analysts surveyed expect the RBI to raise key lending
and borrowing rates by only 25 basis points (bps) on Jan. 25 despite
persistent price pressures, as a slump in industrial production growth
suggests some risks to economic momentum still exist.
The RBI raised its main lending rate or the repo rate Repo rate by 150 bps
to 6.25 percent and its main borrowing rate by 200 bps to 5.25 percent
through six rate increases in 2010.
This is the most widely expected policy action by the RBI to contain price
pressures without sapping the economy's momentum. It would be in line
with what it says is its "calibrated" or gradual approach to tightening,
which is perceived as a 25 bps rate hike by the market.
With November industrial output data at an 18-month low, a 25-basispoint rate hike could be the least disruptive yet send an anti-inflationary
signal.
Third Quarter Review of Monetary
Policy 2010-11



Increase the repo and reverse repo rates by 25 basis points
(bps) each. Accordingly, the repo rate stands at 6.5 per cent
and the reverse repo rate at 5.5 per cent;
Retain the cash reserve ratio (CRR) at 6 per cent of net
demand and time liabilities (NDTL) of banks.
Reserve Bank has cumulatively increased the repo rate by
175 bps and the reverse repo rate by 225 bps. Additionally,
the CRR was increased by 100 bps. Banks have responded to
this calibrated tightening by raising their deposit and lending
rates, suggesting strong monetary policy transmission.
Considerations Behind the Policy
Move
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Inflation is clearly the dominant concern. Primary food
articles inflation has risen again sharply. Non-food articles
inflation and fuel inflation are already at elevated levels.
Non-food manufacturing inflation has remained sticky.
There are signs of food and fuel price increases spilling over
into generalized inflation.
Second, there has been a sharp rise in global commodity
prices which has heightened upside risks to domestic
inflation.
Third, growth has moved close to its pre-crisis trajectory
even in the face of an uncertain global recovery.
Fourth, the uncertainty with regard to global recovery has
reduced.
Role of RBI
during
Recession
What is recession…?



An economy which grows over a period of time tends to
slow down the growth as a part of the normal economic
cycle.
An economy typically expands for 6-10 years and
tends to go into a recession for about six months to 2 years.
A recession normally takes place
When consumers lose confidence in the growth of the economy and spend less.
This leads to a decreased demand for goods and services,
which in turn leads to a decrease in production, lay-offs
and a sharp rise in unemployment.
Investors spend less as they fear stocks values will fall and thus stock markets
fall on negative sentiment
Economic Cycle
RBI’s measures during III QUARTER
OF 2008-09
Role of Monetary policy

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Problem:
Recession and unemployment
Expansionary monetary policy
Measures:
Central bank buys securities through open market operation
Reduces cash reserves ratio
Lowers the bank rate
Leads to
Money supply increases
Investment increases
Aggregate demand increases
Aggregate output increases by a
multiple of the increase in investment
RBI Announces Further Monetary
Stimulus Date : 02 Jan 2009
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On a review of current global and domestic macroeconomic situation, the Reserve Bank has
decided to take the following further measures:
Repo Rate
To reduce the repo rate under the liquidity adjustment facility (LAF) by 100 basis points
from 6.5 per cent to 5.5 per cent with immediate effect.
Reverse Repo Rate
To reduce the reverse repo rate under the LAF by 100 basis points from 5.0 per cent to 4.0
per cent with immediate effect.
Cash Reserve Ratio
To reduce the cash reserve ratio (CRR) of scheduled banks by 50 basis points from 5.5 per
cent to 5.0 per cent from the fortnight beginning January 17, 2009.
The reduction in the CRR will inject additional liquidity of around Rs. 20,000 crore to the
financial system. It is expected that the reduction in the policy interest rates and the CRR
will further enable banks to provide credit for productive purposes at appropriate interest
rates. The Reserve Bank on its part would continue to maintain a comfortable liquidity
position in the system.
The fundamentals of our economy continue to be strong. Once the crisis is behind us, and
calm and confidence are restored in the global markets, economic activity in India would
recover sharply. But a period of painful adjustment is inevitable.
Thank You