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Money, Central Banking in
India and International
Financial Institutions - I
SPECIAL GROUP : D - Banking and Finance Group
M. Com (M 17) – Part I
Semester - II
YASHW
ANTRA
O CHA
VAN MAHARASHTRA OPEN UNIVERSITY
ASHWANTRA
ANTRAO
CHAV
Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Maharashtra
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Open University, Nashik.
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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Vice-Chancellor : Dr. M. M. Salunkhe
Director (I/C), School of Commerce & Management : Dr. Prakash Deshmukh
State Level Advisory Committee
Dr. Pandit Palande
Hon. Vice Chancellor
Dr. B. R. Ambedkar University
Muaaffarpur, Bihar
Dr. Suhas Mahajan
Ex-Professor
Ness Wadia College of Commerce
Pune
Dr. V. V. Morajkar
Ex-Professor
B.Y.K. College, Nashik
Dr. Mahesh Kulkarni
Ex-Professor
B.Y.K. College, Nashik
Dr. J. F. Patil
Economist Kolhapur
Dr. Ashutosh Raravikar
Director, EDMU,
Ministry of Finance, New Delhi
Dr. A. G. Gosavi
Professor
Modern College,
Shivaji Nagar, Pune
Dr. Madhuri Sunil Deshpande
Professor
Swami Ramanand Teerth Marathwada
University, Nanded
Dr. Prakash Deshmukh
Director (I/C)
School of Commerce & Management
Y.C.M.O.U., Nashik
Dr. Parag Prakash Saraf
Director, Institute of Management
Science, Pimpri, Pune
Dr. S. V. Kuvalekar
Associate Professor and
Associate Dean (Training)(Finance )
National Institute of Bank Management,
Pune
Dr. Surendra Patole
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.O.U., Nashik
Authors & Editors
Dr. Parag Prakash Saraf
Director, Institute of Management Science, Pimpri, Pune
Dr. Latika Ajitkumar Ajbani
Assistant Professor, School of Commerce & Management, Y.C.M.O.U., Nashik
Instructional Technology Editing & Programme Co-ordinator
Dr. Latika Ajitkumar Ajbani
Assistant Professor, School of Commerce & Management, Y.C.M.O.U., Nashik
Production
Shri. Anand Yadav
Manager, Print Production Centre
Y.C.M. Open University, Nashik - 422 222.
Copyright © Yashwantrao Chavan Maharashtra Open University, Nashik.
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INTRODUCTION
I am very please to placing the first and enlarge edition of this study material
on 'Money, Central Banking in India and International Financial Institutions' to the
students and practitioners of this subject. This book is design as per the revise
syllabus prescribed by the YCMOU Nashik from August 2015. It gives equal
importance to the theoretical aspects as well as to the practical case studies. Hence
this edition will be an ideal companion not only to the scholars but also to the average
students. I am sure that this present work a result of my sincere and dedicated
efforts would subserve the genuine interest of all the students concerned in enriching
their knowledge of this ever-growing Auditing discipline.
I have made a sincere attempt to make the subject easy to understand. For
this purpose. The theory on each topic is written in a simple and lucid language to
enable the students to grasp the essence of subject.
It gives me great pleasure to introduce you to the world of Money, Central
Banking in India and International Financial Institutions. This book has got knowledge
oriented and exam oriented approach. I am tried to cover all Banking Regulation
Act and provisions of it. I am very much thankful to Prof.Gopal Kalantri of Dhruv
Academy, Sangamner and Prof.Shubhangi Kulkarni of Sangamner College for their
co-operation. Ofcourse blessing of my parents Mr.Prakash Saraf & Mrs.Shubhada
Saraf is important for completion of this work...
So let's start this lovely journey of learning in a positive way.
Any suggestions will be appreciated.
I am confident, that students will welcome new edition of this book.
With knowledge, hard work, marvelous success is just around the corner.
All The Best!
- Dr.Parag Prakash Saraf
Index
Unit No. Unit Name
Page No.
1
EVOLUTION OF MONEY
9
2
FUNCTIONS OF MONEY
16
3
MEASUREMENT OF MONEY SUPPLY
24
4
THEORY OF MONEY
31
5
MODERN MONETARISM
43
6
THEORY OF INFLATION
55
7
CENTRAL BANKING - I
63
8
ORGANIZATION AND DEPARTMENTS
OF RBI
71
9
ROLE AND FUNCTIONS OF RBI
78
10
MONETARY POLICY AND
RESERVE BANK OF INDIA
85
FRAMEWORK AND PROCEDURE
OF MONETARY POLICY
93
MECHANISM OF MONETARY POLICY
106
11
12
Money, Central Banking in India and
International Financial Institutions - I
1) EVOLUTION OF MONEY
Barter Economy, Evolution of Money
2) FUNCTIONS OF MONEY
Functions of Money, Significance of Money, Demand
for Money, Supply of Money
3) MEASUREMENT OF MONEY SUPPLY
The Concept of Money Supply and its Measurement,
Four Measures of Money Supply, Determination of Money
Supply
4) THEORY OF MONEY
Price and Economy, Confusion between prices and costs
of production, Other price terms, Fishers Quantity theory of
Money, Quantity Theory of Money: The Cambridge Cash
Balance Approach
5) MODERN MONETARISM
Keynesian theory - Income Approach, Monetarism: An
Introduction, Keynes's Reformulated Quantity Theory of Money
6) THEORY OF INFLATION
Meaning of Inflation, Demand-Pull Inflation, Cost-Push
Inflation
7) CENTRAL BANKING - I
Overview of central Bank, Objectives of Central Bank,
Reserve Bank of India, Role and Function of Reserve Bank of
India (RBI)
8) ORGANIZATION AND DEPARTMENTS
OF RBI
Organization and Structure of RBI, Departments of RBI
9) ROLE AND FUNCTIONS OF RBI
Role of Reserve bank of India, Functions of Reserve
Bank of India
10) MONETARY POLICY AND RESERVE BANK OF
INDIA
Meaning of Monetary policy, Objectives of monetary
policy, Instruments of Monetary Policy, LIMITATIONS OF
MONETARY POLICY
11) FRAMEWORK
MONETARY POLICY
AND
PROCEDURE
OF
Monetary Policy Targets, Operating Procedures of
Monetary Policy in India, Evolution of the Operating Procedure
12) MECHANISM OF MONETARY POLICY
Transmission mechanism of monetary policy, How does
interest rate policy work?, Reforms in the Monetary Policy
Framework, Press, New Monetary Policy framework
UNIT - 1
EVOLUTION OF MONEY
Structure
1.1
Introduction
1.2
1.3
1.4
1.5
1.6
1.7
Objectives
Barter Economy
Evolution of Money
Summary
Exercise & Questions
Further Reference Books
EVOLUTION OF MONEY
NOTES
1.1 Introduction
The act of trading goods and services between two or more parties without
the use of money is called as barter system. In the barter system goods are
exchanged for other goods. This system prevailed throughout the world in the
olden times. This system suffered from many shortcomings, double coincidence of
wants is one of them. For exchange of goods, persons desiring to exchange goods
must specifically want those goods what others offered in exchange. Money has
removed this difficulty. In the ancient period many things such as clay, cowry,
shells, cattle, salt, stone, gold, leather etc. used as money.
CHECK YOUR
PROGRESS
What is
Economy?
Barter
1.2 Objectives
At the end of this unit, you will be able to a) Know the barter system.
b) Know the kinds used as money in the ancient period
c) Understand the evolution of money
1.3 Barter Economy
A barter economy is a cashless economic system in which services and
goods are traded at negotiated rates.
Barter-based economies are one of the earliest, predating monetary
systems and even recorded history. People can successfully use barter in many
almost any field. Informally, people often participate in barter and other reciprocal
systems without really ever thinking about it as such -- for example, providing web
design or tech support for a farmer or baker and receiving vegetables or baked
goods in return. Strictly Internet-based exchanges are common as well, for example
exchanging content creation for research.
Barter transactions occur when economic actors, such as individuals,
businesses and nations, exchange goods or services without the use of a monetary
medium. While a barter economy is considered more primitive than modern
economies, barter transactions still occur in the marketplace. Below are simple
examples of bartering for goods and services, along with a common contemporary
barter exchange.
DEFINE BARTER SYSTEM.
DEFINITION of 'Barter'
The act of trading goods and services between two or more parties without
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Money, Central Banking in
India and International
Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
NOTES
CHECK YOUR
PROGRESS
Steps in Evolution of
Money?
the use of money.Bartering benefits individuals, companies and countries that see
a mutual benefit in exchanging goods and services rather than cash.
Example 1: Bartering with Consumer Goods
In its most elementary form, bartering is the exchange of one valuable
product for another between two individuals. Person A has two chickens but wants
to get some apples; meanwhile, Person B has six apples but wants some chickens.
If the two can find each other, Person A might trade one of his chickens for three
of Person B's apples. No medium of exchange is used. The problem posed by
simple bartering is what economists call the double coincidence of wants. In this
case, Person A is not satisfied unless he crosses paths with a chicken-wanting
apple-carrier, while Person B needs an apple-wanting chicken-carrier.
Example 2: Bartering with Consumer Services
Bartering can also take place as an exchange for services. Services are
saleable acts, such as performing mechanical work or legal representation. If one
professional agrees to perform tax accounting for another professional in exchange
for cleaning services, this is a barter transaction. Much like with consumer goods,
a barter transaction involving consumer services has demand and supply limitations.
Example 3: Modern Advertising Services
The most common form of business-to-business bartering in modern
economies involves the trading of advertising rights. In these cases, one company
sells its available ad space to another company in exchange for the right to advertise
on the second company's space. These can be TV rights, radio rights, actual billboards
or Internet ad spaces.
1.4 Evolution of Money
Origin and Evolution of Money
1) Barter
Money, as we know it today, is the result of a long
process.
At the beginning, there was no money. People
engaged in barter, the exchange of merchandise for
merchandise, without value equivalence.
Then, a person catching more fish than the
necessary for himself and his group, exchanged his excess
fish for the surplus of another person who, for instance,
had planted and harvested more corn that what he would
need..
Goods used in barter are generally in their natural state, in line with the
environment conditions and activities developed by the group, corresponding to
elementary needs of the group's members. This exchange, however, is not free
from difficulties, since there is not a common measure of value among the items
bartered.
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Financial Institutions - I
2) Commodity Money
Some commodities, for their utility, came to be
more sought than others are.
Accepted by all, they assumed the role of currency,
circulating as an element of exchange for other products
and used to assess their value. This was the commodity
money.
Cattle, mainly bovine, was one of the mostly used, and had the advantages
of moving for itself, reproducing and rendering services, although there was the
risk of diseases and death.
Salt was another commodity money, difficult
to obtain, mainly in the interior part of continents, also
used as a preservative for food. Both cattle and salt
left the marks in the Portuguese language of their
function as an exchange instrument. Similarly, the work
salário (salary,compensation, normally in money, due
by the employer for the services of an employee)
originates from the use of sal [salt], in Rome, for
payment of services rendered.
EVOLUTION OF MONEY
NOTES
WHICH COMMODITY WEWRE USED AS MONEY?
Brazil used, among other commodity
moneys, cowry - brought by Africans -, Brazil
wood, sugar, cocoa, tobacco and cloth,
exchanged in Maranhão in the 17th Century
due to the almost complete lack of money,
traded in the form of yarn balls, skeins and
fabrics.
Later, commodities became inconvenient for
commercial trades, due to changes in their values, the
fact of being indivisible and easily perishable, therefore
checking the accumulation of wealth.
3) Metal
As soon as man discovered
metal, it was used to made utensils
and weapons previously made of stone.
For its advantages, as the possibility of treasuring,
divisibility, easy of transportation and beauty, metal became
the main standard of value. It was exchanged under
different forms. At the beginning, metal was used in its
natural state, and later under the form of ingots and, still,
transformed into objects, from rings to bracelets.
The metal so traded required weight assessment and
assaying of its purity at each transaction. Later, metal money gained definite form
and weight, receiving a mark indicating its value, indicating also the person responsible
for its issue. This measure made transactions faster, as it saved the trouble of
weighing it and enabled prompt identification of the quantity of metal offered for
trade.
4) Money in the Form of Objects
Metal items came to be very valued commodities.
As its production required, in addition to knowledge of
melting, knowing where the metal could be found in nature, the
task was not at the reach of everyone.
The increased value of these objects led to its use as money and
the circulation as money of small-scale replicas of metal objects.
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Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
This is the case of the knife and key coins
found in the East and the talent, a copper or bronze
coin with the form of an animal skin that circulated in
Greece and Cyprus.
NOTES
5) Ancient Coins
In the 7th century B.C. the first coins
resembling current ones appeared: they were small metal pieces, with fixed weight
and value, and bearing an official seal that is the mark of who has minted them and
also a guaranty of their value.
Gold and silver coins are minted in Greece, and
small oval ingots are used in Lydia, made of a gold and
silver alloy called electrum.
Coins reflect the mentality of a people and their
time. One may find political, economic, technological
and cultural aspects in coins. Through the impressions
found in coins, we are able to know the effigy of
personalities who lived centuries ago. Probably, the
first historic character to have his effigy registered in
a coin was Alexander the Great, of Macedonia, around
the year 330 B.C.
At the beginning, coin pieces were made by hand
in a very coarse way, had irregular edges, and were not absolutely equal to one
another as today's ones.
6) Gold, Silver and Copper
The first metals used in coinage
were gold and silver. Employment of these
metals happened for their rarity, beauty,
immunity to corrosion, economic value, and
for old religious habits. In primeval
civilizations, Babylonian priests,
knowledgeable about astronomy, taught to people the close relationship between
gold and the sun, silver and the moon. This led to a belief in the magic power of
such metals and of objects made with them.
Minting of gold and silver coins was common for many centuries, and
pieces were guaranteed by their intrinsic value, that is to say, by the trade value of
the metal used in their production. Then, a coin made with twenty grams of gold
was exchanged for goods of even value.
For many centuries, countries minted their most highly valued coins in
gold, using silver and copper for lesser value coins. This system was kept up to the
end of the last century, when cupronickel, and later other metallic alloys, became
used, and coins came to circulate for their extrinsic value, that is to say, for their
face value, which is independent from their metal content.
With the appearance of paper money, minting of metal coins was restricted
to lower values, necessary as change. In this new role, durability became the most
requested quality for coins. Large quantities of modern alloys appeared, produced
to support the high circulation of change money.
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Money, Central Banking in
India and International
Financial Institutions - I
7) Paper Money
In the Middle Ages, the keeping of values with
goldsmiths, persons trading with gold and silver items,
was common. The goldsmith, as a guaranty, delivered
a receipt. With time, these receipts came to be used to
make payments, circulating from hand to hand, giving origin to paper money.
In Brazil, the first bank notes, precursors of the current notes, were issued
by Banco do Brasil in 1810. They had its value written by hand, as we today do
with our checks.
With time, in the same form it happened with coins, the government came
to conduct the issue of notes, controlling counterfeits and securing the power to
pay.
Currently, all countries have their central bank in charge of issuing coins
and notes.
Paper money experienced an evolution regarding the technique used in
their printing. Today, the printing of notes uses especially prepared paper and several
printing processes, which are complementary to each other, assuring to the final
product a great margin of security and durability conditions.
EVOLUTION OF MONEY
NOTES
Different Shapes
Money has greatly changed its
physical aspect along the centuries.
Coins had already very small
sizes, as the stater, which circulated in
Aradus, Phenicia, and some reached
large sizes, such as the thaler, a 17th
century Swedish copper piece.
Although today the circular form
is used in almost the whole world, there
had been oval, square, polygonal and
other shapes for coins. They were also minted in different non-metallic materials,
such as wood, leather and even porcelain. Porcelain coins circulated, in this century,
in Germany, when the country was under the economic hardships caused by the
war.
Bank notes were generally of rectangular lengthwise format, although with
great variety of sizes. There are, still, square notes and those with inscriptions
written in the vertical.
Bank notes depict the culture of the issuing country, and we may see in
them characteristic and interesting motifs as landscapes, human types, fauna and
flora, monuments of ancient and contemporary architecture, political leaders,
historical scenes, etc.
Bank notes bear, in addition, inscriptions, generally in the country's official
language, although several also bear the same inscriptions in other idioms. The
inscriptions, frequently in English, aim at
permitting the piece to be read by a larger
number of people.
Monetary System
The set of coins and bank notes
used by a country form its monetary
system. The system is regulated by
appropriate legislation and organized
from a monetary unit, its base value.
Currently almost all countries use a monetary system of centesimal basis,
in which the coinage dividing the unit represents one hundredth of its value.
8) Cheques
As coins and notes ceased to be convertible into precious metal, money
became more dematerialized and assumed abstract forms.
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Money, Central Banking in
India and International
Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
NOTES
CHECK YOUR
PROGRESS
What is Mobile
Payment?
One of these forms is the
cheques that, for simplicity of use
and security offered, is being
adopted by an increasing number
of people in their day-by-day
activities.
This document, by which
one orders payment of a certain amount to its bearer or to a person mentioned in it,
aims mainly at transactions with bank deposits.
The 21st century gave
rise to two disruptive forms of currency: Mobile payments and virtual currency.
9) Mobile payment
IT is money rendered for a product or service through a portable electronic
device such as a cell phone, smartphone or PDA. Mobile payment technology can
also be used to send money to friends or family members. Increasingly, services
like Apple Pay and Samsung Pay are vying for retailers to accept their platforms
for point-of-sale payments.
10) Virtual Currency
Bitcoin, invented in 2009 by the pseudonymous Satoshi Nakamoto, became
the gold standard--so to speak--for virtual currencies. Virtual currencies have no
physical coinage. The appeal of virtual currency is it offers the promise of lower
transaction fees than traditional online payment mechanisms and is operated by a
decentralized authority, unlike government issued currencies.
1.5 Summary
Barter transactions occur when economic actors, such as individuals,
businesses and nations, exchange goods or services without the use of a monetary
medium.
At the beginning, there was no money.
In the ancient period many things such as clay, cowry, shells, cattle, salt,
stone, gold, leather etc. used as money.
The first metals used in coinage were gold and silver.
In Brazil, the first bank notes, precursors of the current notes, were issued
by Banco do Brasil in 1810.
Money solves the various problems of barter system.
1.6 Exercise & Questions
Fill in the Blanks 1)
The act of trading goods and services between two or more parties without
the use of money is called as ------------ .
2)
-------------- currencies have no physical coinage.
3)
The 21st century gave rise to two disruptive forms of currency: -------------- and -----------.
4)
-------- has removed the problem of double coincidence.
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Money, Central Banking in
India and International
Financial Institutions - I
Short Answer Questions.
1)
Write down any two example of Barter.
2)
Write down the name of any five commodity used as money in the ancient
period.
3)
4)
5)
Explain the concept of double coincidence.
Write down any four drawbacks of barter system.
Explain how money solve the problem of barter system?
C) Long Answer Questions
1)
Explain the evolution and origin of money.
2)
Explain barter economy with the help of example. Mention the drawbacks
of System.
EVOLUTION OF MONEY
NOTES
1.7 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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Money, Central Banking in
India and International
Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
NOTES
CHECK YOUR
PROGRESS
Describe Functions of
Money?
UNIT - 2
FUNCTIONS OF MONEY
Structure
2.1
Introduction
2.2
Objectives
2.3
Functions of Money
2.4
Significance of Money
2.5
Demand for Money
2.6
Supply of Money
2.7
Summary
2.8
Exercise & Questions
2.9
Further Reference Books
2.1 Introduction
The term money in English is derived from Latin word 'moneta' which
means roman goddess Juno or Moneta. Money is an important and indispensable
element of modern civilization. It is considered to be the basis of all economic
activities. It is one of the most basic and significant inventions of mankind. Money
speeds up the wheel of Industry and makes business a grand success. In ordinary
usage, what we use to pay for things is called money. In India the rupee is the
money, in America the dollar is the money.
2.2 Objectives
At the end of this unit, you will be able to 1) Know the meaning of Money.
2) Understand the functions of Money.
3) Understand the concept of demand and supply of money.
2.3 Functions of Money
Traditionally, money has been defined on the basis of its general acceptability
and its functional aspect. To modern economist, crucial function of money is serves
as a store of value. Functions of money classified into primary and secondary.
Primary and Secondary Functions of Money!
1. Primary Functions (Main or Basic Functions)
2. Secondary Functions (Subsidiary or Derivative Functions)
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Money, Central Banking in
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Financial Institutions - I
1. Primary Functions:
Primary Functions include the most important functions of money, which it
must perform in every country,
These are:
(i) Medium of Exchange:
The most important function of money is to serve as a medium of exchange
or as a means of payment. To be a successful medium of exchange, money must
be commonly accepted by people in exchange for goods and services. While
functioning as a medium of exchange, money benefits the society in a number of
ways:
(a) It overcomes the inconvenience of barter system (i.e., the need for double
coincidence of wants) by splitting the act of barter into two acts of
exchange, i.e., sales and purchases through money.
(b) It promotes transactional efficiency in exchange by facilitating the multiple
exchange of goods and services with minimum effort and time,
(c) It promotes allocation efficiency by facilitating specialization in production
and trade,
(d) It allows freedom of choice in the sense that a person can use his money
to buy the things he wants most, from the people who offer the best
bargain and at a time he considers the most advantageous.
What are the benefits of medium of exchange of money?
FUNCTIONS OF MONEY
NOTES
CHECK YOUR
PROGRESS
Describe Secondary
Functions of Money?
(ii) Measure of Value (Unit of Value):
Money as measure of value means that money works as a common
denomination, in which values of all goods and services are expressed.
1. By reducing the value of all goods and services to a single unit (i.e. price),
it becomes very easy to find out the exchange ratios between them and
comparing their prices.
2. This function facilitates maintenance of business accounts, which would
be otherwise impossible.
3. Money helps in calculating relative prices of goods and services. Due to
this reason, it is regarded as a Unit of Account'. For instance, 'Rupee' is
the unit of account in India, 'Pound' in England and so on.
2. Secondary Functions:
These refer to those functions of money which are supplementary to the
primary functions. These functions are derived from primary functions and, therefore,
they are also known as 'Derivative Functions'.
The major secondary functions are:
(a) Standard of Deferred Payments:
Money as a standard of deferred payments means that money acts as a
'standard' for payments, which are to be made in future. Every day, millions of
transactions take place in which payments are not made immediately. Money
encourages such transactions and helps in capital formation and economic
development of the economy.
This function of money is significant because:
1. Money as a standard of deferred payments has simplified the borrowing
and lending operations.
2. It has led to the creation of financial institutions.
(b) Store of Value (Asset Function of Money):
Money as a store of value means that money can be used to transfer
purchasing power from present to future. Money is a way to store wealth. Although
wealth can be stored in other forms also, but money is the most economical and
convenient way. It provides security to individuals to meet contingencies,
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Money, Central Banking in
India and International
Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
NOTES
CHECK YOUR
PROGRESS
What is Significance
of Money?
unpredictable emergencies and to pay future debts. Under barter system, it was
difficult to use goods as a store of wealth due to perishable nature of some goods
and high cost of storage.
Money as store of value has the following advantages:
1. Money is available in fractional denomination, ranging from Rs 1 to Rs
1,000.
2. Money is easily portable. So, it is easy and economical to store money as
its storage does not require much space.
3. Money has the merit of general acceptability so; it can be easily exchanged
for goods at all times.
4. Savings in terms of money are much more secured than in terms of
goods.
In dynamic sense, money serves following functions.
(c) Transfer of Value:
Money also functions as a means of transferring value. Through money,
value can be easily and quickly transferred from one place to another because
money is acceptable everywhere and to all. For example, it is much easier to
transfer one lakh rupees through bank draft from person A in Amritsar to person B
in Bombay than remitting the same value in commodity terms, say wheat.
(D)Distribution of National Income:
Money facilitates the division of national income between people. Total
output of the country is jointly produced by a number of people as workers, land
owners, capitalists, and entrepreneurs, and, in turn, will have to be distributed among
them. Money helps in the distribution of national product through the system of
wage, rent, interest and profit.
(E) Maximization of Satisfaction:
Money helps consumers and producers to maximize their benefits. A
consumer maximizes his satisfaction by equating the prices of each commodity
(expressed in terms of money) with its marginal utility. Similarly, a producer
maximizes his profit by equating the marginal productivity of a factor unit to its
price.
(F) Basis of Credit System:
Credit plays an important role in the modern economic system and money
constitutes the basis of credit. People deposit their money (saving) in the banks
and on the basis of these deposits, the banks create credit.
(G) Liquidity to Wealth:
Money imparts liquidity to various forms of wealth. When a person holds
wealth in the form of money, he makes it liquid. In fact, all forms of wealth (e.g.,
land, machinery, stocks, stores, etc.) can be converted into money.
Explain the store of value function of Money
2.4 Significance of Money
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Money occupies a central position in our modern economy. Money is
everywhere and for everything in the modern economic life. Money has become
the religion of the day in the ordinary business of life.
As Marshall rightly put: "Money is the pivot around which economic science
clusters." And, "the major part of the subject matter of economics is concerned
with the functioning and malfunctioning of money."
1. Money has Facilitated Exchange and Promoted Trade:
In the first place by serving as a medium of exchange and a common
measure of value, money has removed the difficulties of the barter system and
promoted trade in the economy. The difficulties of the barter system, namely, lack
of double coincidence of wants, lack of division and lack of common measure of
value are well known. By removing these difficulties, money has greatly facilitated
the process of exchange. In the absence of money, trade and exchanges must
have been few and far between and entailed a great waste of time and energy.
FUNCTIONS OF MONEY
2. Money Promote Division of Labour and Productivity:
Money is of great importance as it promotes division of labour and
productivity in the modern economies. Since under the barter system, exchange
was difficult, a man had to be self-sufficient, that is, produced most of the goods
for himself. In the absence of money there were great difficulties in exchanging
goods and services. This worked as an obstacle to the division of labour and
specialisation among various individuals and nations.
Long ago Adam Smith clearly brought out in his now well-known book
"Wealth of Nations" how the division of labour and specialisation enhance
productivity and efficiency of labour force. It is this division of labour and
specialisation that has made the use of more efficient machines and advanced
technology possible for production of goods. Indeed, it is because of the outputaugmenting effect of division of labour that Adam Smith regarded increase in the
division of labour as progress in technology.
By opening up the opportunities of effecting division of labour, and through
facilitating exchange and trade of goods and services money contributes to the
expansion of production. Therefore, money enables the increase in the amount of
production and variety of goods and services produced. "If a modern economy
was somehow deprived of the monetary mechanism and was driven back to a
system of barter, the level of output would be much lower and the variety of goods
and services much smaller than is enjoyed with a money system."
NOTES
CHECK YOUR
PROGRESS
Describe Money
promoters Saving?
3. Money Promotes Saving:
A great significance of money is that it contributes a great deal to the
increase in saving of the economy. Money has made saving easier than in the
barter system. Increase in saving leads to the increase in investment which
determines economic growth of a country.
Further, money has made easier the acts of borrowing and lending and has
given birth to various financial institutions which promote saving. Investment which
is made possible by saving raises the rate of capital formation in the economy. The
higher level of output in the modern economy is mainly due to the extensive use of
capital in the production process.
4. Money helps in Maximizing Satisfaction or Profits by Consumers and
Producers:
Money is of immense advantage both to the consumers and producers. To
the consumers money represents a general purchasing power. He can buy anything
with money he has and at any time convenient to him. Since the values of goods
are expressed in terms of common measure i.e. money, the consumer can easily
compare the relative money prices of the goods and expected utilities from them.
A consumer can easily spend his given money income on various goods in
such a way that marginal utilities goods are proportional to their prices. With this he
will be maximising his satisfaction from his given income. Thus the existence of
money helps the consumer to maximise his satisfaction by acting on the principle
of equi-marginal utility.
Money helps the producer too. The producer can easily compare the money
cost and money income of the different levels of output. He can thus easily decide
about the level of output which maximises his profits by equating marginal cost
with marginal revenue (MC = MR).
Employee want food, clothing, shelter and so many other things. The
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NOTES
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D e s c r i b e
Classification of
Money?
producer cannot supply them all these things easily. But what be can do is to pay
them in money with which they buy the commodities they like at their own convince
and when they need them.
5. Money can help in Reviving the Economy from Recession or Depression:
According to modern economists, money may play an important role in
bringing about real changes. They point out that at times of recession or depression
when there exists a lot of idle productive capacity and unemployment of labour,
expansion of money supply, say through Government's deficit budget financed by
the creation of new money will cause aggregate expenditure or demand to shift
upward. This increase in aggregate expenditure or demand will cause output and
employment in the economy to rise and thus will help the economy to recover from
recession or depression.
Beneficial effect on output and employment of expansion in money supply
can be obtained even if Central bank of a country takes steps to expand money
supply in the economy say through reduction in Cash Reserve Ratio (CRR) and
through buying securities in the open market.
These steps by the central bank aim at expansion in credit availability for
the businessmen. The greater credit availability will lead to more private investment
which through multiplier process will cause income, output and employment to
rise. It follows from above that money is not neutral in its effect on real income and
employment. In fact, as seen just above it plays an important role in the determination
of the level of real economic activity.
CLASSIFICATION OF MONEY Money can be classified on the basis of relationship between the value of
money and value of money as a commodity. Value of money means the face value
of money.
For example, the face value of five rupees coin is five rupees. Value of
money as a commodity means the value of the commodity of which money is
made of. For example, the commodity value of money of a five rupee coin is the
cost of material (metal) used of which the coin is made.
If face value and commodity value of coin are the same, it is called standard
coin. On the other hand, if face value is greater than the commodity value of coin,
it is called token coin. These days, coins are token coins.
Categories of Money:
1. Commodity (full-bodied) money:
Commodity money is that whose face value is equal to its commodity
value. This type of money was in existence when gold standard was prevalent. In
other words, face value of the coin was equal to its intrinsic (commodity) value.
But now this kind of money is not to be found anywhere in the world.
2. Representative (full-bodied) money:
Though in spirit it is like the commodity (full-bodied) money but in form it
is different. This kind of money is usually made of paper but equal to the face value
of the money gold is kept in reserve. This money saves the users from the
inconvenience of carrying money in heavy-weight in case of large quantity because
paper money can be conveniently carried.
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3. Credit Money:
It is that money whose value of money (face-value) is greater than the
commodity value (intrinsic value) of money. Token coins and promissory notes are
part of credit money. Besides these, there are other forms of credit money also.
Various forms of credit money are the following:
(a) Token coins:
Token coins are those whose face value is more than their intrinsic value.
In India, coins of the money value of Rs. 5, Rs. 2, Rs. 1, 50 P, 25 P, 20 P, 10 P and
5 P are token coins.
(b) Representative Token Money:
This is usually of the form of paper, which is in effect a circulating ware
house receipt for token coins or an equivalent amount of bullion thus is backing it.
Not only this, the coin or bullion backing the representative token money is worth
less as a commodity than as money.
(c) Promissory Notes issued by Central Banks:
This is a major component of currency. It includes currency notes of all
denominations issued by Reserve Bank (excluding on rupee note). The system
governing note-issue in India is the Minimum Reserve System. Minimum Reserve
System stipulates that a minimum amount is kept in reserve in the form of gold and
foreign exchange. This means our currency is inconvertible.
(d) Bank Deposit:
Demand deposits (current and saving deposits) are the bank deposits which
can be withdrawn on demand. One can withdraw bank deposits at any time through
cheques. However, bank does not keep 100% reserves to meet the withdrawal of
demand deposits and hence these deposits are credit money.
What is the difference between face value and intrinsic value of money?
FUNCTIONS OF MONEY
NOTES
CHECK YOUR
PROGRESS
Describe Demand for
Money?
2.5 Demand for Money
In economics, the demand for money is generally equated with cash or
bank demand deposits. Generally, the nominal demand for money increases with
the level of nominal output and decreases with the nominal interest rate.
The equation for the demand for money is: Md = P * L(R,Y). This is the
equivalent of stating that the nominal amount of money demanded (Md) equals the
price level (P) times the liquidity preference function L(R,Y)--the amount of money
held in easily convertible sources (cash, bank demand deposits). Specific to the
liquidity function, L(R,Y), R is the nominal interest rate and Y is the real output.
Money is necessary in order to carry out transactions. However inherent
to the holding of money is the trade-off between the liquidity advantage of holding
money and the interest advantage of holding other assets.
When the demand for money is stable, monetary policy can help to stabilize
an economy. However, when the demand for money is not stable, real and nominal
interest rates will change and there will be economic fluctuations.
Impact of the Interest Rate
The interest rate is the rate at which interest is paid by a borrower (debtor)
for the use of money that they borrow from a lender (creditor). It is viewed as a
"cost" of borrowing money. Interest-rate targets are a tool of monetary policy. The
quantity of money demanded varies inversely with the interest rate. Central banks
in countries tend to reduce the interest rate when they want to increase investment
and consumption in the economy. However, low interest rates can create an economic
bubble where large amounts of investments are made, but result in large unpaid
debts and economic crisis. The interest rate is adjusted to keep inflation, the demand
for money, and the health of the economy in a certain range. Capping or adjusting
the interest rate parallel with economic growth protects the momentum of the
economy.
The demand for money is the relationship between the quantity of money
people want to hold and the factors that determine that quantity.
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Money, Central Banking in
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NOTES
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Describe Supply of
Money?
2.5.1 Motives for Holding Money
To understand the factors that determine demand for money, it helps to
know the four main motives she might have for holding money at any given time.
Firstly, People often holds money in the form of cash or checking accounts
in order to buy goods and services. Economists call this the transactions demand
for money. For example, People keeps cash in her wallet so she can buy groceries,
something she does every week. The more cash she has in her wallet at any given
time, the less time she has to take to go to the bank, stand in line and withdraw
more cash.
Secondly, People sometimes hold money as a safety net for unexpected
expenses. Economists call that the precautionary demand for money. When people
keep extra cash under the mattress in case her favorite store has a sale or in case
her minivan needs an emergency repair, she does this as a precaution.
Thirdly, People may hold some of wealth in the form of investments, such
as bonds, that pay her interest. Economists call this the speculative demand for
money. Since cash and most checking accounts don't pay much interest, but bonds
do, money demand varies negatively with interest rates. That means the demand
for money goes down when interest rates rise, and it goes up when interest rates
fall.
What is meant by speculative motive of Money?
2.6 Supply of Money
Money supply plays a crucial role in the determination of price level and
interest rate. In economic analysis it is generally presumed that money supply is
determined by the policy of Central Bank of a country and the Government.
However, this is not fully correct as in the determination of money supply,
besides Central Bank and Government, the public and commercial banks also play
an important role. There are various measures of money supply depending upon
which types of deposits of banks and other financial institutions are included in it.
2.6.1 Importance of Money Supply
Growth of money supply is an important factor not only for acceleration of
the process of economic development but also for the achievement of price stability
in the economy. There must be controlled expansion of money supply if the objective
of development with stability is to be achieved. A healthy growth of an economy
requires that there should be neither inflation nor deflation. Inflation is the greatest
headache of a developing economy.
A mild inflation arising out of the creation of money by deficit financing
may stimulate investment by raising profit expectations and extracting forced
savings. But a runaway inflation is highly detrimental to economic growth. The
developing economies have to face the problem of inadequacy of resources in
initial stages of development and it can make up this deficiency by deficit financing.
But it has to be kept strictly within safe limits. Thus, increase in money
supply affects vitally the rate of economic growth. In fact, it is now regarded as a
legitimate instrument of economic growth. Kept within proper limits it can accelerate
economic growth but exceeding of the limits will retard it. Thus, management of
money supply is essential in the interest of steady economic growth.
2.7 Summary
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Money is an important and indispensable element of modern civilization. It
is considered to be the basis of all economic activities.
At the beginning, there was no money. People engaged in barter, the
exchange of merchandise for merchandise, without value equivalence. A barter
economy is a cashless economic system in which services and goods are traded at
negotiated rates.
In the traditional sense, money serves as medium of exchange, measures
of value, store of value and standard of deferred payment.
In the modern economics, it serves dynamic functions like encouragement
to division of labour, Mobilization of Saving.
In economic analysis it is generally presumed that money supply is
determined by the policy of Central Bank of a country and the Government.
FUNCTIONS OF MONEY
NOTES
2.8 Exercise & Questions
Fill in the Blanks 1)
The term money in English is derived from ……………. word 'moneta'
which means roman goddess Juno or Moneta.
2)
money supply is determined by the policy of -----------.
3)
Money as a ……………….. Means that money can be used to transfer
purchasing power from present to future.
4)
---------- deposits (current deposits) are the bank deposits which can be
withdrawn on demand.
Short Answer Questions
1)
Define Money. Explain the role of money in economy.
2)
Money is liquid store of Value. Comment.
3)
How money has solved the problem of double coincidence of wants?
4)
Define Demand of Money.
5)
Explain the different motives of demand of Money.
Long Answer Questions
1)
Explain the Any Five functions of money.
2)
Explain the concept of demand and supply of money.
3)
Explain the significance of Money.
2.9 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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Money, Central Banking in
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NOTES
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What is Concept of
Money Supply and its
Measurement?
UNIT - 3
MEASUREMENT OF MONEY SUPPLY
Structure
3.1
Introduction
3.2
Objectives
3.3
The Concept of Money Supply and its Measurement
3.4
Four Measures of Money Supply
3.5
Determination of Money Supply
3.6
Summary
3.7
Exercise & Questions
3.8
Further Reference Books
3.1 Introduction
Money supply plays a crucial role in the determination of price level and
interest rate. In economic analysis it is generally presumed that money supply is
determined by the policy of Central Bank of a country and the Government. Currency
with public and demand deposit are the two important component of money supply.
RBI classified stock of money on the basis of liquidity. 1979 the RBI
classified money stock in India in the four categories. The third RBI working group
redefined its parameter for measuring money supply and introduced new monetary
aggregates.
M1 is called as narrow money and M3 is called as broad money. M4has
been excluded from the scheme of new monetary aggregates.
3.2 Objectives
At the end of this unit, you will be able to a) Know the classification of stock of Money.
b) Know the different measures of money supply
c) Understand the difference between narrow and broad money.
d) Know the determinants of Money Supply.
3.3 The Concept of Money Supply and its
Measurement
By money supply we mean the total stock of monetary media of exchange
available to a society for use in connection with the economic activity of the country.
According to the standard concept of money supply, it is composed of the
following two elements:
1. Currency with the public,
2. Demand deposits with the public.
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Before explaining these two components of money supply two things must
be noted with regard to the money supply in the economy.
First, the money supply refers 'to the total sum of money available to the
public in the economy at a point of time. That is, money supply is a stock concept
in sharp contrast to the national income which is a flow representing the value of
goods and services produced per unit of time, usually taken as a year.
Secondly, money supply always refers to the amount of money held by the
public. In the term public are included households, firms and institutions other than
banks and the government. The rationale behind considering money supply as held
by the public is to separate the producers of money from those who use money to
fulfill their various types of demand for money.
Since the Government and the banks produce or create money for the use
by the public, the money (cash reserves) held by them are not used for transaction
and speculative purposes and are excluded from the standard measures of money
supply. This separation of producers of money from the users of money is important
from the viewpoint of both monetary theory and policy.
Let us explain the two components of money supply at some length.
1) Currency with the Public:
In order to arrive at the total currency with the public in India we add the
following items:
1. Currency notes in circulation issued by the Reserve Bank of India.
2. The number of rupee notes and coins in circulation.
3. Small coins in circulation.
It is worth noting that cash reserves with the banks have to be deducted
from the value of the above three items of currency in order to arrive at the total
currency with the public. This is because cash reserves with the banks must remain
with them and cannot therefore be used for making payments for goods or by any
commercial banks' transactions.
It may further be noted that these days paper currency issued by Reserve
Bank of India (RBI) are not fully backed by the reserves of gold and silver, nor it
is considered necessary to do so. Full backing of paper currency by reserves of
gold prevailed in the past when gold standard or silver standard type of monetary
system existed.
According to the modem economic thinking the magnitude of currency
issued should be determined by the monetary needs of the economy and not by the
available reserves of gold and silver. As in other developed countries, since 1957
Reserve Bank of India follows Minimum Reserve System of issuing currency.
Under this system, minimum reserves of Rs. 200 crores of gold and other
approved securities (such as dollars, pound sterling, etc.) have to be kept and
against this any amount of currency can be issued depending on the monetary
requirements of the economy.
RBI is not bound to convert notes into equal value of gold or silver. In the
present times currency is inconvertible. The word written on the note, say 100
rupee notes and signed by the governor of RBI that 'I promise to pay the bearer a
sum of 100 rupees' is only a legacy of the past and does not imply its convertibility
into gold or silver.
Another important thing to note is that paper currency or coins are fiat
money, which means that currency notes and metallic coins serve as money on the
bases of the fiat (i.e. order) of the Government. In other words, on the authority of
the Government no one can refuse to accept them in payment for the transaction
made. That is why they are called legal tender.
2) Demand Deposits with the Public:
The other important components of money supply are demand deposits of
the public with the banks. These demand deposits held by the public are also called
bank money or deposit money. Deposits with the banks are broadly divided into
two types: demand deposits and time deposits.
Demand deposits in the banks are those deposits which can be withdrawn
MEASUREMENT OF
MONEY SUPPLY
NOTES
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NOTES
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What are Four
measures of Money
Supply?
by drawing cheque on them. Through cheque these deposits can be transferred to
others for making payments from which goods and services have been purchased.
Thus, cheque makes these demand deposits as a medium of exchange and
therefore makes them to serve as money. It may be noted that demand deposits
are fiduciary money proper. Fiduciary money is one which functions as money on
the basis of trust of the persons who make payment rather than on the basis of the
authority of Government.
Thus, despite the fact that demand deposits and cheques through which
they are operated are not legal' tender, they functions as money on the basis of the
trust commanded by those who draw cheques on them. They are money as they
are generally acceptable as medium of payment.
Bank deposits are created when people deposits currency with them. But
far more important is that banks themselves create deposits when they give advances
to businessmen and others. On the basis of small cash reserves of currency, they
are able to create a much larger amount of demand deposits through a system
called fractional reserve system which will be explained later in detail.
In the developed countries such as USA and Great Britain deposit money
accounted for over 80 per cent of the total money supply, currency being a relatively
small part of it. This is because banking system has greatly developed there and
also people have developed banking habits.
On the other hand, in the developing countries banking has not developed
sufficiently and also people have not acquired banking habits and they prefer to
make transactions in currency. However in India after 50 years of independence
and economic development the proportion of bank deposits in the money supply
has risen to about 50 per cent.
3.4 Four Measures of Money Supply
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Several definitions of money supply have been given and therefore various
measures of money supply based on them have been estimated. First, different
components of money supply have been distinguished on the basis of the different
functions that money performs.
For example, demand deposits, credit card and currency are used by the
people primarily as a medium of exchange for buying goods and services and
making other transactions. Obviously, they are money because they are used as a
medium of exchange and are generally referred to as M1. Another measure of
money supply is M3 which includes both M1 and time deposits held by the public in
the banks. Time deposits are money that people hold as store of value.
The main reason why money supply is classified into various measures on
the basis of its functions is that effective predictions can be made about the likely
affects on the economy of changes in the different components of money supply.
For example, if M1 is increasing firstly it can be reasonably expected that people
are planning to make a large number of transactions.
On the other hand, if time-deposits component of money-supply measure
M3 which serves as a store of value is increasing rapidly, it can be validly concluded
that people are planning to save more and accordingly consume less.
Therefore, it is believed that for monetary analysis and policy formulation,
a single measure of money supply is not only inadequate but may be misleading
too. Hence various measures of money supply are prepared to meet the needs of
monetary analysis and policy formulation.
Recently in India as well as in some developed countries, three concepts
of money supply have been distinguished. The definition of money supply given
above represents a narrow measure of money supply and is generally described as
M1. From April 1977, the Reserve Bank of India has adopted four concepts of
money supply in its analysis of the quantum of and variations in money supply.
The third RBI working group redefined its parameters for measuring money
supply. These are as follows.
1. Money Supply M1 or Narrow Money:
This is the narrow measure of money supply and is composed of the
following items:
M1 = C + DD + OD
Where
C = Currency with the public
DD = Demand deposits with the public in the Commercial and Cooperative Banks.
OD = Other deposits held by the public with Reserve Bank of India.
The money supply is the most liquid measure of money supply as the
money included in it can be easily used as a medium of exchange, that is, as a
means of making payments for transactions.
Currency with the public (C) in the above measure of money supply consists
of the followings:
(i) Notes in circulation.
(ii) Circulation of rupee coins as well as small coins
(iii) Cash reserves on hand with all banks.
Note that in measuring demand deposits with the public in the banks (i.e.,
DD), inter-bank deposits, that is, deposits held by a bank in other banks are excluded
from this measure.
In the other deposits with Reserve Bank of India (i.e., OD) deposits held
by the Central and State Governments and a few others such as RBI Employees
Pension and Provident Funds are excluded.
However, these other deposits of Reserve Bank of India include the
following items:
(i) Deposits of Institutions such UTI, IDBI, IFCI, NABARD etc.
(ii) Demand deposits of foreign Central Banks and Foreign Governments.
(iii) Demand deposits of IMF and World Bank.
It may be noted that other deposits of Reserve Bank of India constitute a
very small proportion (less than one per cent).
MEASUREMENT OF
MONEY SUPPLY
NOTES
2) Money Supply M2:
M2 is a broader concept of money supply in India than M1. Thus,
M2 = M1 + time liabilities portion of saving deposits with banks. + Certificate
of deposits issued by banks. + Time deposits maturing within a year excluding
FCNR.
The reason why money supply M2 has been distinguished from M1 is that
saving deposits with post office savings banks are not as liquid as demand deposits
with Commercial and Co-operative Banks as they are not chequable accounts.
However, saving deposits with post offices are more liquid than time deposits with
the banks.
3) Money Supply M3 or Broad Money:
M3 is a broad concept of money supply. Thus
M3 = M1 + Time Deposits with the banks maturity over one year+ term
borrowing of the banking system.
It is generally thought that time deposits serve as store of value and represent
savings of the people and are not liquid as they cannot be withdrawn through
drawing cheque on them. However, since loans from the banks can be easily
obtained against these time deposits, they can be used if found necessary for
transaction purposes in this way. Further, they can be withdrawn at any time by
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NOTES
forgoing some interest earned on them.
It may be noted that recently M3 has become a popular measure of money
supply. The working group on monetary reforms under the chairmanship of Late
Prof. Sukhamoy Chakravarty recommended its use for monetary planning of the
economy and setting target of the growth of money supply in terms of M3.
Therefore, recently RBI in its analysis of growth of money supply and its
effects on the economy has shifted to the use of M3measure of money supply.
4) Money Supply M4:
M4 has been excluded from the scheme of new monetary aggregates
3.5 Determination of Money Supply
CHECK YOUR
PROGRESS
What
is
Determination of
Money Supply?
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In order to explain the determinants of money supply in an economy we
shall use M1 concept of money supply which is the most fundamental concept of
money supply. We shall denote it simply by M rather than M1. As seen above this
concept of money supply is composed of currency held by the public (Cp) and
demand deposits with the banks (D). Thus
M =CP + D….. (i)
Where
M = Total money supply with the public
CP = Currency with the public
D = Demand deposits held by the public
The two important determinants of money supply as described in (1) are
(a) the amounts of high-powered money which is also called Reserve Money by
the Reserve Bank of India and (b) the size of money multiplier.
1. High-Powered Money (H):
The high-powered money which we denote by H consists of the currency
(notes and coins) issued by the Government and the Reserve Bank of India. A part
of the currency issued is held by the public, which we designate as CP and a part
is held by the banks as reserves which we designate as R.
A part of these currency reserves of the banks is held by them in their own
cash vaults and a part is deposited in the Reserve Bank of India in the Reserve
Accounts which banks hold with RBI. Accordingly, the high-powered money can
be obtained as sum of currency held by the public and the part held by the banks as
reserves. Thus
H =CP + R …(2)
Where
H = the amount of high-powered money
CP = Currency held by the public R
D = Cash Reserves of currency with the banks.
It is worth noting that Reserve Bank of India and Government are producers
of the high-powered money and the commercial banks do not have any role in
producing this high-powered money (H). However, commercial banks are producers
of demand deposits which are also used as money like currency.
But for producing demand deposits or credit, banks have to keep with
themselves cash reserves of currency which have been denoted by R in equation
(2) above. Since these cash reserves with the banks serve as a basis for the
multiple creations of demand deposits which constitute an important part of total
money supply in the economy, it provides high poweredness to the currency issued
by Reserve Bank and Government.
A glance at equations (1) and (2) above will reveal that the difference in
the two equations, one describing the total money supply and the other high-powered
money is that whereas in the former, demand deposits (D) are added to the currency
held by the public, in the later it is cash reserves (R) of the banks that are added to
the currency held by the public. In fact, it is against these cash reserves (R) that
banks are able to create a multiple expansion of credit or demand deposits due to
which there is large expansion in money supply in the economy.
The theory of determination of money supply is based on the supply of and
demand for high- powered money. Some economists therefore call it 'The H Theory
of Money Supply. However, it is more popularly called 'Money-multiplier Theory
of Money Supply' because it explains the determination of money supply as a
certain multiple of the high-powered money.
The amount of high-powered money is fixed by RBI by its past actions.
Thus, changes in high-powered money are the result of decisions of Reserve Bank
of India or the Government which own and control it.
MEASUREMENT OF
MONEY SUPPLY
NOTES
2. Money Multiplier:
As stated above, money multiplier is the degree to which money supply is
expanded as a) result of the increase in high-powered money. Thus
m = M/H
Rearranging we have, M = H.m…. (3)
Thus money supply is determined by the size of money multiplier (m) and
the amount of high- powered money (H). If we know the value of money multiplier
we can predict how much money will change when there is a change in the amount
of high-powered money.
As mentioned above, change in the high-powered money is decided and
controlled by Reserve Bank of India, the money multiplier determines the extent to
which decision by RBI regarding the change in high-powered money will bring
about change in the total money supply in the economy.
3.6 Summary
Money is an important and indispensable element of modern civilization. It
is considered to be the basis of all economic activities.
In economic analysis it is generally presumed that money supply is
determined by the policy of Central Bank of a country and the Government. Currency
with public and demand deposit are the two important component of money suppl.
The money stock in India is divided into narrow money and broad money.
Narrow money excludes time deposits of the public with the banking system while
broad money includes it. M4 is excluded from stock.
The money supply refers 'to the total sum of money available to the public
in the economy at a point of time.
In economic analysis it is generally presumed that money supply is
determined by the policy of Central Bank of a country and the Government.
The two important determinants of money supply as described in (1) are
(a) the amounts of high-powered money which is also called Reserve Money by
the Reserve Bank of India and (b) the size of money multiplier.
3.7 Exercise & Questions
Fill in the Blanks 1)
………… is a broad concept of money supply.
2)
In------ the RBI classified money stock in India in the four categories.
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3)
4)
These ------------ deposits held by the public are also called bank money or
deposit money.
------- has been excluded from the scheme of new monetary aggregates.
Short Answer Questions
1)
Write a short note on Narrow Money.
2)
Distinction between Narrow Money and Broad Money.
3)
Explain the components of Narrow Money.
4)
Write a short note on High powered money.
Long Answer Questions 1)
Explain the different measurement of Money supply in India.
2)
Explain the determinants of Money Supply.
3)
explain the components of money supply.
3.8 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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UNIT - 4
THEORY OF MONEY
THEORY OF MONEY
NOTES
Structure
4.1
Introduction
4.2
Objectives
4.3
Price and Economy
4.4
Confusion between prices and costs of production
4.5
Other price terms
4.6
Fishers Quantity theory of Money
4.6
Quantity Theory of Money: The Cambridge Cash Balance Approach
4.7
Summary
4.8
Exercise & Questions
4.9
Further Reference Books
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Relationship with
Price and Economy?
4.1 Introduction
Money is an important and indispensible element of modern civilization. In
ordinary usage what we use to pay for thing is called money.
In ordinary usage, price is the quantity of payment or compensation given
by one party to another in return for goods or services.
4.2 Objectives
At the end of this unit, you will be able to 1) Know the meaning of Price
2) Know the difference between price and cost
3) Understand the quantity theory of money
4.3 Price and Economy
l
l
As the consideration given in exchange for transfer of ownership, priceforms
the essential basis of commercial transactions. It may be fixed by a contract,
left to be determined by an agreed upon formula at a future date, or discovered
or negotiated during the course of dealings between the parties involved.
In commerce, price is determined by what (1) a buyer is willing to pay, (2) a
seller is willing to accept, and (3) the competition is allowing to be charged.
In ordinary usage, price is the quantity of payment or compensation given
by one party to another in return for goods or services.[1]
In modern economies, prices are generally expressed in units of some
form of currency. (For commodities, they are expressed as currency per unit weight
of the commodity, e.g. euros per kilogram.) Although prices could be quoted as
quantities of other goods or services this sort of barter exchange is rarely seen.
Prices are sometimes quoted in terms of vouchers such as trading stamps and air
miles. In some circumstances, cigarettes have been used as currency, for example
in prisons, in times of hyperinflation, and in some places during World War 2. In a
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black market economy, barter is also relatively common.
In many financial transactions, it is customary to quote prices in other
ways. The most obvious example is in pricing a loan, when the cost will be expressed
as the percentage rate of interest. The total amount of interest payable depends
upon credit risk, the loan amount and the period of the loan. Other examples can be
found in pricing financial derivatives and other financial assets. For instance the
price of inflation-linked government securities in several countries is quoted as the
actual price divided by a factor representing inflation since the security was issued.
Price sometimes refers to the quantity of payment requested by a seller of
goods or services, rather than the eventual payment amount. This requested amount
is often called the asking price or selling price, while the actual payment may be
called the transaction price or traded price. Likewise, the bid price or buying price
is the quantity of payment offered by a buyer of goods or services, although this
meaning is more common in asset or financial markets than in consumer markets.
Economists sometimes define price more generally as the ratio of the
quantities of goods that are exchanged for each other.
Price theory Economic theory asserts that in a free market economy the
market price reflects interaction between supply and demand: the price is set so as
to equate the quantity being supplied and that being demanded. In turn these
quantities are determined by the marginal utility of the asset to different buyers and
to different sellers. In reality, the price may be distorted by other factors, such as
tax and other government regulations.
When a commodity is for sale at multiple locations, the law of one price is
generally believed to hold. This essentially states that the cost difference between
the locations cannot be greater than that representing shipping, taxes, other
distribution costs and more. In the case of the majority of consumer goods and
services, distribution costs are quite a high proportion of the overall price, so the
law may not be very useful.
4.4 Confusion between prices and costs of production
Price is commonly confused with the notion of cost of production, as in "I
paid a high cost for buying my new plasma television"; but technically these are
different concepts. Price is what a buyer pays to acquire products from a seller.
Cost of production concerns the seller's investment (e.g., manufacturing expense)
in the product being exchanged with a buyer. For marketing organizations seeking
to make a profit, the hope is that price will exceed cost of production so that the
organization can see financial gain from the transaction.
Finally, while pricing is a topic central to a company's profitability, pricing
decisions are not limited to for-profit companies. The behavior of non-profit
organizations, such as charities, educational institutions and industry trade groups,
also involve setting prices.[2]:160-165 For instance, charities seeking to raise money
may set different "target" levels for donations that reward donors with increases in
status (e.g., name in newsletter), gifts or other benefits; likewise educational and
cultural nonprofits often price seats for events in theatres, auditoriums and stadiums.
Furthermore, while nonprofit organizations may not earn a "profit", by definition, it
is the case that many nonprofits may desire to maximize net revenue-total revenue
less total cost-for various programs and activities, such as selling seats to theatrical
and cultural performances.[2]:183-194
4.5 Other price terms
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Basic price is the price a seller gets after removing any taxes paid by a
buyer and adding any subsidy the seller gets for selling.
Producer price is the amount the producer gets from a buyer for a unit of
a good or service produced as output minus any tax, it excludes any transport
charges invoiced separately by the producer.
Price optimization is the use of mathematical analysis by a company to
determine how customers will respond to different prices for its products and services
through different channels.
THEORY OF MONEY
NOTES
4.6 Fishers Quantity theory of Money
Quantity theory of money states that money supply and price level in an
economy are in direct proportion to one another.
Definition: Quantity theory of money states that money supply and price
level in an economy are in direct proportion to one another. When there is a change
in the supply of money, there is a proportional change in the price level and viceversa.
It is supported and calculated by using the Fisher Equation on Quantity
Theory of Money.
M*V= P*T
where,
M = Money supply
V = Velocity of money
P = Price level
T = volume of the transactions
CHECK YOUR
PROGRESS
What is Fishers
quantity theory of
money?
Description: The theory is accepted by most economists per se. However,
Keynesian economists and economists from the Monetarist School of Economics
have criticized the theory.
According to them, the theory fails in the short run when the prices are
sticky. Moreover, it has been proved that velocity of money doesn't remain constant
over time. Despite all this, the theory is very well respected and is heavily used to
control inflation in the market.
The concept of the quantity theory of money (QTM) began in the 16th
century. As gold and silver inflows from the Americas into Europe were being
minted into coins, there was a resulting rise in inflation. This led economist Henry
Thornton in 1802 to assume that more money equals more inflation and that an
increase in money supply does not necessarily mean an increase in economic output.
Here we look at the assumptions and calculations underlying the QTM, as well as
its relationship to monetarism and ways the theory has been challenged.
QTM in a Nutshell
The quantity theory of money states that there is a direct relationship
between the quantity of money in an economy and the level of prices of goods and
services sold. According to QTM, if the amount of money in an economy doubles,
price levels also double, causing inflation (the percentage rate at which the level of
prices is rising in an economy). The consumer therefore pays twice as much for
the same amount of the good or service.
Another way to understand this theory is to recognize that money is like
any other commodity: increases in its supply decrease marginal value (the buying
capacity of one unit of currency). So an increase in money supply causes prices to
rise (inflation) as they compensate for the decrease in money's marginal value.
The Theory's Calculations
In its simplest form, the theory is expressed as:
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What is Quantity
Theory of Money?
MV = PT (the Fisher Equation)
Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services
The original theory was considered orthodox among 17th century classical
economists and was overhauled by 20th-century economists Irving Fisher, who
formulated the above equation, and Milton Friedman. (For more on this important
economist, see Free Market Maven: Milton Friedman.)
It is built on the principle of "equation of exchange":
Velocity of circulation = total spending
Amount of Money x
Thus if an economy has US$3, and those $3 were spent five times in a
month, total spending for the month would be $15.
QTM Assumptions
QTM adds assumptions to the logic of the equation of exchange. In its
most basic form, the theory assumes that V (velocity of circulation) and T (volume
of transactions) are constant in the short term. These assumptions, however, have
been criticized, particularly the assumption that V is constant. The arguments point
out that the velocity of circulation depends on consumer and business spending
impulses, which cannot be constant.
The theory also assumes that the quantity of money, which is determined
by outside forces, is the main influence of economic activity in a society. A change
in money supply results in changes in price levels and/or a change in supply of
goods and services. It is primarily these changes in money stock that cause a
change in spending. And the velocity of circulation depends not on the amount of
money available or on the current price level but on changes in price levels.
Finally, the number of transactions (T) is determined by labor, capital, natural
resources (i.e. the factors of production), knowledge and organization. The theory
assumes an economy in equilibrium and at full employment.
Essentially, the theory's assumptions imply that the value of money is
determined by the amount of money available in an economy. An increase in money
supply results in a decrease in the value of money because an increase in money
supply causes a rise in inflation. As inflation rises, the purchasing power, or the
value of money, decreases. It therefore will cost more to buy the same quantity of
goods or services.
4.6 Quantity Theory of Money: The Cambridge Cash
Balance Approach
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The equation of exchange has been stated by Cambridge economists,
Marshall and Pigou, in a form different from Irving Fisher. Cambridge economists
explained the determination of value of money in line with the determination of
value in general.
Value of a commodity is determined by demand for and supply of it and
likewise, according to them, the value of money (i.e., its purchasing power) is
determined by the demand for and supply of money. As studied in cash-balance
approach to demand for money Cambridge economists laid stress on the store of
value function of money in sharp contrast to the medium of exchange function of
money emphasised by in Fisher's transactions approach to demand for money.
According to cash balance approach, the public likes to hold a proportion
of nominal income in the form of money (i.e., cash balances). Let us call this
proportion of nominal income that people want to hold in money as k.
Then cash balance approach can be written as:
Md =kPY ….(1)
Y = real national income (i.e., aggregate output)
P = the price level PY = nominal national income
k = the proportion of nominal income that people want to hold in money
Md = the amount of money which public want to hold
Now, for the achievement of money-market equilibrium, demand for money
must equal worth the supply of money which we denote by M. It is important to
note that the supply of money M is exogenously given and is determined by the
monetary policies of the central bank of a country. Thus, for equilibrium in the
money market.
M = Md
As Md =kPY
Therefore, in equilibrium M = kPY …(2)
Monetary equilibrium Cambridge cash balance approach is shown in Fig.
20.2 where demand for money is shown by a rising straight line kPY which indicates
that with k and Y being held constant demand for money increases proportionately
to the rise in price level. As price level rises people demand more money for
transaction purposes. Now, if supply of money fixed by the Government (or the
Central Bank) is equal to M0, the demand for money APK equals the supply of
money, M0 at price level P0. Thus, with supply of money equal to M0 equilibrium
price level P0 is determined. If money supply is increased, how the monetary
equilibrium will change? Suppose money supply is increased to M1 at the initial
price level P0 the people will be holding more money than they demand at it.
Therefore, they would want to reduce their money holding. In order to
reduce their money holding they would increase their spending on goods and
services. In response to the increase in money spending by the households the
firms will increase prices of their goods and services.
As prices rise, the households will need and demand more money to hold
for transaction purposes (i.e., for buying goods and services). It will be seen from
Fig. 20.2 that with the increase in money supply to M1 new equilibrium between
demand for money and supply of money is attained at point E1 on the demand for
money curve kPY and price level has risen to P1.
It is worth mentioning that k in the equations (1) and (2) is related to
velocity of circulation of money V in Fisher's transactions approach. Thus, when a
greater proportion of nominal income is held in the form of money (i.e., when k is
higher), V falls. On the other hand, when less proportion of nominal income is held
in money, K rises. In the words of Crowther, "The higher the proportion of their
real incomes that people decide to keep in money, the lower will be the velocity of
circulation, and vice versa.
THEORY OF MONEY
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It follows from above that k = 1/V. Now, rearranging equation (2) we have
cash balance approach in which P appears as dependent variable. Thus, on
rearranging equation (2) we have
P = 1/k.M/Y…………(3)
Like Fisher's equation, cash balance equation is also an accounting identity
because k is defined as:
Quantity of Money Supply/National Income, that is, M/PY
Now, Cambridge economists also assumed that k remains constant. Further,
due to their belief that wage-price flexibility ensures full employment of resources,
the level of real national income was also fixed corresponding to the level of
aggregate output produced by full employment of resources.
Thus, from equation (3) it follows that with k and Y remaining constant
price level (P) is deter-mined by the quantity of money (M); changes in the quantity
of money will cause proportionate changes in the price level.
Some economists have pointed out similarity between Cambridge cashbalance approach and
Fisher's transactions approach. According to them, k is reciprocal of
V (k = 1/V or V = 1/k). Thus in equation (2) if we replace k by, we have
M = 1/PY
Or MV=PY
Which is income version of Fisher's quantity theory of money? However,
in spite of the formal similarity between the cash balance and transactions
approaches, there are important conceptual differences between the two which
makes cash balance approach superior to the transactions approach. First, as
mentioned above.
Fisher's transactions approach lays stress on the medium of exchange
function of money, that is, according to its people want money to use it as a means
of payment for buying goods and services. On the other hand, cash balance approach
emphasizes the store-of-value function of money. They hold money so that some
value is stored for spending on goods and services after some lapse of time.
Further, in explaining the factors which determine velocity of circulation,
transactions approach points to the mechanical aspects of payment methods and
practices such as frequency of wages and other factor payments, the speed with
which funds can be sent from one place to another, the extent to which bank
deposits and cheques are used in dealing with others and so on.
On the other hand, k in the cash balance approach is behavioural in nature.
Thus, according to Prof S.B. Gupta, "Cash- balance approach is behavioural in
nature: it is build around the demand for money, however simple. Unlike Fisher s V,
k is a behavioural ratio. As such it can easily lead to stress being placed on the
relative usefulness of money as an asset."
Thirdly, cash balance approach explains determination of value of money
in a framework of general demand-supply analysis of value. Thus, according to
this approach value of money (that is, its purchasing power is determined by the
demand for and supply of money).
To sum up cash balance approach has made some improvements over
Fisher's transactions approach in explaining the relation between money and prices.
However it is essentially the same as the Fisher's transactions approach. Like
Fisher's approach if considers substitution between money and commodities.
That is, if they decide to hold less money, they spend more on commodities
rather than on other assets such as bonds, shares real property, and durable
consumer goods. Further, like Fisher's transactions approach it visualises changes
in the quantity of money causes proportional changes in the price level.
Like Fisher's approach, cash balance approach also assumes that full-
employment of resources will prevail due to the wage-price flexibility. Hence, it
also believes the aggregate supply curve as perfectly inelastic at full-employment
level of output.
An important limitation of cash balance approach is that it also assumes
that the proportion to income that people want to hold in money, that is, k, remains
constant. Note that. In practice it has been found that proportionality factor k orvelocity of circulation has not remained constant but has been fluctuating, especially
in the short run.
Besides, cash-balance approach falls short of considering demand for
money as an asset. If demand for money as an asset were considered, it would
have a determining influence on the rate of interest on which amount of investment
in the economy depends. Investment plays an important role in the determination
of/level of real income in the economy.
It was left to J.M. Keynes who later emphasised the role of demand for
money as an asset which was one of the alternative assets in which individuals can
keep their income or wealth. Finally, it may be mentioned that other criticisms of
Fisher's transactions approach to quantity theory of money discussed above equally
apply to the Cambridge cash balance approach.
THEORY OF MONEY
NOTES
Keynes's Critique of the Quantity Theory of Money:
The quantity theory of money has been widely criticised.
1. Useless truism:
With the qualification that velocity of money (V) and the total output (T)
remain the same, the equation of exchange (MV= PT) is a useless truism. The real
trouble is that these things seldom remain the same. They change not only in the
long run but also in a short period. Fisher's equation of exchange simply tells us that
expenditure made on goods (MV) is equal to the value of output of goods and
services sold (PT).
2. Velocity of money is not stable:
Keynesian economists have challenged the assumption that velocity of
money remains stable. According to them, velocity of money changes inversely
with the change in money supply. They argue that increase in money supply, demand
for money remaining constant, leads to the fall in the rate of interest.
At a lower rate of interest, people will be induced to hold more money as
idle cash balances (under speculative motive). This means velocity of circulation
of money will be reduced. Thus, if a decline in interest rate reduces velocity, then
increase in the money supply will be offset by reduction in velocity, with the result
that price level, need not rise when money supply is increased.
3. Increase in quantity of money may not always lead to the increase in
aggregate spending or demand:
Further, according to Keynes' the quantity theory of money is based upon
two more wrong assumptions.
Basically, for, the quantity theory to be true, the following two assumptions
must hold:
(i) An increase is money supply must lead to an increase in spending, that is,
aggregate demand i.e., no part of additional money created should be
kept in idle hoards.
(ii) The resulting increase in spending or aggregate demand must face a
totally inelastic output.
Both the assumptions according to Keynes, lack generality and, therefore,
it either of them does not hold, the quantity theory cannot be accepted as a valid
explanation of the changes in price level.
Let us take the first assumption. Under this assumption, the entire increase
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in the quantity of money must express itself in the form of increased spending. If
spending does not increase, there is no question of a change in prices or output.
But, is it valid to make such an assumption?
Obviously, there is no such direct link between the increase in the quantity
of money and the increase in the volume of total spending or aggregate demand.
No one is going to increase his expenditure simply because the government is
printing more notes or the banks are more liberal in their lending policies. Thus, if
the demand for money is highly interest-elastic, the increase in money supply will
not lead to any appreciable fall in the rate of interest.
With no significant fall in rate of interest, the investment expenditure and
expenditure on durable consumer goods will not increase much. As a result, increase
in money supply may not lead to increase in expenditure or aggregate demand and
therefore price level may remain unaffected.
This is not to say, however, that changes in the quantity of money have no
influence whatsoever on the volume of aggregate spending. As we shall show
below, changes in the quantity of money are often capable of inducing changes in
the volume of aggregate spending. What Keynes and his followers deny is the
assertion that there exists a direct, simple, and more or less a propor-tional relation
between variation in money supply and variation in the level of total spending.
4. Assumption of constant volume of transactions or constant level of
aggregate output is not valid:
Keys asserted that the assumption of constant aggregate output valid only
under conditions of full employment. It is only then that we can assume a totally
inelastic supply of output, for all the available resources are being already fully
utilised. In conditions of less than full employment, the supply curve of output will
be elastic.
Now, if we assume that aggregate spending or demand increases with an
increase in the quantity of money, it does not follow that prices must necessarily
rise. If the supply curve of output is fairly elastic, it is more likely that effect of an
increase in spending will be more to raise production rather than prices.
Of course, at full-employment level every further increase in spending or
aggregate demand must lead to the rise in the price level as output is inelastic in
supply at full-employment level. Since full-employment cannot be assumed to be a
normal affair, we cannot accept the quantity theory of money as a valid explanation
of changes in the price level in the short run.
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The quantity theory of money states that the quantity of money is the main
determinant of the price level or the value of money. Any change in the quantity of
money produces an exactly proportionate change in the price level.
In the words of Irving Fisher, "Other things remaining unchanged, as the
quantity of money in circulation increases, the price level also increases in direct
proportion and the value of money decreases and vice versa." If the quantity of
money is doubled, the price level will also double and the value of money will be
one half. On the other hand, if the quantity of money is reduced by one half, the
price level will also be reduced by one half and the value of money will be twice.
Fisher has explained his theory in terms of his equation of exchange:
PT=MV+ M' V'
Where P = price level, or 1 IP = the value of money;
M = the total quantity of legal tender money;
V = the velocity of circulation of M;
M' - the total quantity of credit money;
V' = the velocity of circulation of M;
T = the total amount of goods and services exchanged for money or
transactions performed by money.
This equation equates the demand for money (PT) to supply of money
(MV=M'V). The total volume of transactions multiplied by the price level (PT)
represents the demand for money.
According to Fisher, PT is SPQ. In other words, price level (P) multiplied
by quantity bought (Q) by the community (S) gives the total demand for money.
This equals the total supply of money in the community consisting of the quantity of
actual money M and its velocity of circulation V plus the total quantity of credit
money M' and its velocity of circulation V'. Thus the total value of purchases (PT)
in a year is measured by MV+M'V'. Thus the equation of exchange is
PT=MV+M'V'. In order to find out the effect of the quantity of money on the price
level or the value of money, we write the equation as
P= MV+M'V'
T
Fisher points out the price level (P) (M+M') provided the volume of tra
remain unchanged. The truth of this proposition is evident from the fact that if M
and M' are doubled, while V, V and T remain constant, P is also doubled, but the
value of money (1/P) is reduced to half.
Fisher's quantity theory of money is explained with the help of Figure 65.1.
(A) and (B). Panel A of the figure shows the effect of changes in the quantity of
money on the price level. To begin with, when the quantity of money is M, the price
level is P.
THEORY OF MONEY
NOTES
When the quantity of money is doubled to M2, the price level is also doubled
to P2. Further, when the quantity of money is increased four-fold to M4, the price
level also increases by four times to P4. This relationship is expressed by the curve
P = f (M) from the origin at 45°.
In panel ? of the figure, the inverse relation between the quantity of money
and the value of money is depicted where the value of money is taken on the
vertical axis. When the quantity of money is M1 the value of money is HP. But
with the doubling of the quantity of money to M2, the value of money becomes
one-half of what it was before, 1/P2. And with the quantity of money increasing by
four-fold to M4, the value of money is reduced by 1/P4. This inverse relationship
between the quantity of money and the value of money is shown by downward
sloping curve 1/P = f (M).
Assumptions of the Theory:
Fisher's theory is based on the following assumptions:
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Give Criticism on
Fishers Quantity
Theory?
1. P is passive factor in the equation of exchange which is affected by the
other factors.
2. The proportion of M' to M remains constant.
3. V and V are assumed to be constant and are independent of changes in
M and M'.
4. T also remains constant and is independent of other factors such as M,
M, V and V.
5. It is assumed that the demand for money is proportional to the value of
transactions.
6. The supply of money is assumed as an exogenously determined constant.
7. The theory is applicable in the long run.
8. It is based on the assumption of the existence of full employment in the
economy.
Criticisms of the Theory:
1. The Fisherian quantity theory has been subjected to severe criticisms
by economists.
1. Truism:
According to Keynes, "The quantity theory of money is a truism." Fisher's
equation of exchange is a simple truism because it states that the total quantity of
money (MV+M'V') paid for goods and services must equal their value (PT). But it
cannot be accepted today that a certain percentage change in the quantity of money
leads to the same percentage change in the price level.
2. Other things not equal:
The direct and proportionate relation between quantity of money and price
level in Fisher's equation is based on the assumption that "other things remain
unchanged". But in real life, V, V and T are not constant. Moreover, they are not
independent of M, M' and P. Rather, all elements in Fisher's equation are interrelated
and interdependent. For instance, a change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change
in the quantity of money. Similarly, a change in P may cause a change in M. Rise in
the price level may necessitate the issue of more money. Moreover, the volume of
transactions T is also affected by changes in P. When prices rise or fall, the volume
of business transactions also rises or falls. Further, the assumptions that the proportion
M' to M is constant, has not been borne out by facts. Not only this, M and M' are
not independent of T. An increase in the volume of business transactions requires
an increase in the supply of money (M and M').
3. Constants Relate to Different Time:
Prof. Halm criticises Fisher for multiplying M and V because M relates to
a point of time and V to a period of time. The former is a static concept and the
latter a dynamic. It is therefore, technically inconsistent to multiply two noncomparable factors.
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4. Fails to Measure Value of Money:
Fisher's equation does not measure the purchasing power of money but
only cash transactions, that is, the volume of business transactions of all kinds or
what Fisher calls the volume of trade in the community during a year. But the
purchasing power of money (or value of money) relates to transactions for the
purchase of goods and services for consumption. Thus the quantity theory fails to
measure the value of money.
5. Weak Theory:
According to Crowther, the quantity theory is weak in many respects.
First, it cannot explain 'why' there are fluctuations in the price level in the short run.
Second, it gives undue importance to the price level as if changes in prices were
the most critical and important phenomenon of the economic system. Third, it
places a misleading emphasis on the quantity of money as the principal cause of
changes in the price level during the trade cycle.
Prices may not rise despite increase in the quantity of money during
depression; and they may not decline with reduction in the quantity of money during
boom. Further, low prices during depression are not caused by shortage of quantity
of money, and high prices during prosperity are not caused by abundance of quantity
of money. Thus, "the quantity theory is at best an imperfect guide to the causes of
the trade cycle in the short period" according to Crowther.
THEORY OF MONEY
NOTES
6. Neglects Interest Rate:
One of the main weaknesses of Fisher's quantity theory of money is that it
neglects the role of the rate of interest as one of the causative factors between
money and prices. Fisher's equation of exchange is related to an equilibrium situation
in which rate of interest is independent of the quantity of money.
7. Unrealistic Assumptions:
Keynes in his General Theory severely criticised the Fisherian quantity
theory of money for its unrealistic assumptions. First, the quantity theory of money
for its unrealistic assumptions. First, the quantity theory of money is unrealistic
because it analyses the relation between M and P in the long run. Thus it neglects
the short run factors which influence this relationship. Second, Fisher's equation
holds good under the assumption of full employment. But Keynes regards full
employment as a special situation. The general situation is one of the underemployment equilibrium. Third, Keynes does not believe that the relationship between
the quantity of money and the price level is direct and proportional.
Rather, it is an indirect one via the rate of interest and the level of output.
According to Keynes, "So long as there is unemployment, output and employment
will change in the same proportion as the quantity of money, and when there is full
employment, prices will change in the same proportion as the quantity of money."
Thus Keynes integrated the theory of output with value theory and monetary theory
and criticised Fisher for dividing economics "into two compartments with no doors
and windows between the theory of value and theory of money and prices."
8. V not Constant:
Further, Keynes pointed out that when there is underemployment
equilibrium, the velocity of circulation of money V is highly unstable and would
change with changes in the stock of money or money income. Thus it was unrealistic
for Fisher to assume V to be constant and independent of M.
9. Neglects Store of Value Function:
Another weakness of the quantity theory of money is that it concentrates
on the supply of money and assumes the demand for money to be constant. In
order words, it neglects the store-of-value function of money and considers only
the medium-of-exchange function of money. Thus the theory is one-sided.
10. Neglects Real Balance Effect:
Don Patinkin has critcised Fisher for failure to make use of the real balance
effect, that is, the real value of cash balances. A fall in the price level raises the
real value of cash balances which leads to increased spending and hence to rise in
income, output and employment in the economy. According to Patinkin, Fisher
gives undue importance to the quantity of money and neglects the role of real
money balances.
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NOTES
11. Static:
Fisher's theory is static in nature because of its such unrealistic assumptions
as long run, full employment, etc. It is, therefore, not applicable to a modern dynamic
economy.
4.7 Summary
In ordinary usage, price is the quantity of payment or compensation given
by one party to another in return for goods or services.
Quantity theory of money states that money supply and price level in an
economy are in direct proportion to one another. When there is a change in the
supply of money, there is a proportional change in the price level and vice-versa.
According to cash balance approach, the public likes to hold a proportion
of nominal income in the form of money (i.e., cash balances).
Fisher has explained his theory in terms of his equation of exchange:
PT=MV+ M' V'
Where P = price level, or 1 IP = the value of money;
M = the total quantity of legal tender money;
V = the velocity of circulation of M;
M' - the total quantity of credit money;
V' = the velocity of circulation of M;
T = the total amount of goods and services exchanged for money or
transactions performed by money.
4.8 Exercise & Questions
Fill in the Blanks 1)
---------is the quantity of payment or compensation given by one party to
another in return for goods or services.
2)
----------- is the price a seller gets after removing any taxes paid by a buyer
and adding any subsidy the seller gets for selling.
3)
Fisher has explained his theory in terms of his equation of exchange --------------------.
4)
One of the main weaknesses of --------------- of money is that it neglects the
role of the rate of interest as one of the causative factors between money
and prices.
Short answer Questions 1)
Define Price.
2)
Distinguish between price and cost.
3)
Write down the equation of fisher's quantity theory of money.
4)
Write down any two assumptions of Quantity theory of money.
Long Answer Questions.
1)
Explain the quantity theory of Money.
2)
Explain the Cambridge cash balance approach.
3)
Explain Fishers theory of Money.
4.9 Further Reference Books
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Money, Central Banking in
India and International
Financial Institutions - I
l Indian Financial System - Dr. S Gurusamy
l Central Banking for Emerging Market Economies - A. Vasudevan
l Money & Banking : Theory with Indian Banking - Hajela T.N.
l International Financial Institutions and Indian Banking - Autar Krishen
and Mihir Chatterjee
UNIT - 5
MODERN MONETARISM
MODERN MONETARISM
NOTES
Structure
5.1
Introduction
5.2
Objectives
5.3
Keynesian theory - Income Approach
5.4
Monetarism: An Introduction
5.5
Keynes's Reformulated Quantity Theory of Money
5.6
Summary
5.7
Exercise & Questions
5.8
Further Reference Books
5.1 Introduction
The old monetarists like Irving Fisher put forward quantity theory of money
which explained that changes in money supply had a direct and proportionate
relationship with the price level. However, modem monetarists led by Prof. Milton
Friedman of Chicago University have put forward an alternative macroeconomics
to the Keynesian macroeconomic theory. The Monetarism and Friedman's
Modern Quantity Theory of Money!
CHECK YOUR
PROGRESS
What is Keynesians
Theory?
5.2 Objectives
At the end of this unit, you will be able to 1) Know modern theory of Monetarism.
2) Understand the theory of Friedman
3) Understand the income approach of Keynes. .
5.3 Keynesian theory - Income Approach
It is important to note that the main difference between the monetarists
and Keynesians lies in their approaches to the determination of aggregate demand.
While Keynesians hold that many different factors such as consumption investment
Government expenditure, taxes, exports and money determine aggregate demand,
monetarists argue it is the changes in money supply that are primary factor in
determining aggregate demand which affect both output and prices.
Besides, there are important ideological differences between the monetarists
and Keynesians. Monetarists believe that a private market economy is inherently
stable and if left free will automatically adjust itself to full-employment level of
output.
Therefore, they argue that there is no need for Government intervention in
the economy. In fact, they point out that it is the discretionary monetary and fiscal
policies pursued by the monetary authorities and Government that are responsible
for much instability in the private economies.
On the other hand, Keynesians believe that private economy is inherently
un-liable and for its stabilisation and growth, the Government should play an active
role by adopting proper discretionary fiscal and monetary policies.
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1. Two Different Approaches to Aggregate Demand:
Keynesians focus on aggregate demand as a determinant of income and
employment and view it as a sum of consumption, investment, Government
expenditure and net exports (that is, exports- imports). In symbolic terms Keynesian
aggregate demand is written as
AD = C + I + G + (X-M)
Keynesians equate it with value of goods and services produced to
determine equilibrium level of national income or national product. Thus,
C+I+G+X-M=Y
where Y is national income or Gross National Product (GNP).
On the other hand, monetarists focus on only money supply as a primary
determinant of aggregate demand.
The fundamental equation of monetarists is the equation of exchange which
is as under:
MV = PQ
Where M is the quantity of money
V is income velocity of money
P is general price level
Q is level of physical output of goods and services
MV in the above equation represents aggregate expenditure or aggregate
demand in the monetarist approach. Thus, in monetarist approach aggregate demand
is simply the sum of money multiplied by its velocity. PQ in the above equation of
exchange represents nominal income or nominal GNP. Thus, in monetarist model,
MV = Nominal GNP
Since monetarist believes that velocity (V) is stable and predictable, there
is direct relationship between money supply and nominal income or GNP. With V
as stable, when money supply increases, consumers and businesses find themselves
with excess money balances which they spend on goods and services. As a result
of this increase in aggregate demand caused by the expansion in money supply,
PQ or nominal GNP rises.
It is clear from above that though aggregate demand may be equal in the
two approaches, the fundamental difference lies in the conception of aggregate
demand. Keynesians view it as C + I + G + (X-M), monetarists view it as simply
MV. The question which has been debated which approach provides a better
explanation of determination of income, employment and prices and which therefore
can be made a basis for formulation of economic policy.
2. Growth of Money Supply is the Prime Determinant of Growth in Nominal
GNP:
A fundamental principal of monetarism is that "Only money matters". As
seen above, like the Keynesian approach, monetarism is basically a theory of
aggregate demand. They view aggregate demand as being equal to MV. With their
belief that V is stable, aggregated demand is influenced primarily by changes in
money supply.
From the equation of exchange, MV - PQ, if V is stable the only force that
can affect nominal income PQ is supply of money (M). According to monetarists,
changes in money play a more and direct role in determining nominal income or
GNP.
They emphasise that while fiscal measures such as changes in amount
and pattern of Government expenditure and taxation is important for determining
how much is allocated to defence, private consumption or investment but the
important macroeconomic variables such national output, employment and prices
are determined mainly by money supply.
On the other hand, as seen above, Keynesians view aggregate demand as
C + I+G + X-M which determines the level of national income, output and
employment. In the Keynesian model, the effect of increase in money supply on
national income and employment is very indirect and operates through its effect on
investment component of aggregate demand.
According to it, expansion in money supply causes a fall in rate of interest.
At a lower interest rate, more private investment is undertaken; When the economy
is in the grip of depression and there is a lot of idle productive capacity, more
investment through multiplier process leads to the increase in aggregate demand
and therefore in national income and employment.
It may however be noted that early Keynesians regarded this effect of
changes in money supply through its effect on interest and investment very weak
because they thought money demand curve (i.e. liquidity preference curve) at low
rates of interest is quite flat and investment demand curve quite steep.
Therefore, the early Keynesians thought that monetary policy did not play
an important role in reviving the depressed economy. However, modem Keynesians
have veered round to the view that changes in money supply can play a significant
role in raising national output and employment. But unlike monetarists they trace
the effect of changes in money supply on the real macroeconomic variables through
its effect on interest and investment.
MODERN MONETARISM
NOTES
3. Differences Regarding Shape of Aggregate Supply Curve:
Another important difference between monetarist and Keynesian theories
revolves around the shape of economy's aggregate supply curve. It is important to
note that in monetarist approach it is the elasticity or steepness of the aggregate
supply curve that determines how changes in nominal
GNP (i.e., PQ) will be divided between the change in output (i.e., real
income) and change in the price level. Monetarists believe that short-run aggregate
supply curve is relatively steep so that when aggregate demand increases
consequent to the expansion in money supply, it results in rise in price level (P)
much more than the expansion in output (Q).
In other words, in case of steep aggregate supply curve, increase in nominal
income leads more to rise in price than to increase in output. This is illustrated in
panel (a) of Fig. 22.5. It will be seen from panel (a) where a relatively steep shortrun aggregate supply is drawn that when due to the expansion in money supply
(?M) aggregate demand increases from AD1 to AD2, price level rises sharply
from P1 and P2 whereas real GNP (that is, aggregate output) increases relatively
much less from Q1 and Q2. Thus, it is clear how division of nominal GNP into
change in price level and change in output depends on the steepness of aggregate
supply curve. It is important to note that, according to monetarists, long-run aggregate
supply is vertical because they believe that due to wage-price flexibility, long-run
equilibrium is established at the level of potential output (that is, full-employment
level of output). In panel (b) of Fig. 22.5 vertical straight LAS represents long-run
aggregate supply curve.
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NOTES
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PROGRESS
Now, in this case of long-run vertical aggregate supply curve when
aggregate demand shifts upward from AD1 to AD2 due to the expansion in money
supply (?M), price level rises sharply from P to P' whereas real GNP remains
constant. Thus, according to monetarists, in the long run expansion in money supply
only causes price level to rise level of output remaining unaffected.
On the other hand, Keynesians believe that the short-run aggregate supply
curve is quite flat (in the extreme cause it is a horizontal straight line), the effect of
increase in aggregate demand is more on raising real GNP with little rise in the
price level. This is shown in Fig. 22.6 where it will be observed that the part SR is
a short-run aggregate supply curve which is quite flat. According to Keynesians,
this flat short-run aggregate supply curve represents the situation of an economy
which is having depression or recession and therefore has a lot of idle capacity and
a large unemployment of labour in the economy. In such a situation when aggregate
demand increases, say through increase in investment, from AD1 to AD2, it leads
to a large expansion in real GNP with only a small rise in price level from P1 to P2.
Similarly, when demand aggregate increases from AD2 to AD3, real GNP increases
by a large amount with only a relatively small rise in price from P2 to P3.
What is Monetarism?
However, Keynesians' point out that when the economy is operating at the
level of full- employment or potential output, aggregate supply curve takes a vertical
shape. Thus, with vertical aggregate supply curve at full-employment level of output,
any increase in aggregate demand in this case from AD3 to AD4 will cause a
sharp rise in price level from P3 to P4 with no effect at all on real GNP which
remains constant at Q3.
It is important to note that, in Keynesian theory, the effect of changes in
money supply on aggregate demand and consequently on output and prices is quite
indirect and operates through its effect on interest.
According to it, the increase in money supply pushes down the rate of
interest. The lower market interest rate encourages more private investment. The
increase in private investment which is a component of aggregate demand (C + I
+ G + X - M) shifts the aggregate demand curve upward and through a multiplier
process leads to higher output, employment and prices.
5.4 Monetarism: An Introduction
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The quantity theory of money as put forward by classical economists
emphasised that increase in the quantity of money would bring about an equal
proportionate rise in the price level. The quantity theory of money had come into
disrepute, together with the rest of classical economists as a result of the Great
Depression of the 1930s. J.M. Keynes criticised quantity theory of money and
brought out that expansion in money supply did not always cause the price level to
rise.
Keynes and his early followers, often called early Keynesians, believed
that money was not important in influ-encing the level of economic activity and
that depression was not caused by contraction in money supply by the central
banks of the countries.
Keynes and his early followers argued that demand for money at a low
rate of interest was almost infinitely elastic (that is, liquidity trap existed in the
demand for money) so that increase in money supply would not succeed in lowering
the rate of interest. As a result, investment would not increase following the expansion
in money supply.
They further argued that investment demand was very much less interestelastic which made it doubly sure that expansionary monetary policy was quite
ineffective in giving boost to investment and thereby the level of economic activity.
Briefly specking Early Keynesians thought that money was unimportant or "Money
does not matter".
However, in the fifties and sixties, the new thinking emerged under the
influence of Milton Friedman, an eminent American economist and a Nobel Laureate
in economics, who laid stress on the importance of money not only in determining
the general price level but more importantly in influencing the level of economic
activity.
Friedman asserted that events of 1930s had been wrongly assessed and
did not in fact offer evidence against the quantity theory of money. He however
realised that there was a need to restate or reformulate the quantity theory of
money which should re-establish the importance of money determining the level of
economic activity and the price level.
However, in his restatement of the quantity theory of money he took account
of Keynes's contribution to mon-etary theory, especially his emphasis on the demand
for money as an asset.
MODERN MONETARISM
NOTES
We may describe Friedman's monetarism into the following three
propositions:
1)
The level of economic activity in current rupee terms, that is, the level of
nominal income is determined primarily by the stock of money.
2)
In the long run, the effect of expansion in money supply is primarily on the
price level and other nominal variables. In the long run, the level of economic
activity in real terms, that is level of real output and employment are determined
by the real factors such as stock of capital goods, the state of technology, the
size and quality of labour force.
3)
In the short run price level as well as the level of real national income (i.e.,
real output) and employment are determined by the supply of money. In the
short-run changes in the quantity of money are the dominant factors causing
cyclical fluctuations in output and employment.
We shall explain below the above three propositions of Friedman's monetary
theory. The above conclusions derived by Friedman depend on the restatement of
the quantity theory of money. It is important to note that Friedman's modem quantity
theory of money is in fact based on his theory of demand.
Therefore, in our analysis below we start from Friedman's theory of demand
for money. We then explain how his theory of money demand explains the
determination of the level of economic activity and the price level, both in the short
run and long run.
Demand for Money and Friedman's Restatement Quantity Theory of
Money:
Friedman's modem quantity theory of money is very close to the
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Cambridge's cash balance approach. Friedman and other modem monetarists have
emphasised that k in Cambridge approach should be interpreted as proportion of
nominal income that people desire or demand to hold in the form of money balances.
Interpreting k in this desired or ex-ante sense helps to convert the Cambridge
equation of exchange into a theory of nominal income.
Thus, rewriting Cambridge equation as demand for money (Md) we have:
Md = kPY
Where k is assumed to be constant, PY is the nominal income obtained by
multiplying the real income (F) with the price level (P). Like Cambridge economists,
Friedman regards the quantity of money being fixed exogenously by the central
bank of the country. If M represents the quantity of money set exogenously by the
central bank we have the equation which describes the Cambridge theory of
determination of nominal income.
M = Md =kPY…..(2)
Or M.1/k = PY …..(3)
According to Cambridge equation (3) nominal income is determined by
the supply of money (AO multiplied by the reciprocal of constant k. Now, Friedman
introduced changes in the above Cambridge theory of money demand incorporating
important aspects of Keynes's theory of demand for money. Keynes emphasised
the role of money as an asset apart from its role in meeting transactions demand.
In studying the factors that determine demand for money as an asset relative
to other assets, he simplified his analysis by lumping together all non-monetary
assets under a single category 'bonds'. He then examined what determined people's
allocation of their wealth between money and bonds.
According to him, the level of income and rate of interest determined the
allocation of wealth between money and bonds. According to Keynes, rate of
interest was the most important determinant of k in the Cambridge cash balance
approach. It may be recalled that k in Cambridge theory indicates how much
proportion of income people hold as money.
However, Keynes regarded k as the proportion of income that people
want to hold in money as an asset. Friedman accepted Keynes's emphasis on the
role of money as an asset and presented his own theory of demand for money. In
his analysis of determinants of money demand, Friedman included not only level of
income and rate of interest on bonds but also rates at return on other assets such
as equity shares, durable goods including real property.
Thus, Friedman's theory demand for money can be written as follows:
Md = F(P, Y, rB, rE, rD)
Where P = price level
Y = level of real income
rB = rate of interest on bonds
rE = rate of return on equity shares
rD = rate of return on durable goods
It will be seen from Friedman's money demand function that the product
of the first two variables, namely, P and Y give us the level of nominal income. It
therefore follows that, in Friedman's function, demand for money depends on nominal
income. The higher the level of nominal income, the greater the demand for money.
It is worth mentioning that for a given level of nominal income, in Friedman's
money demand function as in that of Keynes, demand for money depends on the
rates of return on non-monetary alternative assets. But, unlike Keynes, Friedman
regards money demand function is stable.
Stability of money demand function implies that it will not shift erratically
and that variables in the function will determine the quantity of money that will be
demanded. Friedman's theory of demand for money can be used to restate the
Cambridge money demand equation so as to bring out the important role of money
demand function in the determination of the level of economic activity.
Thus Friedman money demand function can be restated as follows:
Md = K(P, Y, rB, rE, rD) PY…..(4)
It is worth noting that whereas in Cambridge cash balance equation, k,
that is, the proportion of income that is held in money, is mainly dependent on the
transactions demand for money in Friedman's theory, it has been taken to be a
function of rates of return on alternative non-monetary assets such as bonds, equity
shares, durable goods.
Any rise in the rates of return on these alternative assets, it will cause k to
fall showing the increased desirability of alternative non-monetary assets. "In these
terms Friedman can be seen to have restated the quantity theory, providing a
systematic explanation of k, an explanation that takes account of the Keynesian
analysis of money's role as an asset."
MODERN MONETARISM
NOTES
Money Market Equilibrium: Friedman's Analysis:
In terms of Friedman money demand function, the condition for equilibrium
in the money market can be stated as under:
M = Md = k (rB, rE, rD) PY
Where M stands for the supply of money which is determined by the
central bank policies, k is the proportion of nominal income (PY) that is held in the
form of money and is determined by the rates of return (rB, rE, rD) on alternative
non-monetary assets such as bond, equity shares, durable goods respectively.
Friedman assumes that money demand function is stable.
Given the stable money demand function, any increase in money supply by
the central bank will cause either increase in nominal income (PY) or decline in
rates of return so that k rises or alternatively some increase in nominal income
(PY) and some rise in k. Friedman believes that much of the effect of exogenous
increase in money supply will be to bring about increase in nominal income (PY)
rather than k.
Thus Friedman concludes that quantity of money is an important determinant
of the level of economic activity, that is, output, employment and prices. Here the
short-run and long-run effects of exogenous increase in money supply must be
distinguished. In the short run, the increase in money supply will lead to a change
partly in real income (i.e., real aggregate output or Y) and partly in the price level
(F).
That is, in the short run the effect of increase in money supply will be
distributed between change in real income (Y) and change in price level (P)
depending upon the elasticity of the aggregate supply curve. Friedman recognised
that at times of depression, aggregate supply curve was fairly elastic so that the
effect of the increase in money will be more in the form of expansion in real output
and less in the form of rise in the price level. But, in the long run, the aggregate
supply curve is perfectly inelastic at full-employment level and, therefore, the
exogenous increase in money supply will be reflected in the rise in price level.
Determination of Nominal Income: Friedman's Approach:
Let us show how in Friedman's modem quantity theory nominal income is
determined. To show this Friedman makes some strong assumptions about the
behaviour of k. Friedman converts his money demand function into a theory of
nominal income by assuming that variables in his money demand function other
that nominal income (PY), that is, rB, rE, rD have little effect on k.
With this assumption, money held as a proportion of income will be nearly
constant. It may be noted by taking this assumption Friedman's theory comes very
close to Cambridge theory of determination of nominal income.
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5.5 Keynes's Reformulated Quantity Theory of
Money
NOTES
The Keynesian reformulated quantity theory of money is based on the
following:
Assumptions:
1.
All factors of production are in perfectly elastic supply so long as there is
any unemployment.
2.
All unemployed factors are homogeneous, perfectly divisible and
interchangeable.
3.
There are constant returns to scale so that prices do not rise or fall as output
increases.
4.
Effective demand and quantity of money change in the same proportion so
long as there are any unemployed resources.
CHECK YOUR
PROGRESS
Given these assumptions, the Keynesian chain of causation between
changes in the quantity of money and in prices is an indirect one through the rate of
interest. So when the quantity of money is increased, its first impact is on the rate
of interest which tends to fall. Given the marginal efficiency of capita], a fall in the
rate of interest will increase the volume of investment.
The increased investment will raise effective demand through the multiplier
effect thereby increasing income, output and employment. Since the supply curve
of factors of production is perfectly elastic in a situation of unemployment, wage
and non-wage factors are available at constant rate of remuneration. There being
constant returns to scale, prices do not rise with the increase in output so long as
there is any unemployment.
Under the circumstances, output and employment will increase in the same
proportion as effective demand, and the effective demand will increase in the
same proportion as the quantity of money. But "once full employment is reached,
output ceases to respond at all to changes in the supply of money and so in effective
demand. The elasticity of supply of output in response to changes in the supply,
which was infinite as long as there was unemployment falls to zero. The entire
effect of changes in the supply of money is exerted on prices, which rise in exact
proportion with the increase in effective demand."
Thus so long as there is unemployment, output will change in the same
proportion as the quantity of money, and there will be no change in prices; and
when there is full employment, prices will change in the same proportion as the
quantity of money. Therefore, the reformulated quantity theory of money stresses
the point that with increase in the quantity of money prices rise only when the level
of full employment is reached, and not before this.
Describe Keyne’s
Reformulated
Quantity Theory of
Money?
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This reformulated quantity theory of money is illustrated in Figure 67.1
(A) and (B) where OTC is the output curve relating to the quantity of money and
PRC is the price curve relating to the quantity of money. Panel A of the figure
shows that as the quantity of money increases from ? to M, the level of output also
rises along the ?? portion of the OTC curve.
MODERN MONETARISM
NOTES
As the quantity of money reaches OM level, full employment output OQF
is being produced. But after point T the output curve becomes vertical because
any further increase in the quantity of money cannot raise output beyond the full
employment level OQF.
Panel ? of the figure shows the relationship between quantity of money
and prices. So long as there is unemployment, prices remain constant whatever the
increase in the quantity of money. Prices start rising only after the full employment
level is reached.
In the figure, the price level OP remains constant at the OM quantity of
money corresponding to the full employment level of output OQ1. But an increase
in the quantity of money above OM raises prices in the same proportion as the
quantity of money. This is shown by the RC portion of the price curve PRC.
Keynes himself pointed out that the real world is so complicated that the
simplifying assumptions, upon which the reformulated quantity theory of money is
based, will not hold. According to him, the following possible complications would
qualify the statement that so long as there is unemployment, employment will change
in the same proportion as the quantity of money, and when there is full employment,
prices will change in the same proportion as the quantity of money."
1)
"Effective demand will not change in exact proportion to the quantity of
money.
2)
Since resources are homogenous, there will be diminishing, and not constant
returns as employment gradually increases.
3)
Since resources are not interchangeable, some commodities will reach a
condition of inelastic supply while there are still unemployed resources
available for the production of other commodities.
4)
The wage-unit will tend to rise, before full employment has been reached.
5)
The remunerations of factors entering into marginal cost will not all change
in the same proportion."
Taking into account these complications, it is clear that the reformulated
quantity theory of money does not hold. An increase in effective demand will not
change in exact proportion to the quantity of money, but it will partly spend itself in
increasing output and partly in increasing the price level. So long as there are
unemployed resources, the general price level will not rise much as output increases.
But a sudden large increase in aggregate demand will encounter bottlenecks when
resources are still unemployed.
It may be that the supply of some factors becomes inelastic or others may
be in short supply and are not interchangeable. This may lead to increase in marginal
cost and price. Price would accordingly rise above average unit cost and profits
would increase rapidly which, in turn, tend to raise money wages owing to trade
union pressures. Diminishing returns may also set in. As full employment is reached,
the elasticity of supply of output falls to zero and prices rise in proportion to the
increase in the quantity of money.
The complicated model of the Keynesian theory of money and prices is
shown diagrammatically in Figure 67.2 in terms of aggregate supply (S) and
aggregate demand (D) curves. The price level is measured on the vertical axis and
output on the horizontal axis.
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NOTES
According to Keynes, an increase in the quantity of money increases
aggregate money demand on investment as a result of the fall in the rate of interest.
This increases output and employment in the beginning but not the price level. In
the figure, the increase in the aggregate money demand from D1 to D2 raises
output from OQ1 to OQ2 but the price level remains constant at OP. As aggregate
money demand increases further from D2 to D3output increases from OQ2 to
OQ3 and the price level also rises to OP3.
This is because costs rise as bottlenecks develop through the immobility of
resources. Diminishing returns set in and less efficient labour and capital are
employed. Output increases at a slower rate than a given increase in aggregate
money demand, and this leads to higher prices. As full employment is approached,
bottlenecks increase. Further-more, rising prices lead to increased demand,
especially for stocks. Thus prices rise at an increasing rate. This is shown over the
range in the figure.
But when the economy reaches the full employment level of output, any
further increase in aggregate money demand brings about a proportionate increase
in the price level but output remains unchanged at that level. This is shown in the
figure when the demand curve D5 shifts upward to D6 and the price level increases
from OP5 to OP6 while the level of output remains constant at OQF.
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Superiority of the Keynesian Theory over the Traditional Quantity Theory
of Money:
The Keynesian theory of money and prices is superior to the traditional
quantity theory of money for the following reasons.
Keynes's reformulated quantity theory of money is superior to the traditional
approach in that he discards the old view that the relationship between the quantity
of money and prices is direct and proportional. Instead, he establishes an indirect
and non-proportional relationship between quantity of money and prices.
In establishing such a relationship, Keynes brought about a transition from
a pure monetary theory of prices to a monetary theory of output and employment.
In so doing, he integrates monetary theory with value theory. He integrates monetary
theory with value theory and also with the theory of output and employment through
the rate of interest.
In fact, the integration between monetary theory and value theory is done
through the theory of output in which the rate of interest plays the crucial role.
When the quantity of money increases the rate of interest falls which increases the
volume of investment and aggregate demand thereby raising output and employment.
In this way, monetary theory is integrated with the theory of output and employment.
As output and employment increase they further raise the demand for
factors of production. Consequently, certain bottlenecks appear which raise the
marginal cost including money wage rates. Thus prices start rising.
Monetary theory is integrated with value theory in this way. The Keynesian
theory is, therefore, superior to the traditional quantity theory of money because it
does not keep the real and monetary sectors of the economy into two separate
compartments with 'no doors or windows between the theory of value and the
theory of money and prices.'
Again, the traditional quantity theory is based on the unrealistic assumption
of full employment of resources. Under this assumption, a given increase in the
quantity of money always leads to a proportionate increase in the price level. Keynes,
on the other hand, believes that full employment is an exception.
Therefore, so long as there is unemployment, output and employment will
change in the same proportion as the quantity of money, but there will be no change
in prices; and when there is full employment, prices will change in the same
proportion as the quantity of money. Thus the Keynesian analysis is superior to the
traditional analysis because it studies the relationship between the quantity of money
and prices both under unemployment and full employment situations.
Further, the Keynesian theory is superior to the traditional quantity theory
of money in that it emphasises important policy implications. The traditional theory
believes that every increase in the quantity of money leads to inflation.
Keynes, on the other hand, establishes that so long as there is unemployment,
the rise in prices is gradual and there is no danger of inflation. It is only when the
economy reaches the level of full employment that the rise in prices is inflationary
with every increase in the quantity of money. Thus "this approach has the virtue of
emphasising that the objectives of full employment and price stability may be
inherently irreconcilable."
MODERN MONETARISM
NOTES
Criticisms of Keynes Theory of Money and Prices:
Keynes' views on money and prices have been criticised by the monetarists
on the following grounds.
1. Direct Relation:
Keynes mistakenly took prices as fixed so that the effect of money appears
in his analysis in terms of quantity of goods traded rather than their average prices.
That is why Keynes adopted an indirect mechanism through bond prices, interest
rates and investment of the effects of monetary changes on economic activity. But
the actual effects of monetary changes are direct rather than indirect.
2. Stable Demand for Money:
Keynes assumed that monetary changes were largely absorbed by changes
in the demand for money. But Friedman has shown on the basis of his empirical
studies that the demand for money is highly stable.
3. Nature of Money:
Keynes failed to understand the true nature of money. He believed that
money could be exchanged for bonds only. In fact, money can be exchanged for
many different types of assets like bonds, securities, physical assets, human wealth,
etc.
4. Effect of Money:
Since Keynes wrote for a depression period, this led him to conclude that
money had little effect on income. According to Friedman, it was the contraction
of money that precipitated the depression. It was, therefore, wrong on the part of
Keynes to argue that money had little effect on income. Money does affect national
income.
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NOTES
5.6 Summary
The quantity theory of money as put forward by classical economists
emphasised that increase in the quantity of money would bring about an equal
proportionate rise in the price level. The quantity theory of money had come into
disrepute, together with the rest of classical economists as a result of the Great
Depression of the 1930s. J.M. Keynes criticised quantity theory of money and
brought out that expansion in money supply did not always cause the price level to
rise.
Keynes and his early followers, often called early Keynesians, believed
that money was not important in influ-encing the level of economic activity and
that depression was not caused by contraction in money supply by the central
banks of the countries.
5.7 Exercise & Questions
Fill in the blanks 1)
Difference between the monetarists and -------------- lies in their approaches
to the determination of aggregate demand.
2)
Keynes regarded ---- as the proportion of income that people want to hold in
money as an asset.
3)
Thus ------- concludes that quantity of money is an important determinant of
the level of economic activity, that is, output, employment and prices.
4)
-------------- focus on aggregate demand as a determinant of income and
employment and view it as a sum of consumption, investment, Government
expenditure and net exports (that is, exports- imports).
Short answer Questions 1)
Define aggregate demand.
2)
Explain three proposition of Friedman's Theory.
Long Answer Questions1)
Explain the income approach of Keynes.
2)
Explain the quantity theory of money of Friedman.
3)
Explain the difference between fishers quantity theory and modern theory of
Money.
5.8 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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UNIT - 6
THEORY OF INFLATION
THEORY OF INFLATION
NOTES
Structure
6.1
Introduction
6.2
Objectives
6.3
Meaning of Inflation
6.4
Demand-Pull Inflation
6.5
Cost-Push Inflation
6.6
Summary
6.7
Exercise & Questions
6.8
Further Reference Books
6.1 Introduction
CHECK YOUR
PROGRESS
What is Inflation?
Inflation refers to a persistent upward movement in the general price level.
It results in a decline of the purchasing power. According to the most economists
inflation does not occur until price increase less than 5% per year for a sustained
period. Inflation take placeeither as a result of rise in aggregate demand or a
failure of aggregate supply. Increase in public expenditure, erratic agricultural
growth, deficit financing also contribute in Inflation.
6.2 Objectives
At the end of this unit, you will be able to:
1) Understand the meaning of Inflation.
2) Know the types of inflation on the basis of magnitude.
3) Understand the meaning of demand pull inflation.
4) Understand the meaning of cost push inflation.
5) Know the different causes of inflation.
6.3 Meaning of Inflation
To the neo-classical and their followers at the University of Chicago, inflation
is fundamentally a monetary phenomenon.
In the words of Friedman, "Inflation is always and everywhere a monetary
phenomenon…and can be produced only by a more rapid increase in the quantity
of money than output.'" But economists do not agree that money supply alone is
the cause of inflation.
As pointed out by Hicks, "Our present troubles are not of a monetary
character." Economists, therefore, define inflation in terms of a continuous rise in
prices.
Johnson defines "inflation as a sustained rise" in prices.
Brooman defines it as "a continuing increase in the general price level."
Shapiro also defines inflation in a similar vein "as a persistent and appreciable
rise in the general level of prices."
However, it is essential to understand that a sustained rise in prices may
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NOTES
be of various magni-tudes. Accordingly, different names have been given to inflation
depending upon the rate of rise in prices.
1. Creeping Inflation:
When the rise in prices is very slow like that of a snail or creeper, it is
called creeping inflation. In terms of speed, a sustained rise in prices of annual
increase of less than 3 per cent per annum is characterised as creeping inflation.
Such an increase in prices is regarded safe and essential for economic growth.
2. Walking or Trotting Inflation:
When prices rise moderately and the annual inflation rate is a single digit.
In other words, the rate of rise in prices is in the intermediate range of 3 to 6 per
cent per annum or less than 10 per cent. Inflation at this rate is a warning signal for
the government to control it before it turns into running inflation.
3. Running Inflation:
When prices rise rapidly like the running of a horse at a rate or speed of 10
to 20 per cent per annum, it is called running inflation. Such an inflation affects the
poor and middle classes adversely. Its control requires strong monetary and fiscal
measures, otherwise it leads to hyperinflation.
4. Hyperinflation:
When prices rise very fast at double or triple digit rates from more than 20
to 100 per cent per annum or more, it is usually called runaway ox galloping inflation.
It is also characterised as hyperinflation by certain economists. In reality,
hyperinflation is a situation when the rate of inflation becomes immeasurable and
absolutely uncontrollable. Prices rise many times every day. Such a situation brings
a total collapse of monetary system because of the continuous fall in the purchasing
power of money.
The speed with which prices tend to rise is illustrated in Figure 1. The
curve ? shows creeping inflation when within a period of ten years the price level
has been shown to have risen by about 30 per cent. The curve W depicts walking
inflation when the price level rises by more than 50 per cent during ten years. The
curve R illustrates running inflation showing a rise of about 100 per cent in ten
years. The steep curve H shows the path of hyperinflation when prices rise by
more than 120 per cent in less than one year.
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5. Semi-Inflation:
According to Keynes, so long as there are unemployed resources, the
general price level will not rise as output increases. But a large increase in aggregate
expenditure will face shortages of supplies of some factors which may not be
substitutable. This may lead to increase in costs, and prices start rising. This is
known as semi-inflation or bottleneck inflation because of the bottlenecks in supplies
of some factors.
6. True Inflation:
According to Keynes, when the economy reaches the level of full
employment, any increase in aggregate expenditure will raise the price level in the
same proportion. This is because it is not possible to increase the supply of factors
of production and hence of output after the level of full employment. This is called
true inflation.
The Keynesian semi-inflation and true inflation situations are illustrated in
Figure.2.
THEORY OF INFLATION
NOTES
Employment and price level are taken on vertical axis and aggregate
expenditure on horizontal axis. FE is the full employment curve. When with the
increase in aggregate expenditure, the price level rises slowly from A to the full
employment level B, this is semi-inflation. But when the aggregate expenditure
increases beyond point ? the price level rises from ? to T in proportion to the
increase in aggregate expenditure. This is true inflation.
7. Open Inflation:
Inflation is open when "markets for goods or factors of production are
allowed to function freely, setting prices of goods and factors without normal
interference by the authorities. Thus open inflation is the result of the uninterrupted
operation of the market mechanism. There are no checks or controls on the
distribution of commodities by the government. Increase in demand and shortage
of supplies persist which tend to lead to open inflation. Unchecked open inflation
ultimately leads to hyperinflation.
8. Suppressed Inflation:
Men the government imposes physical and monetary controls to check
open inflation, it is known as repressed or suppressed inflation. The market
mechanism is not allowed to function normally by the use of licensing, price controls
and rationing in order to suppress extensive rise in prices.
So long as such controls exist, the present demand is postponed and there
is diversion of demand from controlled to uncontrolled commodities. But as soon
as these controls are removed, there is open inflation. Moreover, suppressed inflation
adversely affects the economy.
When the distribution of commodities is controlled, the prices of uncontrolled
commodities rise very high. Suppressed inflation reduces the incentive to work
because people do not get the commodities which they want to have. Controlled
distribution of goods also leads to mal-allocation of resources. This results in the
diversion of productive resources from essential to non-essential industries. Lastly,
suppressed inflation leads to black marketing, corruption, hoarding and profiteering.
9. Stagflation:
Stagflation is a new term which has been added to economic literature in
the 1970s. It is a paradoxical phenomenon where the economy expedience's
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CHECK YOUR
PROGRESS
What is Demand-Pull
Inflation?
stagnation as well as inflation. The word stagflation is the combination of' stag'
plus 'flation' taking 'stag' from stagnation and 'flation' from inflation.
Stagflation is a situation when recession is accompanied by a high rate of
inflation. It is, therefore, also called inflationary recession. The principal cause of
this phenomenon has been excessive demand in commodity markets, thereby causing
prices to rise, and at the same time the demand for labour is deficient, thereby
creating unemployment in the economy.
Three factors have been responsible for the existence of stagflation in the
advanced countries since 1972. First, rise in oil prices and other commodity prices
along with adverse changes in the terms of trade, second, the steady and substantial
growth of the labour force; and third, rigidities in the wage structure due to strong
trade unions.
10. Mark-up Inflation:
The concept of mark-up inflation is closely related to the price-push problem.
Modem labour organisations possess substantial monopoly power. They, therefore,
set prices and wages on the basis of mark-up over costs and relative incomes.
Firms possessing monopoly power have control over the prices charged by them.
So they have administered prices which increase their profit margin. This sets off
an inflationary rise in prices. Similarly, when strong trade unions are successful in
raising the wages of workers, this contributes to inflation.
11. Ratchet Inflation:
A ratchet is a toothed wheel provided with a catch that prevents the ratchet
wheel from moving backward. The same is the case under ratchet inflation when
despite downward pressures in the economy, prices do not fall. In an economy
having price, wage and cost inflations, aggregate demand falls below full employment
level due to the deficiency of demand in some sectors of the economy.
But wage, cost and price structures are inflexible downward because large
business firms and labour organisations possess monopoly power. Consequently,
the fall in demand may not lower prices significantly. In such a situation, prices will
have an upward ratchet effect, and this is known as "ratchet inflation."
12. Sectoral Inflation:
Sectoral inflation arises initially out of excess demand in particular industries.
But it leads to a general price rise because prices do not fall in the deficient demand
sectors.
13. Reflation:
Is a situation when prices are raised deliberately in order to encourage
economic activity. When there is depression and prices fall abnormally low, the
monetary authority adopts measures to put more money in circulation so that prices
rise. This is called reflation.
6.4 Demand-Pull Inflation
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Demand-Pull or excess demand inflation is a situation often described as
"too much money chasing too few goods." According to this theory, an excess of
aggregate demand over aggregate supply will generate inflationary rise in prices.
Its earliest explanation is to be found in the simple quantity theory of money.
The theory states that prices rise in proportion to the increase in the money
supply. Given the full employment level of output, doubling the money supply will
double the price level. So inflation proceeds at the same rate at which the money
supply expands.
In this analysis, the aggregate supply is assumed to be fixed and there is
always full employment in the economy. Naturally, when the money supply increases
it creates more demand for goods but the supply of goods cannot be increased due
to the full employment of resources. This leads to rise in prices.
Modem quantity theorists led by Friedman hold that "inflation is always
and everywhere a monetary phenomenon. The higher the growth rate of the nominal
money supply, the higher the rate of inflation. When the money supply increases,
people spend more in relation to the available supply of goods and services. This
bids prices up. Modem quantity theorists neither assume full employment as a
normal situation nor a stable velocity of money. Still they regard inflation as the
result of excessive increase in the money supply.
The quantity theory version of the demand-pull inflation is illustrated in
Figure 3.
Suppose the money supply is increased at a given price level OP as
determined by the demand and supply curves D and S1 respectively. The initial full
employment situation OYF at this price level is shown by the interaction of these
curves at point E. Now with the increase in the quantity of money, the aggregate
demand increase which shifts the demand curve D to D1to the right. The aggregate
supply being fixed, as shown by the vertical portion of the supply curve SS1 the D1
curve intersects it at point E1. This raises the price level to OP1.
The Keynesian theory on demand-pull inflation is based on the argument
that so long as there are unemployed resources in the economy; an increase in
investment expenditure will lead to increase in employment, income and output.
Once full employment is reached and bottlenecks appear, further increase in
expenditure will lead to excess demand because output ceases to rise, thereby
leading to inflation.
The Keynesian theory of demand pull inflation is explained diagrammatically in
Figure 3. Suppose the economy is in
equilibrium at E where the SS1and D curves
intersect with full employment income level
OYF .The price level is OP. Now the
government increases its expenditure. The
increase in government expenditure implies an
increase in aggregate demand which is shown
by the upward shift of the D curve to D1 in
the figure. This tends to raise the price level
to OP1, as aggregate supply of output cannot
be increased after the full employment level.
THEORY OF INFLATION
NOTES
6.4.1
The UK experienced
demand pull inflation during the
Lawson boom of the late 1980s.
Fuelled by rising house prices,
high consumer confidence and
tax cuts, the economy was
growing by 5% a year, but this
caused supply bottlenecks and
firms responded by increasing
prices.
This graph shows inflation and economic growth in the UK during the
1980s. High growth in 1987, 1988 of 4-5% caused an increase in the inflation rate.
It was only when the economy went into recession in 1990 and 1991, that we saw
a fall in the inflation rate.
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6.5 Cost-Push Inflation
Cost-push inflation is caused by wage increases enforced by unions and
profit increases by employers. This type of inflation has not been a new phenomenon
and was found even during the medieval period. But it was revived in the 1950s
and again in the 1970s as the principal cause of inflation. It also came to be known
as the "New Inflation."
6.5.1 Example of Cost push inflation in the UK
CHECK YOUR
PROGRESS
What is Cost-Push
Inflation?
In early 2008, the UK economy entered a deep recession(GDP fell 6%).
However, at the same time, we experienced a rise in inflation. This inflation was
definitely not due to demand side factors; it was due to cost push factors, such as
rising oil prices, rising taxes and rising import prices (as a result of depreciation in
the Pound) By 2013, cost push factors had mostly disappeared and inflation had
fallen back to its target of 2%.
Cost-push inflation is caused by wage-push and profit-push to prices for
the following reasons:
1. Rise in Wages:
The basis cause of cost-push inflation is the rise in money wages more
rapidly than the productivity of labour. In advanced countries, trade unions are
very powerful. They press employers to grant wage increases considerably in
excess of increases in the productivity of labour, thereby raising the cost of production
of commodities. Employers, in turn, raise prices of their products.
Higher wages enable workers to buy as much as before, in spite of higher
prices. On the other hand, the increase in prices induces unions to demand still
higher wages. In this way, the wage-cost spiral continues, thereby leading to costpush or wage-push inflation. Cost-push inflation may be further aggravated by
upward adjustment of wages to compensate for rise in the cost of living index.
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2. Sectoral Rise in Prices:
Again, a few sectors of the economy may be affected by money wage
increases and prices of their products may be rising. In many cases, their production
such as steel, raw materials, etc. are used as inputs for the production of commodities
in other sectors. As a result, the production cost of other sectors will rise and
thereby push up the prices of their products. Thus wage- push inflation in a few
sectors of the economy may soon lead to inflationary rise in prices in the entire
economy.
3. Rise in Prices of Imported Raw Materials:
An increase in the prices of imported raw materials may lead to cost-push
inflation. Since raw materials are used as inputs by the manufacturers of the finished
goods, they enter into the cost of production of the latter. Thus a continuous rise in
the prices of raw materials tends to sets off a cost-price-wage spiral.
THEORY OF INFLATION
NOTES
4. Profit-Push Inflation:
Oligopolist and monopolist firms raise the prices of their products to offset
the rise in labour and production costs so as to earn higher profits. There being
imperfect competition in the case of such firms, they are able to "administer prices"
of their products. "In an economy in which so called administered prices abound
there is at least the possibility that these prices may be administered upward faster
than cost in an attempt to earn greater profits.
To the extent such a process is wide-spread profit-push inflation will result."
Profit-push inflation is, therefore, also called administered-price theory of inflation
or price-push inflation or sellers' inflation or market-power inflation. Cost-push
inflation is illustrated in Figure 4. Where S1 S is the supply curve and D is the
demand curve. Both intersect at E which is the full employment level OYF, and the
price level OP is determined. Given the demand, as shown by the D curve, the
supply curve S1 is shown to shift to S2 as a result of cost-push factors. Consequently,
it intersects the D curve at E1 showing rise in the price level from OP to OP1 and
fall in aggregate output from OYF to OY1level. Any further shift in the supply
curve will shift and tend to raise the price level and decrease aggregate output
further.
6.6 Summary
Inflation refers to a persistent upward movement in the general price level.
It results in a decline of the purchasing power.
Sustained rise in prices may be of various magnitudes. Accordingly, different
names have been given to inflation depending upon the rate of rise in prices.
Demand pull inflation refers to the phenomenon when prices rises
consistently because demand is more than the supply of goods and services.
Cost push inflation refers to a situation where price persistently rise because
of growing factor cost of Production.
A moderate inflation can promote growth by inducing both savings and
investment in the desired channels.
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Money, Central Banking in
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6.7 Exercise & Questions
Fill in the Blanks 1)
---------- refers to a persistent upward movement in the general price level.
2)
When the rise in prices is very slow like that of a snail or creeper, it is called
------------ inflation.
3)
------- is a situation when recession is accompanied by a high rate of inflation.
4)
The basis cause of --------- inflation is the rise in money wages more rapidly
than the productivity of labour.
Very short answer questions 1)
Define Inflation. In the period of inflation purchasing power increases. True
or false? Why?
2)
Cost push inflation is difficult to control than demand pull inflation. Discuss.
3)
Explain Cost push inflation.
4)
Explain how inflation affect on our day to day life?
Long Answer Questions 1)
Explain the various types of inflation.
2)
Explain the various causes of inflation.
3)
Explain the theory of demand pull inflation. Draw Diagram.
4)
Explain the impact of inflation.
6.8 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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UNIT - 7
CENTRAL BANKING - I
Structure
7.1
Introduction
7.2
Objectives
7.3
Overview of central Bank
7.4
Objectives of Central Bank
7.5
Reserve Bank of India
7.6
Role and Function of Reserve Bank of India (RBI)
7.7
Summary
7.8
Exercise & Questions
7.9
Further Reference Books
7.1 Introduction
A central bank is one which constitutes the apex of the monetary and
banking structure of a country. The central bank acts as a organ of the state. The
ultimate responsibility of framing and executing economic policies is that of the
state and, therefore, the central bank has to advance the policies of the state. For
that purpose, the central bank has to act in close collaboration with finance ministry
and other economic ministries.
The central bank's role is to ensure that the other banks conduct their
business with safety, security and in pursuance of the national plan priorities and
objectives of the economic and social development. Commercial banks are largely
profit oriented institutions, the central bank is not so. Its objective is not to make
profit.
CENTRAL BANKING - I
NOTES
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Give Overview of
Central Bank?
7.2 Objectives
At the end of this unit, you will be able to:
a) Know the meaning of central bank.
b) Know the formation of central bank
c) Understand the basic functions of central bank.
d) Know the role and functions of Reserve bank of India.
7.3 Overview of central Bank
There is no standard terminology for the name of a central bank, but many
countries use the "Bank of Country".
Example: Bank of England (which is in fact the central bank of the United
Kingdom as a whole), Bank of Canada, Bank of Mexico.
Some are styled "national" banks, such as the National Bank of Ukraine,
although the term national bank is also used for private commercial banks in some
countries.
In other cases, central banks may incorporate the word "Central" (for
example, European Central Bank, Central Bank of Ireland, Central Bank of Brazil).
The word "Reserve" is also often included, such as the Reserve Bank of
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Give Objectives of
Central Bank?
India, Reserve Bank of Australia, Reserve Bank of New Zealand, the South African
Reserve Bank, and U.S. Federal Reserve System.
Other central banks are known as monetary authorities such as theMonetary
Authority of Singapore, Maldives Monetary Authority and Cayman Islands
Monetary Authority.
In some countries, particularly in formerly Communist countries, the term
national bank may be used to indicate both the monetary authority and the leading
banking entity, such as the Soviet Union's Gosbank (state bank).
In other countries, the term national bank may be used to indicate that the
central bank's goals are broader than monetary stability, such as full employment,
industrial development, or other goals. Some state-owned commercial banks have
names suggestive of central banks, even if they are not: examples are the Bank of
India and the Central Bank of India.
The chief executive of a central bank is usually known as the Governor.
Central banks have a wide range of responsibilities, from overseeing
monetary policy to implementing specific goals such as currency stability, low inflation
and full employment. Central banks also generally issue currency, function as the
bank of the government, regulate the credit system, oversee commercial banks,
manage exchange reserves and act as a lender of last resort.
A central bank, reserve bank, or monetary authority is an institution
that manages a state's currency, money supply, and interest rates. Central banks
also usually oversee the commercial banking system of their respective countries.
In contrast to a commercial bank, a central bank possesses amonopoly on increasing
the monetary base in the state, and usually also prints the national currency,which
usually serves as the state's legal tender.
The primary function of a central bank is to control the nation's money
supply (monetary policy), through active duties such as managing interest rates,
setting the reserve requirement, and acting as a lender of last resort to thebanking
sector during times of bank insolvency or financial crisis. Central banks in most
developed nations are institutionally designed to be independent from political
interference.
7.4 Objectives of Central Bank
l
l
l
l
l
l
l
l
l
l
To manage the monetary and credit system of the country.
To stabilizes internal and external value of rupee.
For balanced and systematic development of banking in the country.
For the development of organized money market in the country.
For proper arrangement of agriculture finance.
For proper arrangement of industrial finance.
For proper management of public debts.
To establish monetary relations with other countries of the world and
international financial institutions.
For centralization of cash reserves of commercial banks.
To maintain balance between the demand and supply of currency.
7.5 Reserve Bank of India
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The Reserve Bank of India is the central bank of the country entrusted
with monetary stability, the management of currency and the supervision of the
financial as well as the payments system.
The genesis of Reserve Bank of India (RBI) started in 1926 when the
Hilton-Young Commission or the Royal Commission on Indian Currency and
Finance made recommendation to the British Government of India for creation of
a central bank.
The chief objective of such recommendation were twofold: To separate
the control of currency and credit from the government To augment banking facilities
throughout the country. To give effect to above recommendations, a bill was
introduced in Legislative Assembly in 1927 but this bill was withdrawn because
various sections of the people were not in agreement.
The recommendation to create a reserve bank was made by White Paper
on Indian Constitutional Reforms. Thus, a fresh bill was introduced and was enacted
in 1935. Thus, Reserve Bank of India was established via the RBI Act of 1934 as
the banker to the central government. RBI launched its operations from April 1,
1935.
Its headquarters were in Kolkata in the beginning, but it was shifted to
ShahidBhagat Singh Marg, Mumbai in 1937.
Prior to establishment of RBI, the functions of a central bank were virtually
being done by the Imperial Bank of India, which was established in 1921 by merging
three Presidency banks. It was mainly a commercial bank but also served as banker
to the government to some extent.
It's worth note that RBI started as a privately owned bank. It started with
a Share Capital of Rs. 5 Crore, divided into shares of Rs. 100 each fully paid up.
In the beginning, this entire capital was owned by private shareholders. Out of this
Rs. 5 Crore, the amount of Rs. 4,97,8000 was subscribed by the private shareholders
while Rs. 2,20,000 was subscribed by central government.
After independence, the government passed Reserve Bank (Transfer to
Public Ownership) Act, 1948 and took over RBI from private shareholders after
paying appropriate compensation. Thus, nationalisation of RBI took place in 1949
and from January 1, 1949, RBI started working as a government owned central
bank of India.
CENTRAL BANKING - I
NOTES
7.5.1 Key Landmarks in the journey of RBI
In 1926, the Royal Commission on Indian Currency and Finance
recommended creation of a central bank for India.
In 1927, a bill to give effect to the above recommendation was introduced
in the Legislative Assembly, but was later withdrawn due to lack of agreement
among various sections of people.
In 1933, the White Paper on Indian Constitutional Reforms recommended
the creation of a Reserve Bank. A fresh bill was introduced in the Legislative
Assembly.
In 1934, the Bill was passed and received the Governor General's assent
In 1935, Reserve Bank commenced operations as India's central bank on April 1
as a private shareholders' bank with a paid up capital of rupees five crore.
In 1942 Reserve Bank ceased to be the currency issuing authority of Burma
(now Myanmar).
In 1947, Reserve Bank stopped acting as banker to the Government of
Burma.
In 1948, Reserve Bank stopped rendering central banking services to
Pakistan.
In 1949, the Government of India nationalized the Reserve Bank under the
Reserve Bank (Transfer of Public Ownership) Act, 1948.
In 1949, Banking Regulation Act was enacted.
In 1951, India embarked in the Planning Era. In 1966, the Cooperative
Banks came within the regulations of the RBI. Rupee was devaluated for the first
time.
In 1969, Nationalization of 14 Banks was a Turning point in the history of
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What is Role and
Function of RBI?
Indian Banking.
In 1973, the Foreign Exchange Regulation act was amended and exchange
control was strengthened.
In 1974, the Priority Sector Advance Targets started getting fixed.
In 1975, Regional Rural Banks started
In 1985, the Sukhamoy Chakravarty and Vaghul Committee reports
embarked the era of Financial Market Reforms in India.
In 1991, India came under the Balance of Payment crisis and RBI pledged
Gold to shore up reserves.
In 2008-09, world under the grip of Global Financial Slowdown, RBI
Proactive.
RBI Established in 1935, its functions and focus have evolved in response
to the changing economic environment. Its history is not only intrinsically interwoven
with the economic and financial history of the country, but also gives insights into
the thought processes that have helped shape the country's economic policies.
Here we present some facets of the Bank's history for the layperson. We look
forward to the viewer's suggestions and comments.
7.6 Role and Function of Reserve Bank of India
(RBI)
As a central bank, the Reserve Bank has significant powers and duties to
perform. For smooth and speedy progress of the Indian Financial System, it has to
perform some important tasks. Among others it includes maintaining monetary and
financial stability, to develop and maintain stable payment system, to promote and
develop financial infrastructure and to regulate or control the financial institutions.
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a) Issuer of currency
Except for issuing one rupee notes and coins, RBI is the sole authority for
the issue of currency in India. The Indian government issues one rupee notes and
coins. Major currency is in the form of RBI notes, such as notes in the denominations
of two, five, ten, twenty, fifty, one hundred, five hundred, and one thousand. Earlier,
notes of higher denominations were also issued. But, these notes were demonetized
to discourage users from indulging in black-market operations.
RBI has two departments - the Issue department and Banking department.
The issue department is dedicated to issuing currency. All the currency issued is
the monetary liability of RBI that is backed by assets of equal value held by this
department. Assets consist of gold, coin, bullion, foreign securities, rupee coins,
and the government's rupee securities. The department acquires these assets
whenever required by issuing currency. The conditions governing the composition
of these assets determine the nature of the currency standard that prevails in
India.
The Banking department of RBI looks after the banking operations. It
takes care of the currency in circulation and its withdrawal from circulation. Issuing
new currency is known as expansion of currency and withdrawal of currency is
known as contraction of currency.
CENTRAL BANKING - I
NOTES
b) Banker to the Government
RBI acts as banker, both to the central government and state governments.
It manages all the banking transactions of the government involving the receipt and
payment of money. In addition, RBI remits exchange and performs other banking
operations.
RBI provides short-term credit to the central government. Such credit
helps the government to meet any shortfalls in its receipts over its disbursements.
RBI also provides short term credit to state governments as advances.
RBI also manages all new issues of government loans, servicing the
government debt outstanding, and nurturing the market for government's securities.
RBI advises the government on banking and financial subjects, international finance,
financing of five-year plans, mobilizing resources, and banking legislation.
c) Managing Government Securities
Various financial institutions such as commercial banks are required by
law to invest specified minimum proportions of their total assets/liabilities in
government securities. RBI administers these investments of institutions.
The other responsibilities of RBI regarding these securities are to ensure l
Smooth functioning of the market
l
Readily available to potential buyers
l
Easily available in large numbers
l
Undisturbed maturity-structure of interest rates because of excess or deficit
supply
l
Not subject to quick and huge fluctuations
l
Reasonable liquidity of investments
l
Good reception of the new issues of government loans
d) Banker to Other Banks
The role of RBI as a banker to other banks is as follows:
l
Holds some of the cash reserves of banks
l
Lends funds for short period
l
Provides centralized clearing and quick remittance facilities
RBI has the authority to statutorily ensure that the scheduled commercial
banks deposit a stipulated ratio of their total net liabilities. This ratio is known as
cash reserve ratio [CRR]. However, banks can use these deposits to meet their
temporary requirements for interbank clearing as the maintenance of CRR is
calculated based on the average balance over a period.
e) Controller of Money Supply and Credit
The most important function of the central bank is to control the credit
creation power of commercial bank in order to control inflationary and deflationary
pressures within this economy. For this purpose, it adopts quantitative methods and
qualitative methods. Quantitative methods aim at controlling the cost and quantity
of credit by adopting bank rate policy, open market operations, and by variations in
reserve ratios of commercial banks.
Qualitative methods control the use and direction of credit. These involve
selective credit controls and direct action. By adopting such methods, the central
bank tries to influence and control credit creation by commercial banks in order to
stabilise economic activity in the country.
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Besides the above noted functions, the central banks in a number of
developing countries have been entrusted with the responsibility of developing a
strong banking system to meet the expanding requirements of agriculture, industry,
trade and commerce.
Accordingly, the central banks possess some additional powers of
supervision and control over the commercial banks. They are the issuing of licenses;
the regulation of branch expansion; to see that every bank maintains the minimum
paid up capital and reserves as provided by law; inspecting or auditing the accounts
of banks; to approve the appointment of chairmen and directors of such banks in
accordance with the rules and qualifications; to control and recommend merger of
weak banks in order to avoid their failures and to protect the interest of depositors;
to recommend nationalization of certain banks to the government in public interest;
to publish periodical reports relating to different aspects of monetary and economic
policies for the benefit of banks and the public; and to engage in research and train
banking personnel
In a planned economy, the central bank plays an important role in controlling
the paper currency system and inflationary tendency. RBI has to regulate the
claims of competing banks on money supply and credit. RBI also needs to meet
the credit requirements of the rest of the banking system.
RBI needs to ensure promotion of maximum output, and maintain price
stability and a high rate of economic growth. To perform these functions effectively,
RBI uses several control instruments such as l
Open Market Operations
l
Changes in statutory reserve requirements for banks
l
Lending policies towards banks
l
Control over interest rate structure
l
Statutory liquidity ration of banks
f) Exchange Manager and Controller
RBI manages exchange control, and represents India as a member of the
international Monetary Fund [IMF]. Exchange control was first imposed on India
in September 1939 when World War II started and continues till date. Exchange
control was imposed on both receipts and payments of foreign exchange.
According to foreign exchange regulations, all foreign exchange receipts,
whether on account of export earnings, investment earnings, or capital receipts,
whether of private or government accounts, must be sold to RBI either directly or
through authorized dealers. Most commercial banks are authorized dealers of RBI.
g) Publisher of Monetary Data and Other Data
RBI maintains and provides all essential banking and other economic data,
formulating and critically evaluating the economic policies in India. In order to
perform this function, RBI collects, collates and publishes data regularly. Users
can avail this data in the weekly statements, the RBI monthly bulletin, annual report
on currency and finance, and other periodic publications.
Developmental and Promotional role of RBI
Along with the routine traditional functions, central banks especially in the
developing country like India have to perform numerous functions. These functions
are country specific functions and can change according to the requirements of
that country. The RBI has been performing as a promoter of the financial system
since its inception. Some of the major development functions of the RBI are
maintained below.
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h) Development of the Financial System
The financial system comprises the financial institutions, financial markets
and financial instruments. The sound and efficient financial system is a precondition
of the rapid economic development of the nation. The RBI has encouraged
establishment of main banking and non-banking institutions to cater to the credit
requirements of diverse sectors of the economy.
CENTRAL BANKING - I
NOTES
i) Development of Agriculture
In an agrarian economy like ours, the RBI has to provide special attention
for the credit need of agriculture and allied activities. It has successfully rendered
service in this direction by increasing the flow of credit to this sector. It has earlier
the Agriculture Refinance and Development Corporation (ARDC) to look after
the credit, National Bank for Agriculture and Rural Development (NABARD) and
Regional Rural Banks (RRBs).
j) Provision of Industrial Finance
Rapid industrial growth is the key to faster economic development. In this
regard, the adequate and timely availability of credit to small, medium and large
industry is very significant. In this regard the RBI has always been instrumental in
setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM
BANK etc.
k) Provisions of Training
The RBI has always tried to provide essential training to the staff of the
banking industry. The RBI has set up the bankers' training colleges at several
places. National Institute of Bank Management i.e NIBM, Bankers Staff College
i.e BSC and College of Agriculture Banking i.e CAB are few to mention.
l) Collection of Data
Being the apex monetary authority of the country, the RBI collects process
and disseminates statistical data on several topics. It includes interest rate, inflation,
savings and investments etc. This data proves to be quite useful for researchers
and policy makers.
m) Publication of the Reports
The Reserve Bank has its separate publication division. This division collects
and publishes data on several sectors of the economy. The reports and bulletins
are regularly published by the RBI. It includes RBI weekly reports, RBI Annual
Report, Report on Trend and Progress of Commercial Banks India., etc. This
information is made available to the public also at cheaper rates.
n) Promotion of Banking Habits
As an apex organization, the RBI always tries to promote the banking
habits in the country. It institutionalizes savings and takes measures for an expansion
of the banking network. It has set up many institutions such as the Deposit Insurance
Corporation-1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These
organizations develop and promote banking habits among the people. During
economic reforms it has taken many initiatives for encouraging and promoting
banking in India.
0) Promotion of Export through Refinance
The RBI always tries to encourage the facilities for providing finance for
foreign trade especially exports from India. The Export-Import Bank of India (EXIM
Bank India) and the Export Credit Guarantee Corporation of India (ECGC) are
supported by refinancing their lending for export purpose.
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7.7 Summary
The overall control of the monetary and banking structure of an economy
lies the central bank of a country.
Central banks have a wide range of responsibilities, from overseeing
monetary policy to implementing specific goals such as currency stability, low inflation
and full employment. Central banks also generally issue currency, function as the
bank of the government, regulate the credit system, oversee commercial banks,
manage exchange reserves and act as a lender of last resort.
India's central bank is Reserve Bank of India established in the year 1935.
After independence, the government passed Reserve Bank (Transfer to
Public Ownership) Act, 1948 and took over RBI from private shareholders after
paying appropriate compensation. Thus, nationalization of RBI took place in 1949
and from January 1, 1949, RBI started working as a government owned central
bank of India.
Reserve bank of India is also called as bankers bank and bank of
government.
To manage the monetary and credit system of the country is the important
function of central bank.
Except for issuing one rupee notes and coins, RBI is the sole authority for
the issue of currency in India.
7.8 Exercise & Questions
Fill in the Blanks a)
The …………… function of a central bank is to control the nation's money
supply.
b)
…………… is the central bank of India.
c)
Reserve Bank of India Nationalized in the year ………….. .
d)
Except for issuing--------------, RBI is the sole authority for the issue of
currency in India.
Short Answer Questions 1)
Explain the meaning of central bank.
2)
What are the objectives of central bank?
3)
Explain the Bankers Bank function of central bank.
Long Answer Questions 1)
Explain the key landmark of RBI.
2)
Explain any five functions of Reserve bank of India.
3)
Central bank is known as lender of last resort. Discuss.
4)
Explain the role of central bank for the smooth functioning of economy.
5)
Explain the promotional role of RBI.
7.9 Further Reference Books
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l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
UNIT - 8
ORGANIZATION AND DEPARTMENTS
OF RBI
ORGANIZATION AND
DEPARTMENTS OF RBI
NOTES
Structure
8.1
Introduction
8.2
Objectives
8.3
Organization and Structure of RBI
8.4
Departments of RBI
8.5
Summary
8.6
Exercise & Questions
8.7
Further Reference Books
8.1 Introduction
RBI established in the year 1935. In 1949, the Government of India
nationalized the Reserve Bank under the Reserve Bank (Transfer of Public
Ownership) Act, 1948. RBI is the central bank of India. The executive head of the
Bank is called Governor who is assisted by four Deputy Governors. They are
appointed by the Government of India for a period of five years. The head office
of the Reserve Bank is at Bombay. RBI work under different departments such as
Issue department, Exchange control department, Industrial credit department,
Economic analysis and Policy etc.
CHECK YOUR
PROGRESS
Give Organization
Structure of RBI?
8.2 Objectives
At the end of this unit, you will be able to 1) Understand the organization structure of RBI
2) Know the role of different departments of RBI.
8.3 Organization and Structure of RBI
Organizational Structure
Governor
|
Deputy Governor
|
Executive Directors
|
Principal Chief General Manager
|
Chief General Manager
|
General Manager
|
Deputy General Manager
|
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Describe Three Parts
of organization of
RBI?
Asstt. General Manager
|
Managers
|
Asstt. Managers
|
Support Staff
Management
The management of the Reserve Bank is under the control of Central Board of
Directors consisting of 20 members:
(a) The executive head of the Bank is called Governor who is assisted by four
Deputy Governors. They are appointed by the Government of India for a
period of five years. The head office of the Reserve Bank is at Bombay,
(b) There are four local boards at Delhi, Kolkata, Chennai and Mumbai
representing four regional areas, i.e., northern, eastern, southern and western
respectively. These local boards are advisory in nature and the Government
of India nominates one member each from these boards to the Central Board.
(c) There are ten directors from various fields and one government official from
the Ministry of Finance.
The Reserve Bank of India Act, 1934 requires that there must be at least
six meetings in a year and the gap between two meetings must not exceed three
months. The Governor of the Reserve Bank can call a meeting of the Central
Board whenever he feels it necessary. The Governor and the Deputy Governors
are full-time officials of the Reserve Bank and are paid prescribed salaries and
allowances. Other directors are part-time officials and are given fare and allowance
to participate in the meetings.
8.3.1 The organization of RBI can be divided into three
parts:
1) Central Board of Directors.
2) Local Boards
3) Offices of RBI
A) Central Board of Directors :
The organization and management of RBI is vested on the Central Board of
Directors. It is responsible for the management of RBI.Central Board of Directors
consist of 20 members. It is constituted as follows.
a)
One Governor: it is the highest authority of RBI. He is appointed by the
Government of India for a term of 5 years. He can be re-appointed for
another term.
b)
Four Deputy Governors: Four deputy Governors are nominated by Central
Govt. for a term of 5 years
c)
Fifteen Directors :Other fifteen members of the Central Board are appointed
by the Central Government. Out of these , four directors,one each from the
four local Boards are nominated by the Government separately by the Central
Government.
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Ten directors nominated by the Central Government are among the experts
of commerce, industries, finance, economics and cooperation. The finance secretary
of the Government of India is also nominated as Govt. officer in the board. Ten
directors are nominated for a period of 4 years. The Governor acts as the Chief
Executive officer and Chirman of the Central Board of Directors. In his absence a
deputy Governor nominated by the Governor, acts as the Chirman of the Central
Board. The deputy governors and government's officer nominee are not entitled to
vote at the meetings of the Board. The Governor and four deputy Governors are
full time officers of the Bank.
B) Local Boards :
Besides the central board, there are local boards for four regional areas of
the country with their head-quarters at Mumbai, Kolkata, Chennai, and New Delhi.
Local Boards consist of five members each, appointed by the central Government
for a term of 4 years to represent territorial and economic interests and the interests
of co-operatives and indigenous banks. The function of the local boards is to advise
the central board on general and specific issues referred to them and to perform
duties which the central board delegates.
C) Offices of RBI:
The Head office of the bank is situated in Mumbai and the offices of local
boards are situated in Delhi, Kolkata and Chennai. In order to maintain the smooth
working of banking system, RBI has opened local offices or branches in Ahmedabad,
Bangalore, Bhopal, Bhubaneshwar, Chandigarh, Guwahati, Hyderabad, Jaipur,
Jammu, Kanpur, Nagpur, Patna, Thiruvananthpuram, Kochi, Lucknow and Byculla
(Mumbai). The RBI can open its offices with the permission of the Government of
India. In places where there are no offices of the bank, it is represented by the
state Bank of India and its associate banks as the agents of RBI.
ORGANIZATION AND
DEPARTMENTS OF RBI
NOTES
CHECK YOUR
PROGRESS
What is Departments
of RBI?
8.4 Departments of RBI
The Reserve Bank of India has the following departments.
1. Banking Department:
The Banking Department is responsible for rendering the bank's services
as a banker to the Government and to the banks.
It consists of four sub-divisions:
(i) Public Accounts Department;
(ii) Public Debt Department;
(iii) Deposit Accounts Department; and
(iv) Securities Department.
There are 14 branches of the Banking Department, each headed by a
Joint/Deputy Manager.
2. Issue Department:
The Issue Department is concerned with the proper and efficient
management of the note issue. For the conduct of monetary transactions, the country
has been divided into 14 circles of issue, each having an Office of Issue - the
branch of the Issue Department. Each branch of the Issue Department consists
of:
(i) The General Department and
(ii) The Cash Department controlled by the currency officer.
The General Department deals with resource operations, i.e., arrangement
of supply of notes and coins from the presses and Government Mints. The Cash
Department deals with the cash transactions.
3. Department of Currency Management:
This department is concerned with the forecasting of the long-term
requirements of the currency, indenting and allocation of currency notes to various
branches of the Issue Department taking into account the demand pattern, storage
facilities, etc. It is headed by the Chief Officer.
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4. Department of Expenditure and Budgetary Control:
This department is concerned with the preparation of the bank's budget
and monitoring of the expenditure of the different units. It is headed by the Financial
Controller.
NOTES
5. Department of Government and Bank Accounts:
This department is concerned with the maintenance and supervision of the
bank's accounts
in the Issue and the Banking Departments and the compilation of weekly
statements of affairs and the Annual Profits & Loss Account and Balance Sheet.
It is headed by the Chief Accountant.
6. Exchange Control Department:
The Exchange Control department is responsible for controlling foreign
exchange transactions and maintaining exchange rate stability.
7. Department of Banking Operations and Development:
This Department was entrusted with the responsibility of the supervision,
control and development of the commercial bank system in the country. Till July
1982, it was also concerned with the Lead Bank Scheme and bank credit to the
priority sectors.
8. Industrial Credit Department:
The Industrial Finance Department is basically concerned with the
administration of the Credit Guarantee Scheme for small scale industries or as
agent of the Government of India, with the operational and organisational aspects
of the State Financial Corporation's (SFCs), work connected with the Industrial
Development Bank of India (IDBI), data collection about financing of small-scale
industries and other relevant problems.
It also deals with the operation and administration of the Credit Authorisation
Scheme.
9. Agricultural Credit Department:
This department is mainly responsible for building up of a sound cooperative
credit structure in rural financing, supplementing the financial resources of state
co-operative banks, providing financial assistance to State Governments to
strengthen the co-operative structure, advising Central and State Governments on
agricultural and rural credit, formulating policies for taking over of PACs for
financing by commercial banks, coordinating the long-term credit activities of State
Land Development Banks, etc.
The department also keeps liaison with the Agricultural Refinance and
Development Corporation, the Agricultural Finance Corporation, SCBs and LDBs.
With the establishment of the NABARD now, all functions of the
Agricultural Credit Department have been transferred to this new institution, except
for the supervision and control over the operations of the primary (urban) cooperative banks. The responsibility of supervision and control of PCBs are now
shifted to the Department of Banking Operations and Development.
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10. Rural Planning and Credit Department:
This department was established in 1982. It is basically concerned with
issues like District Credit Plans, Lead Bank Scheme, provision of expert guidance/
assistance and processing and sanction of general lines of credit for short-term
advances to the NABARD, special studies for promoting IRDP, and for framing
the Reserve Bank's policy on rural development.
11. Department of Non-Banking Companies:
This department administers and controls as well as regulates deposits of
non-banking financial companies.
12. Credit Planning Cell:
The Credit Planning and Banking Development Cell have been constituted
for the formulation and monitoring of credit policies as well as the developmental
aspects of commercial banking.
It chalks out macro-level monetary budgets of the country.
ORGANIZATION AND
DEPARTMENTS OF RBI
NOTES
13. Department of Economic Analysis and Policy:
This department conducts economic research and reviews financial and
banking conditions in the country. The Economic Department comprises five units:
(i) the Internal Finance Unit;
(ii) International Finance Unit;
(iii) Prices, Production and General Unit;
(iv) Analysis of National Economic Parameters Unit; and
(v) General Unit.
The Economic Department prepares the Bank's Annual Report, the Report
on Trend and Progress of Banking in India, the Report on Currency and Finance,
and the Reserve Bank of India Bulletins. It also undertakes ad hoc studies on
emerging aspects of banking and other important issues.
14. Department of Statistical Analysis and Computer Services:
Its main function involves the generation, collection, processing and
compilation of statistical data relating to the banking and financial sectors from the
operational as well as research point of view.
15. Legal Department:
It tenders legal advice on various matters referred to it by the Bank.
16. Inspection Department:
It carries out internal inspections of the offices and departments of the
bank.
17. Department of Administration and Personnel:
It looks after the general administration and personnel policy, such as
recruitment, training, placements, promotions, transfers, discipline, appeals, service
conditions, wage structure, etc.
18. Premises Department:
It is mainly concerned with the construction of buildings for the Bank's
offices, training institutions and staff quarters.
19. Management Services Department:
It is basically concerned with organisational analysis, systems research
and development, work procedure studies and codification, manpower planning,
costing studies, etc.
20. Reserve Bank of India Service Board:
Its functions involve conducting of examinations/interviews for the selection
and promotion of staff in the Reserve Bank.
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Financial Institutions - I
21. Central Records and Documentation Centre:
It is meant for the preservation of non-current records of the Bank. It
provides arrangement for the scientific preservation of records, retrieval service to
the enquirer departments, tools of reference such as catalogues, indices, etc.
NOTES
22. Secretary's Department:
It attends to the secretarial work connected with the meetings of the Central
Board and its committee and of the Administrators of the RBI Employee's Provident
Fund and RBI Employees' Co-operative Guarantee Fund.
23. Training Establishments:
The Reserve Bank has set-up three prominent training institutions for
imparting training in different areas of banking.
These are:
(i) The Banker's Training College, Bombay
(ii) The College of Agricultural Banking, Pune
(iii) The Reserve Bank Staff College, Madras
8.5 Summary
RBI established in the year 1935. In 1949, the Government of India
nationalized the Reserve Bank under the Reserve Bank (Transfer of Public
Ownership) Act, 1948. RBI is the central bank of India.
The management of the Reserve Bank is under the control of Central
Board of Directors. The executive head of the Bank is called Governor who is
assisted by four Deputy Governors. They are appointed by the Government of
India for a period of five years.
RBI work under different departments such as Issue department, Exchange
control department, Industrial credit department, Economic analysis and Policy
etc.
8.6 Exercise & Questions
Fill in the Blanks 1)
The executive head of the Bank is called……………..Who is assisted by
four Deputy Governors.
2)
---------- directors nominated by the Central Government are among the
experts of commerce, industries, finance, economics and cooperation.
3)
There are -------branches of the Banking Department.
4)
The organization of RBI is divided into ------ parts.
Short answer Questions -
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Money, Central Banking in
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Financial Institutions - I
a)
Write a short note on Banking Department of RBI.
b)
Write a short note on central board of RBI.
c)
Draw a tree diagram of Organization structure of RBI.
Long Answer Questions
1)
Explain the working of any five departments of RBI.
2)
Explain the organization and structure of reserve bank of India.
3)
Explain the working of following departments of RBI -
ORGANIZATION AND
DEPARTMENTS OF RBI
NOTES
a) Issue department.
b) Exchange control department.
c) Industrial credit department
d) Economic analysis and Policy
8.7 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
(77)
Money, Central Banking in
India and International
Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
UNIT - 9
ROLE AND FUNCTIONS OF RBI
NOTES
Structure
CHECK YOUR
PROGRESS
Describe Role of
RBI?
9.1
Introduction
9.2
Objectives
9.3
Role of Reserve bank of India
9.4
Functions of Reserve Bank of India
9.5
Summary
9.6
Exercise & Questions
9.7
Further Reference Books
9.1 Introduction
The Reserve Bank of India is the central bank of the country entrusted
with monetary stability, the management of currency and the supervision of the
financial as well as the payments system. RBI established in the year 1935 and
nationalized in1949. The RBI is the apex monetary institution authority in India.
Consequently, it plays an important role in strengthening, developing and diversifying
the countries economic and financial structure.
9.2 Objectives
At the end of this unit, you will be able to 1) Understand the role of RBI
2) Understand the different functions of RBI
9.3 Role of Reserve bank of India
The Reserve Bank of India is the central bank of the country entrusted
with monetary stability, the management of currency and the supervision of the
financial as well as the payments system.
Established in 1935, its functions and focus have evolved in response to
the changing economic environment. Its history is not only intrinsically interwoven
with the economic and financial history of the country, but also gives insights into
the thought processes that have helped shape the country's economic policies.
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1)
The RBI is the apex monetary institution of the highest authority in India.
Consequently, it plays an important role in strengthening, developing and
diversifying the countries economic and financial structure.
2)
RBI is responsible to maintain the economic stability in India.
3)
RBI implements monetary policy through the instruments of credit control in
order to maintain the money supply in market.
4)
RBI act as bank of government and perform various functions like maintain
the account of government, manage public debt, adviser to government etc.
5)
RBI is also known as banker's bank. RBI control banking system as per
banking regulation act - 1949.
6)
RBI protect the market for government securities.
7)
RBI is responsible for promoting banking habits among people
9.4 Functions of Reserve Bank of India
ROLE AND FUNCTIONS
OF RBI
NOTES
As a central bank, the Reserve Bank has significant powers and duties to
perform. For smooth and speedy progress of the Indian Financial System, it has to
perform some important tasks. Among others it includes maintaining monetary and
financial stability, to develop and maintain stable payment system, to promote and
develop financial infrastructure and to regulate or control the financial institutions.
a) Issuer of currency
Except for issuing one rupee notes and coins, RBI is the sole authority for
the issue of currency in India. The Indian government issues one rupee notes and
coins. Major currency is in the form of RBI notes, such as notes in the denominations
of two, five, ten, twenty, fifty, one hundred, five hundred, and one thousand. Earlier,
notes of higher denominations were also issued. But, these notes were demonetized
to discourage users from indulging in black-market operations.
RBI has two departments - the Issue department and Banking department.
The issue department is dedicated to issuing currency. All the currency issued is
the monetary liability of RBI that is backed by assets of equal value held by this
department. Assets consist of gold, coin, bullion, foreign securities, rupee coins,
and the government's rupee securities. The department acquires these assets
whenever required by issuing currency. The conditions governing the composition
of these assets determine the nature of the currency standard that prevails in
India.
The Banking department of RBI looks after the banking operations. It
takes care of the currency in circulation and its withdrawal from circulation. Issuing
new currency is known as expansion of currency and withdrawal of currency is
known as contraction of currency.
The central bank is the bank of issue. It has the monopoly of note issue.
Notes issued by it circulate as legal tender money. It has its issue department
which issues notes and coins to commercial banks. Coins are manufactured in the
government mint but they are put into circulation through the central bank.
Central banks have been following different methods of note issue in different
countries. The central bank is required by law to keep a certain amount of gold and
foreign securities against the issue of notes. In some countries, the amount of gold
and foreign securities bears a fixed proportion, between 25 to 40 per cent of the
total notes issued.
In other countries, a minimum fixed amount of gold and foreign currencies
is required to be kept against note issue by the central bank. This system is operative
in India whereby the Reserve Bank of India is required to keep Rs 115 crores in
gold and Rs 85 crores in foreign securities. There is no limit to the issue of notes
after keeping this minimum amount of Rs 200 crores in gold and foreign securities.
The monopoly of issuing notes vested in the central bank ensures uniformity
in the notes issued which helps in facilitating exchange and trade within the country.
It brings stability in the monetary system and creates confidence among the public.
The central bank can restrict or expand the supply of cash according to the
requirements of the economy. Thus it provides elasticity to the monetary system.
By having a monopoly of note issue, the central bank also controls the banking
system by being the ultimate source of cash. Last but not the least, by entrusting
the monopoly of note issue to the central bank, the government is able to earn
profits from printing notes whose cost is very low as compared with their face
value.
CHECK YOUR
PROGRESS
Describe Functions of
RBI?
(79)
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Financial Institutions - I
Money, Central Banking in
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Financial Institutions - I
NOTES
b) Banker to the Government
RBI acts as banker, both to the central government and state governments.
It manages all the banking transactions of the government involving the receipt and
payment of money. In addition, RBI remits exchange and performs other banking
operations.
RBI provides short-term credit to the central government. Such credit
helps the government to meet any shortfalls in its receipts over its disbursements.
RBI also provides short term credit to state governments as advances.
RBI also manages all new issues of government loans, servicing the
government debt outstanding, and nurturing the market for government's securities.
RBI advises the government on banking and financial subjects, international finance,
financing of five-year plans, mobilizing resources, and banking legislation.
c) Managing Government Securities
Various financial institutions such as commercial banks are required by
law to invest specified minimum proportions of their total assets/liabilities in
government securities. RBI administers these investments of institutions.
The other responsibilities of RBI regarding these securities are to ensure l
Smooth functioning of the market
l
Readily available to potential buyers
l
Easily available in large numbers
l
Undisturbed maturity-structure of interest rates because of excess or deficit
supply
l
Not subject to quick and huge fluctuations
l
Reasonable liquidity of investments
l
Good reception of the new issues of government loans
d) Banker to Other Banks
The role of RBI as a banker to other banks is as follows:
l
Holds some of the cash reserves of banks
l
Lends funds for short period
l
Provides centralized clearing and quick remittance facilities
RBI has the authority to statutorily ensure that the scheduled commercial
banks deposit a stipulated ratio of their total net liabilities. This ratio is known as
cash reserve ratio [CRR]. However, banks can use these deposits to meet their
temporary requirements for interbank clearing as the maintenance of CRR is
calculated based on the average balance over a period.
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e) Controller of Money Supply and Credit
The most important function of the central bank is to control the credit
creation power of commercial bank in order to control inflationary and deflationary
pressures within this economy. For this purpose, it adopts quantitative methods and
qualitative methods. Quantitative methods aim at controlling the cost and quantity
of credit by adopting bank rate policy, open market operations, and by variations in
reserve ratios of commercial banks.
Qualitative methods control the use and direction of credit. These involve
selective credit controls and direct action. By adopting such methods, the central
bank tries to influence and control credit creation by commercial banks in order to
stabilise economic activity in the country.
Besides the above noted functions, the central banks in a number of
developing countries have been entrusted with the responsibility of developing a
strong banking system to meet the expanding requirements of agriculture, industry,
trade and commerce.
Accordingly, the central banks possess some additional powers of
supervision and control over the commercial banks. They are the issuing of licenses;
the regulation of branch expansion; to see that every bank maintains the minimum
paid up capital and reserves as provided by law; inspecting or auditing the accounts
of banks; to approve the appointment of chairmen and directors of such banks in
accordance with the rules and qualifications; to control and recommend merger of
weak banks in order to avoid their failures and to protect the interest of depositors;
to recommend nationalization of certain banks to the government in public interest;
to publish periodical reports relating to different aspects of monetary and economic
policies for the benefit of banks and the public; and to engage in research and train
banking personnel
In a planned economy, the central bank plays an important role in controlling
the paper currency system and inflationary tendency. RBI has to regulate the
claims of competing banks on money supply and credit. RBI also needs to meet
the credit requirements of the rest of the banking system.
RBI needs to ensure promotion of maximum output, and maintain price
stability and a high rate of economic growth. To perform these functions effectively,
RBI uses several control instruments such as l
Open Market Operations
l
Changes in statutory reserve requirements for banks
l
Lending policies towards banks
l
Control over interest rate structure
l
Statutory liquidity ration of banks
ROLE AND FUNCTIONS
OF RBI
NOTES
f) Exchange Manager and Controller
RBI manages exchange control, and represents India as a member of the
international Monetary Fund [IMF]. Exchange control was first imposed on India
in September 1939 when World War II started and continues till date. Exchange
control was imposed on both receipts and payments of foreign exchange.
According to foreign exchange regulations, all foreign exchange receipts,
whether on account of export earnings, investment earnings, or capital receipts,
whether of private or government accounts, must be sold to RBI either directly or
through authorized dealers. Most commercial banks are authorized dealers of RBI.
g) Publisher of Monetary Data and Other Data
RBI maintains and provides all essential banking and other economic data,
formulating and critically evaluating the economic policies in India. In order to
perform this function, RBI collects, collates and publishes data regularly. Users
can avail this data in the weekly statements, the RBI monthly bulletin, annual report
on currency and finance, and other periodic publications.
f) Lender of the Last Resort:
The central bank lends to such institutions in order to help them in times of
stress so as to save the financial structure of the country from collapse. It acts as
lender of the last resort through discount house on the basis of treasury bills,
government securities and bonds at "the front door".
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Money, Central Banking in
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Financial Institutions - I
NOTES
The other method is to give temporary accommodation to the commercial
banks or discount houses directly through the "back door". The difference between
the two methods is that lending at the front door is at the bank rate and in the
second case at the market rate. Thus the central bank as lender of the last resort
is a big source of cash and also influences prices and market rates.
g) Clearing House for Transfer and Settlement:
As bankers' bank, the central bank acts as a clearing house for transfer
and settlement of mutual claims of commercial banks. Since the central bank holds
reserves of commercial banks, it transfers funds from one bank to other banks to
facilitate clearing of cheques. This is done by making transfer entries in their
accounts on the principle of book-keeping. To transfer and settle claims of one
bank upon others, the central bank operates a separate department in big cities and
trade centres. This department is known as the "clearing house" and it renders the
service free to commercial banks.
When the central bank acts as a clearing agency, it is time-saving and
convenient for the commercial banks to settle their claims at one place. It also
economises the use of money. "It is not only a means of economising cash and
capital but is also a means of testing at any time the degree of liquidity which the
community is maintaining."
Developmental and Promotional role of RBI
Along with the routine traditional functions, central banks especially in the
developing country like India have to perform numerous functions. These functions
are country specific functions and can change according to the requirements of
that country. The RBI has been performing as a promoter of the financial system
since its inception. Some of the major development functions of the RBI are
maintained below.
H) Development of the Financial System:
The financial system comprises the financial institutions, financial markets
and financial instruments. The sound and efficient financial system is a precondition
of the rapid economic development of the nation. The RBI has encouraged
establishment of main banking and non-banking institutions to cater to the credit
requirements of diverse sectors of the economy.
i) Development of Agriculture
In an agrarian economy like ours, the RBI has to provide special attention
for the credit need of agriculture and allied activities. It has successfully rendered
service in this direction by increasing the flow of credit to this sector. It has earlier
the Agriculture Refinance and Development Corporation (ARDC) to look after
the credit, National Bank for Agriculture and Rural Development (NABARD) and
Regional Rural Banks (RRBs).
j) Provision of Industrial Finance
Rapid industrial growth is the key to faster economic development. In this
regard, the adequate and timely availability of credit to small, medium and large
industry is very significant. In this regard the RBI has always been instrumental in
setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM
BANK etc.
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k) Provisions of Training
The RBI has always tried to provide essential training to the staff of the
banking industry. The RBI has set up the bankers' training colleges at several
places. National Institute of Bank Management i.e NIBM, Bankers Staff College
i.e BSC and College of Agriculture Banking i.e CAB are few to mention.
l) Collection of Data
Being the apex monetary authority of the country, the RBI collects process
and disseminates statistical data on several topics. It includes interest rate, inflation,
savings and investments etc. This data proves to be quite useful for researchers
and policy makers.
ROLE AND FUNCTIONS
OF RBI
NOTES
m) Publication of the Reports
The Reserve Bank has its separate publication division. This division collects
and publishes data on several sectors of the economy. The reports and bulletins
are regularly published by the RBI. It includes RBI weekly reports, RBI Annual
Report, Report on Trend and Progress of Commercial Banks India., etc. This
information is made available to the public also at cheaper rates.
n) Promotion of Banking Habits
As an apex organization, the RBI always tries to promote the banking
habits in the country. It institutionalizes savings and takes measures for an expansion
of the banking network. It has set up many institutions such as the Deposit Insurance
Corporation-1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These
organizations develop and promote banking habits among the people. During
economic reforms it has taken many initiatives for encouraging and promoting
banking in India.
0) Promotion of Export through Refinance
The RBI always tries to encourage the facilities for providing finance for
foreign trade especially exports from India. The Export-Import Bank of India (EXIM
Bank India) and the Export Credit Guarantee Corporation of India (ECGC) are
supported by refinancing their lending for export purpose.
9.5 Summary
The RBI is the apex monetary institution of the highest authority in India.
Consequently, it plays an important role in strengthening, developing and diversifying
the countries economic and financial structure. RBI is responsible to maintain the
economic stability in India.
As bankers' bank, the central bank acts as a clearing house for transfer
and settlement of mutual claims of commercial banks.
The monopoly of issuing notes vested in the central bank ensures uniformity
in the notes issued which helps in facilitating exchange and trade within the country.
RBI is responsible for promoting banking habits among people.
9.6 Exercise & Questions
Fill
1)
2)
3)
4)
in the blanks The -------- is the apex monetary institution authority in India.
--------- methods aim at controlling the cost and quantity of credit.
RBI control banking system as per banking ------------.
--------- is the sole authority for the issue of currency in India.
(83)
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Money, Central Banking in
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Financial Institutions - I
NOTES
Short Answer Questions 1)
RBI is called as lender of last resort. Explain.
2)
Write a short note on issue of currency function of RBI.
3)
How RBI control credit through monetary policy?
4)
RBI is also called as banker's bank. Discuss.
Long Answer Questions 1)
Explain the promotional functions of RBI.
2)
Explain the role of RBI.
3)
Explain any five functions of
9.7 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
(84)
Money, Central Banking in
India and International
Financial Institutions - I
UNIT - 10
MONETARY POLICY AND RESERVE
BANK OF INDIA
MONETARY POLICY AND
RESERVE BANK OF INDIA
NOTES
Structure
10.1
Introduction
10.2
Objectives
10.3
Meaning of Monetary policy
10.4
Objectives of monetary policy
10.5
Instruments of Monetary Policy
10.6
LIMITATIONS OF MONETARY POLICY
10.7
Summary
10.8
Exercise & Questions
10.9
Further Reference Books
10.1 Introduction
CHECK YOUR
PROGRESS
What is the meaning
of Monetary Policy?
Monetary policy is the process by which the monetary authority of a country
controls the supply of money, often targeting an inflation rate or interest rate to
ensure price stability and general trust in the currency.
Further goals of a monetary policy are usually to contribute to economic
growth and stability, to lower unemployment, and to maintain predictable exchange
rates with other currencies.
Monetary economics provides insight into how to craft optimal monetary
policy.
10.2 Objectives
At the end of this unit, you will be able to 1) Understand the meaning of monetary policy.
2) Understand the objectives of monetary policy.
3) Know the instruments of credit control.
4) Understand the limitations of monetary policy.
10.3 Meaning of Monetary policy
Definition: Monetary policy is the macroeconomic policy laid down by the
central bank. It involves management of money supply and interest rate and is the
demand side economic policy used by the government of a country to achieve
macroeconomic objectives like inflation, consumption, growth and liquidity.
Monetary policy is the process by which the government, central bank, or
monetary authority of a country controls (i) the supply of money, (ii) availability of
money, and (iii) cost of money or rate of interest to attain a set of objectives
oriented towards the growth and stability of the economy.
Monetary policy is referred to as either being expansionary or contractionary,
where an expansionary policy increases the total supply of money in the economy
more rapidly than usual, and contractionary policy expands the money supply more
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Money, Central Banking in
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Financial Institutions - I
NOTES
slowly than usual or even shrinks it.
Expansionary policy is traditionally used to try to combat unemployment in
a recession by lowering interest rates in the hope that easy credit will entice
businesses into expanding.
Contractionary policy is intended to slow inflation in order to avoid the
resulting distortions and deterioration of asset values.
Monetary policy differs from fiscal policy, which refers to taxation,
government spending, and associated borrowing.[4]
10.4 Objectives of monetary policy
CHECK YOUR
PROGRESS
Describe Objectives
of Monetary Policy?
The objectives of monetary policy differ from country to country according
to their economic conditions. In the less developing countries like India or Pakistan
its objective may be the maintenance of monetary stability and help in the process
of economic development. In the developed countries its objective may be to achieve
full employment, without inflation. Anyhow following are the main objectives of
the monetary policy.
1. Control of Inflation and Deflation :Inflation and deflation both are not suitable for the economy. If the price
level is reasonable and there is an adjustment between the price and cost, rate of
out put can increase. Monetary policy is used to coordinate the cost and price. So
price stability is achieved through the monetary policy.
2. Exchange Stability :Monetary policy second objective is to achieve the stable foreign exchange
rate. If the rate of exchange is stable it shows that economic condition of the
country is stable.
3. Economic Development :Monetary policy plays very effective role in promoting economic growth
by providing adequate credit to productive sectors.
4. Increase in the Rate of Employment :Monetary policy another objective is to achieve full employment but without
inflation.
5. Equal Distribution of Credit :Monetary policy should also ensure that distribution of credit should be
equitable and purposeful. The credit priority should be given to backward areas.
6. Improvement in Standard of Living :It is also the major objective of the monetary policy that it should improve
the quality of life in the country.
These are the objectives of the monetary policy but efforts should be made
to minimize the conflicts.
(86)
Money, Central Banking in
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Financial Institutions - I
Objectives of Monetary policy in India OBJECTIVES OF MONETARY POLICY OF INDIA :The main objective of monetary policy in India is 'growth with stability'.
Monetary Management regulates availability, cost and use of money and credit. It
also brings institutional changes in the financial sector of the economy. Following
are the main objectives of monetary policy in India :-
1.
Growth With Stability :Traditionally, RBI's monetary policy was focused on controlling inflation
through contraction of money supply and credit. This resulted in poor growth
performance. Thus, RBI have now adopted the policy of 'Growth with Stability'.
This means sufficient credit will be available for growing needs of different sectors
of economy and at the same time, inflation will be controlled with in a certain limit.
MONETARY POLICY AND
RESERVE BANK OF INDIA
NOTES
2.
Regulation, Supervision And Development Of Financial Stability :Financial stability means the ability of the economy to absorb shocks and
maintain confidence in financial system. Threats to financial stability can come
from internal and external shocks. Such shocks can destabilize the country's financial
system. Thus, greater importance is being given to RBI's role in maintaining
confidence in financial system through proper regulation and controls, without
sacrificing the objective of growth. Therefore, RBI is focusing on regulation,
supervision and development of financial system.
3.
Promoting Priority Sector :Priority sector includes agriculture, export and small scale enterprises and
weaker section of population. RBI with the help of bank provides timely and
adequately credit at affordable cost of weaker sections and low income groups.
RBI, along with NABARD, is focusing on microfinance through the promotion of
Self Help groups and other institutions.
4.
Generation Of Employment :Monetary policy helps in employment generation by influencing the rate of
investment and allocation of investment among various economic activities of
different labour Intensities.
5.
External Stability :With the growth of imports and exports India's linkages with global economy
are getting stronger. Earlier, RBI controlled foreign exchange market by determining
eaxchange rate. Now, RBI has only indirect control over external stability through
the mechanism of 'managed Flexibility', where it influences exchange rate by buying
and selling foreign currencies in open market.
6.
Encouraging Savings And Investments :RBI by offering attractive interest rates encourage savings in the economy.
A high rate of saving promotes investment. Thus the monetary management by
influencing rates of interest can influence saving mobilization in the country.
7.
Redistribution Of income And Wealth :By control of inflation and deployment of credit to weaker sectors of society
the monetary policy may redistribute income and wealth favouring to weaker
sections.
8.
Regulation Of NBFIs:Non - Banking Financial Institutions (NBFIs), like UTI, IDBI, IFCI plays
an important role in deployment of credit and mobilization of savings. RBI does not
have any direct control on the functioning of such institutions. However it can
indirectly affects the policies and functions of NBFIs through its monetary policy.
(87)
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Financial Institutions - I
Money, Central Banking in
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Financial Institutions - I
NOTES
CHECK YOUR
PROGRESS
Give Instruments of
Monetary Policy?
(88)
Money, Central Banking in
India and International
Financial Institutions - I
10.5 Instruments of Monetary Policy
A) MONETARY POLICY OF RBI :The Monetary Policy of RBI is not merely one of credit restriction, but it
has also the duty to see that legitimate credit requirements are met and at the same
time credit is not used for unproductive and speculative purposes RBI has various
weapons of monetary control and by using them, it hopes to achieve its monetary
policy.
There are two methods of Credit Control A) Quantitative Method B) Qualitative Method A) General I Quantitative Credit Control Methods :In India, the legal framework of RBI's control over the credit structure
has been provided
Under Reserve Bank of India Act, 1934 and the Banking RegulationAct,
1949. Quantitative credit controls are used to maintain proper quantity of credit of
money supply in market. Some of the important general credit control methods
are:I. Quantitative Method:
(i) Bank Rate:
The bank rate, also known as the discount rate, is the rate payable by
commercial banks on the loans from or rediscounts of the Central Bank. A change
in bank rate affects other market rates of interest. An increase in bank rate leads
to an increase in other rates of interest and conversely, a decrease in bank rate
results in a fall in other rates of interest.
A deliberate manipulation of the bank rate by the Central Bank to influence
the flow of credit created by the commercial banks is known as bank rate policy. It
does so by affecting the demand for credit the cost of the credit and the availability
of the credit.
An increase in bank rate results in an increase in the cost of credit; this is
expected to lead to a contraction in demand for credit. In as much as bank credit is
an important component of aggregate money supply in the economy, a contraction
in demand for credit consequent on an increase in the cost of credit restricts the
total availability of money in the economy, and hence may prove an anti-inflationary
measure of control.
Likewise, a fall in the bank rate causes other rates of interest to come
down. The cost of credit falls, i. e., and credit becomes cheaper. Cheap credit may
induce a higher demand both for investment and consumption purposes. More
money, through increased flow of credit, comes into circulation.
A fall in bank rate may, thus, prove an anti-deflationary instrument of control.
The effectiveness of bank rate as an instrument of control is, however, restricted
primarily by the fact that both in inflationary and recessionary conditions, the cost
of credit may not be a very significant factor influencing the investment decisions
of the firms.
(ii) Open Market Operations:
Open market operations refer to the sale and purchase of securities by the
Central bank to the commercial banks. A sale of securities by the Central Bank,
i.e., the purchase of securities by the commercial banks, results in a fall in the total
cash reserves of the latter.
A fall in the total cash reserves is leads to a cut in the credit creation
power of the commercial banks. With reduced cash reserves at their command the
commercial banks can only create lower volume of credit. Thus, a sale of securities
by the Central Bank serves as an anti-inflationary measure of control.
Likewise, a purchase of securities by the Central Bank results in more
cash flowing to the commercials banks. With increased cash in their hands, the
commercial banks can create more credit, and make more finance available. Thus,
purchase of securities may work as an anti-deflationary measure of control.
The Reserve Bank of India has frequently resorted to the sale of
government securities to which the commercial banks have been generously
contributing. Thus, open market operations in India have served, on the one hand
as an instrument to make available more budgetary resources and on the other as
an instrument to siphon off the excess liquidity in the system.
MONETARY POLICY AND
RESERVE BANK OF INDIA
NOTES
(iii) Variable Reserve Ratios:
Variable reserve ratios refer to that proportion of bank deposits that the
commercial banks are required to keep in the form of cash to ensure liquidity for
the credit created by them.
A rise in the cash reserve ratio results in a fall in the value of the deposit
multiplier. Conversely, a fall in the cash reserve ratio leads to a rise in the value of
the deposit multiplier.
A fall in the value of deposit multiplier amounts to a contraction in the
availability of credit, and, thus, it may serve as an anti-inflationary measure.
A rise in the value of deposit multiplier, on the other hand, amounts to the
fact that the commercial banks can create more credit, and make available more
finance for consumption and investment expenditure. A fall in the reserve ratios
may, thus, work as anti-deflationary method of monetary control.
The Reserve Bank of India is empowered to change the reserve
requirements of the commercial banks.
The Reserve Bank employs two types of reserve ratio for this purpose,
viz. the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR).
The statutory liquidity ratio refers to that proportion of aggregate deposits
which the commercial banks are required to keep with themselves in a liquid form.
The commercial banks generally make use of this money to purchase the government
securities. Thus, the statutory liquidity ratio, on the one hand is used to siphon off
the excess liquidity of the banking system, and on the other it is used to mobilise
revenue for the government.
The Reserve Bank of India is empowered to raise this ratio up to 40 per
cent of aggregate deposits of commercial banks. Presently, this ratio stands at 25
per cent.
The cash reserve ratio refers to that proportion of the aggregate deposits
which the commercial banks are required to keep with the Reserve Bank of India.
Presently, this ratio stands at 9 percent.
II) SELECTIVE / QUALITATIVE CREDIT CONTROL METHODS :Under Selective Credit Control, credit is provided to selected borrowersfor
selected purpose, depending upon the use to which the control try to regulate the
quality of credit - the direction towards thecredit flows. The Selective Controls
are:1. Ceiling On Credit
The Ceilingon level of credit restricts the lending capacity of a bank to
grant advances against certain controlled securities.
2. MarginRequirements
A loan is sanctioned against Collateral Security. Margin means that
proportion of the value of security against which loan is not given. Margin against
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NOTES
a particular security is reduced or increased in order to encourageor to discourage
the flow of credit to a particular sector. It varies from 20% to 80%. For agricultural
commodities it is as high as 75%. Higher the margin lesser will be the loan sanctioned.
e.g.- a person mortgages his property worth Rs. 100,000 against loan. The
bank will give loan of Rs. 80,000 only. The marginal requirement here is 20%.
In case the flow of credit has to be increased, the marginal requirement
will be lowered. RBI has been using this method since 1956.[2]
3. Discriminatory Interest Rate (DIR)
Through DIR, RBI makes credit flow to certain priority or weaker sectors
by charging concessional rates of interest. RBI issues supplementary instructions
regarding granting of additional credit against sensitive commodities, issue of
guarantees, making advances etc.
CHECK YOUR
PROGRESS
Give Limitations of
Monetary Policy?
4. Directives
The RBI issues directives to banks regarding advances. Directives are
regarding the purpose for which loans may or may not be given.
5. Direct Action
It is too severe and is therefore rarely followed. It may involve refusal by
RBI to rediscount bills or cancellation of license, if the bank has failed to comply
with the directives of RBI.
6. Moral Suasion
Moral suasion and credit monitoring arrangement are other methods of
credit control. The policy of moral suasion will succeed only if the Central Bank is
strong enough to influence the commercial banks.
In India, from 1949 onwards, the Reserve Bank has been successful in
using the method of moral suasion to bring the commercial banks to fall in line with
its policies regarding credit. Publicity is another method, whereby the Reserve
Bank marks direct appeal to the public and publishes data which will have sobering
effect on other banks and the commercial circles.
10.6 LIMITATIONS OF MONETARY POLICY
1. Huge Budgetary Deficits :RBI makes every possible attempt to control inflation and to balance money
supply in the market. However Central Government's huge budgetary deficits have
made monetary policy ineffective. Huge budgetary deficits have resulted in excessive
monetary growth.
2. Coverage Of Only Commercial Banks :Instruments of monetary policy cover only commercial banks so inflationary
pressures caused by banking finance can be controlled by RBI, but in India, inflation
also results from deficit financing and scarcity of goods on which RBI may not
have any control.
3. Problem Of Management Of Banks And Financial Institutions :The monetary policy can succeed to control inflation and to bring overall
development only when the management of banks and Financial institutions are
efficient and dedicated. Many officials of banks and financial institutions are corrupt
and inefficient which leads to financial scams in this way overall economy is affected.
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4. Unorganised Money Market :Presence of unorganised sector of money market is one of the main obstacle
in effective working of the monetary policy. As RBI has no power over the
unorganised sector of money market, its monetary policy becomes less effective.
5. Less Accountability:At present time, the goals of monetary policy in India, are not set out in
specific terms and there is insufficient freedom in the use of instruments. In such
a setting, accountability tends to be weak as there is lack of clarity in the
responsibility of governments and RBI.
MONETARY POLICY AND
RESERVE BANK OF INDIA
NOTES
6. Black Money :There is a growing presence of black money in the economy. Black money
falls beyond the purview of banking control of RBI. It means large proposition of
total money Supply in a country remains outside the purview of RBI's monetary
management.
7. Increase Volatility :The integration of domestic and foreign exchange markets could lead to
increased volatility in the domestic market as the impact of exogenous factors
could be transmitted to domestic market. The widening of foreign exchange market
and development of rupee - foreign exchange swap would reduce risks and volatility.
8. Lack Of Transparency :According to S. S. Tarapore, the monetary policy formulation, in its present
form in India, cannot be continued indefinitely. For a more effective policy, it would
be necessary to have greater transparency in the policy formulation and transmission
process and the RBI would need to be clearly demarcated.
B.
CONCLUSION :Thus, from above we can say that despite several problems RBI has made
a good effort for effective implementation of the monetary policy in India.
10.7 Summary
Monetary policy is the process by which the monetary authority of a country
controls the supply of money, often targeting an inflation rate or interest rate to
ensure price stability and general trust in the currency.
Monetary policy is the macroeconomic policy laid down by the central
bank. It involves management of money supply and interest rate and is the demand
side economic policy used by the government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.
The Monetary Policy of RBI is not merely one of credit restriction, but it
has also the duty to see that legitimate credit requirements are met and at the same
time credit is not used for unproductive and speculative purposes RBI has various
weapons of monetary control and by using them, it hopes to achieve its monetary
policy.
There are two methods of Credit Control A) Quantitative Method
B) Qualitative Method
10.8 Exercise & Questions
Fill in the blanks1)
------------- is the process by which the government, central bank, or monetary
authority of a country controls the supply of money.
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NOTES
2)
3)
4)
The bank rate, also known as the------------, is the rate payable by commercial
banks on the loans from or rediscounts of the Central Bank.
------------- refer to the sale and purchase of securities by the Central bank
to the commercial banks.
In the period of ---------------, RBI increase Bank rate.
Short answer questions1)
How central bank control inflationary situation through a) Bank Rate
b) CRR
2)
Distinguish between CRR and SLR.
3)
Distinguish between Qualitative and Quantitative method of credit control.
4)
explain the meaning of a) Repo Rate
b) Open Market operation.
Long Answer Questions 1)
Explain the objectives monetary policy.
2)
Explain the different instruments of quantitative credit control method.
3)
Explain the different instruments of qualitative credit control method.
10.9 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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UNIT - 11
FRAMEWORK AND PROCEDURE
OF MONETARY POLICY
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
Structure
11.1
Introduction
11.2
Objectives
11.3
Monetary Policy Targets
11.4
Operating Procedures of Monetary Policy in India
11.5
Evolution of the Operating Procedure of -
11.6
Summary
11.7
Exercise & Questions
11.8
Further Reference Books
11.1 Introduction
CHECK YOUR
PROGRESS
What is Monetary
Policy Targets?
Monetary policy is the process by which the government, central bank, or
monetary authority of a country controls (i) the supply of money, (ii) availability of
money, and (iii) cost of money or rate of interest to attain a set of objectives
oriented towards the growth and stability of the economy.
Values of specific economic variables that the monetary authority seeks
achieve with monetary policy. The three most noted monetary policy targets are
interest rates, monetary aggregates, and exchange rates.
11.2 Objectives
At the end of this unit, you will be able to 1) Understand the monetary policy target
2) Understand the monetary policy procedure and its evaluation.
11.3 Monetary Policy Targets
Values of specific economic variables that the monetary authority seeks
achieve with monetary policy. The three most noted monetary policy targets are
interest rates, monetary aggregates, and exchange rates. These targets are usually
intermediate targets that can be quickly achieved and easily measured, but then
move the economy toward the ultimate macroeconomic goals of full employment,
stability, and economic growth.
Monetary policy targets are specific values of macroeconomic variables,
including interest rates, monetary aggregates, and exchange rates, that a monetary
authority pursues in the course of conducting monetary policy. The presumption,
based on extensive economic theory, is that attaining a monetary policy target
subsequently results in achieving one or more of the macroeconomic goals.
For example, achieving a particular Federal funds interest rate value might
be presumed to induce the level of investment expenditures and aggregate production
that results in a business-cycle expansion with low rates of both unemployment
and inflation. Alternatively, the monetary authority might deem that targeting a
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NOTES
specific growth rate of the M1 monetary aggregate attains this state of the economy.
In a perfect world, the monetary authority could target a variable like M1
or the Federal funds rate to simultaneously achieve full employment, stability, and
economic growth. However, in the real world, targeting one variable over others
invariably means the pursuit of one goal over others.
1) Interest Rates
Interest rates are charges for borrowing or returns from lending through
financial markets. A complex economy like that in the United States has a large
slate of interest rates, from credit cards to corporate bonds, from savings accounts
to government securities. One of the most important interest rates is the Federal
funds rate, the interest rate commercial banks charge each other for lending bank
reserves.
This rate is commonly targeted by the U.S. monetary authority (Federal
Reserve System) because:
l
It is directly affected by Federal Reserve System monetary policy, specifically
open market operations.
l
It is a benchmark interest rate that influences the values of most other interest
rates in the economy.
Federal Reserve System monetary policy is observed almost immediately
as a change in the Federal funds rate. Because open market operations affect the
amount of reserves, banks are willing to extend loans to other banks at a higher or
lower Federal funds rate.
However, changes in the Federal funds rate filter throughout the economy,
inducing corresponding changes in other interest rates, which then affect
macroeconomic activity and the pursuit of full employment, stability, and economic
growth.
2) Monetary Aggregates
Monetary aggregates, labeled M1, M2, and M3, are measures of money
and highly liquid assets, especially accounts maintained by banks. M1 is the basic
money supply, the financial assets used for actual payments, including currency
and checkable deposits. M2 is a broader measure of the money supply and includes
highly liquid near monies (savings deposits) in addition to currency and checkable
deposits. M3 is a broader measure that includes M2 plus slightly less liquid assets.
A monetary authority like the Federal Reserve System might be inclined to
target one of these monetary aggregates. Over the years, the U.S. Federal Reserve
System has targeted both M1 and M2 at different times. Targeting is typically
implemented by identifying a desired growth rate of the monetary aggregate, which
is then translated as a specific value of the aggregate at the end of a period.
If, for example, the current level of M1 is $1 trillion and a 5 percent annual
growth rate in M1 is deemed appropriate to achieve the desired macroeconomic
goals, then the Federal Reserve System targets a value of M1 at $1.05 trillion by
the end of the year.
Although M1, which contains the actual assets used for transactions, would
seem to be the logical monetary aggregate target, the Federal Reserve System has
preferred to target M2 in recent years. Focus has shifted because M2 has a more
stable connection to overall macroeconomic activity. The Federal Reserve System
has concluded that achieve a specific M2 value is more likely to generate the
desired macroeconomic goals.
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3) Exchange Rates
Exchange rates are the prices one nation's currency in terms of the
currencies of other nations. For example, the exchange rate between U.S. dollars
and Japanese yen might be something like 100 yen per dollar. One dollar can buy
100 yen or 100 yen can buy one dollar.
Exchange rates depend, in part, on the quantity of money an economy has.
If an economy with more money in circulation, then like any commodity that is
relatively abudandant, the price declines. This means that the exchange rates for a
country fall. That is, one dollar might be purchased with 90 yen rather than 100
yen.
Exchange rates are commonly targeted by a monetary authority with an
eye toward foreign trade. Lower exchange rates induce exports and limit imports,
which stimulate economic activity. Higher exchange rates have the opposite effect.
Some modern nations, especially smaller countries, take this a step further
by fixing exchanges rates. In particular, a smaller country implements monetary
policy that ensures the exchange rate between their domestic currency and that of
another country, usually a larger country like United States, is essentially fixed.
A fixed exchange rate provides a direct link between the two countries,
meaning any monetary policy by the larger country affects the smaller one, as
well. The smaller country has thus relinquished all monetary policy control to the
larger country.
A Mix
While monetary authorities can and do pursue one target to the exclusive
of others, most monetary policy generally works with a mix of targets, keeping an
eye on interest rates, monetary aggregates, and exchange rates at the same time.
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
CHECK YOUR
PROGRESS
What is Operating
Procedures
of
Monetary Policy in
India?
11.4 Operating Procedures of Monetary Policy in
India
Issues and Options
The liquidity adjustment facility (LAF) has emerged as the key element of
the present operating procedure of monetary policy. It has generally helped in
steering the desired trajectory of interest rates in response to evolving market
conditions. The Group noted that while the system, on the whole, has worked well,
some issues - both policy and operational - have arisen from changes in the market
microstructure and liquidity conditions, which have had a bearing on the smooth
functioning of the framework. In light of the current experience and keeping in
view international best practices, the Group recommends certain changes in the
operating framework.
Monetary Transmission
1)
At the heart of the operating framework is the nature of monetary
transmission. The pertinent question is whether the interest rate channel of
monetary transmission is working. The empirical exercise carried out by the
Group suggests that though the impact of the interest rate channel of monetary
transmission varies across the segments of the financial market, it is the
strongest in the money market. The Group, therefore, recommends that the
LAF with some modifications should continue as the key instrument in the
operating framework of the RBI.
2)
Monetary transmission is substantially more effective in a deficit liquidity
situation than in a surplus liquidity situation. An empirical exercise carried
out by the Group suggests that under deficit liquidity conditions, money market
rates respond immediately to a policy rate shock (Technical Appendix I).
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For example, a 100 basis points (bps) change in the repo rate causes around
80 bps change in the weighted average call rate over a month. However, the
strength of the response is relatively small in a surplus liquidity situation: a
100 bps change in the reverse repo rate, which is the operational rate in a
surplus liquidity situation, causes around 25 bps change in the weighted
average call rate over a month. Given the substantially superior strength of
monetary transmission in a deficit liquidity condition, the Group recommends
that the RBI should operate the modified LAF in a deficit liquidity mode to
the extent feasible. This is also consistent with international best practices
as in most countries, market participants, on a net basis, depend on the
central bank for reserves.
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3)
While recommending that the LAF should operate in a deficit mode, the
Group examined what the magnitude of liquidity should be. The Group noted
that the RBI has articulated a net liquidity level of (+)/(-) one per cent of net
demand and time liabilities (NDTL) of banks as ideal for effective monetary
transmission. The Group recognises that the RBI has an internal mechanism
for liquidity assessment on a daily basis. Similarly, money market participants
make their own assessment of liquidity. However, it is difficult to exactly
predict liquidity on a daily basis. Hence, the Group recommends that the
RBI should accommodate frictional liquidity changes in the LAF window
within reasonable bands consistent with effective monetary transmission. A
simulation exercise carried out by the Group showed that at a liquidity deficit
of one per cent of NDTL, the weighted average of money market rates
exceeded the repo rate, on average, by around 15 bps. Similarly, with a
liquidity surplus of one per cent of NDTL, the weighted average of money
market rates was lower by about 20 bps. But when the liquidity deficit
increased beyond one per cent of NDTL, the impact on the weighted average
of money market rates was non-linear. For example, for a deficit at 1.25 per
cent of NDTL, the deviation in weighted average of money market rates
was 40 bps which rose to 75 bps for deficits at 1.5 per cent of NDTL and
became unbounded at higher deficit levels (Technical Appendix II). The
Group was of the view that the objective of the LAF should be to stabilise
short-term interest rates around the chosen policy rate for the smooth
transmission of monetary policy. The Group, therefore, recommends that
the liquidity level in the LAF should be contained around (+)/(-) one per cent
of NDTL. If the liquidity surplus/deficit persists beyond (+)/(-) one per cent
of NDTL, the RBI should use alternative instruments to supplement the
LAF operations for effective monetary transmission.
4)
Policy Rate
The present LAF framework is such that the operating policy rate alternates
between the repo rate and the reverse repo rate, depending on the prevailing
liquidity condition. In a surplus liquidity condition, the reverse repo rate becomes
the operating policy rate. In a deficit liquidity situation, the repo rate becomes
the policy rate. The Group was of the view that going by international best
practices, it is unconventional to have two policy rates. These two rates
were supposed to provide the corridor for overnight interest rates to settle in
between. However, in practice, the call rates more often are either above or
below the corridor, depending on the liquidity situation, thus defeating the
very purpose of the corridor. Moreover, the shift in the policy rate from one
rate to another does create confusion in the minds of market participants. In
addition, it poses a major communication challenge to clearly articulate the
stance of monetary policy, particularly in a situation when liquidity alternates
between the surplus mode and the deficit mode in quick succession. As
indicated above, central banks generally follow a corridor approach and
they have a single policy rate as the system mostly operates in a deficit
mode. As the Group suggests that the RBI operate the LAF in a deficit
mode, it recommends the repo rate as the single policy rate. Further, the
Group recommends that the repo rate should operate within a corridor so
that the overnight interest rate moves around the repo rate in a narrow
informal bound. This will entail redesigning the corridor.
5)
Bank Rate
Ideally the corridor should have a discount rate at the upper bound and an
uncollateralised deposit facility at the lower bound. The RBI in its tool kit
has the Bank Rate which is essentially a discount rate. Under Section 49 of
the RBI of India Act, the Bank Rate has been defined as "the standard rate
at which it [the Reserve Bank] is prepared to buy or re-discount bills of
exchange or other commercial paper eligible for purchase under this Act".
While the Bank Rate was an important instrument of monetary control, its
importance declined once the LAF system was instituted and progressively
refinance facilities were provided at the repo rate. It is now used for
calculating penalty on default in the cash reserve ratio (CRR) and the
statutory liquidity ratio (SLR) as required by Section 42(3) of the Reserve
Bank of India Act, 1934 and Section 24 of the Banking Regulation Act,
1949, respectively. Against this backdrop, it was not felt necessary to revise
the Bank Rate. The Bank Rate has not been changed since April 2003
when it was last revised to 6 per cent, even as the policy rates have moved
in either direction quite significantly. Thus, for all practical purposes, the
Bank Rate as an instrument of monetary management has become dormant.
The Group recommends that the Bank Rate be activated as a discount rate
with a spread over the repo rate. Once the policy rate changes, the Bank
Rate should change automatically with a fixed spread over the repo rate.
6)
Constituents of the Corridor
The prescription of the Bank Rate by itself will not make it active unless
there are liquidity facilities linked to the Bank Rate. The Group recommends
the institution of a collateralised Exceptional Standing Facility (ESF) at the
Bank Rate up to one per cent of the NDTL of banks carved out of their
required SLR portfolio. This facility is not entirely new. In the recent episode
of liquidity tightness, the RBI has been providing additional liquidity up to 1
to 2 per cent of NDTL but on an ad hoc basis at the repo rate. The Group's
recommendation is to have the facility on a standing basis. The advantages
of this facility are four-fold. First, it will provide an upper bound to the policy
rate corridor. Second, it will provide a safety valve against unanticipated
liquidity shocks. Third, it will help stabilise the overnight interest rate around
the repo rate in a liquidity deficit situation. Fourth, it will enhance the liquidity
attribute of the SLR portfolio without compromising its prudential nature.
7)
Under sub-section (8) of Section 24 of the Banking Regulation Act, 1949,
the RBI is allowed to waive payment of the penal interest on account of
default in the maintenance of the SLR by a banking company2. The RBI
has used this sub-section on several occasions in the recent period to enable
banks to avail of funds from the RBI under the LAF due to the tight liquidity
situation. Banks availing of this facility have to seek a waiver of the penal
interest for any shortfall in maintenance of SLR arising out of availment of
additional liquidity support under the LAF. The idea of a standing lending
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
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facility is to enable banks to obtain funding from the central bank when all
other options have been exhausted. Furthermore, the idea of liquidity facility
up to one per cent of NDTL by waiving the penalty for the SLR default is to
ensure that interest rates in the overnight inter-bank market do not spike for
want of eligible collateral with some banks.TheGroup, therefore, recommends
that the RBI should grant general exemption from payment of penal interest
rate for the proposed ESF. Under Section 53 of the BR Act, the Central
Government, on the recommendation of the RBI, can exempt the banking
company or a class of banking companies from any or all of the provisions
of the BR Act by issuing a notification. The Group, therefore, recommends
that the RBI may write to the Central Government requesting it to grant
general exemption from penal interest rate for the proposed ESF.
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8)
While the upper bound to the corridor could be provided by the ESF proposed
by the Group, it is not feasible to establish a standing uncollateralised deposit
facility which will be treated as uncollateralised borrowing by the RBI and
this is not permitted under Section 17(4) of the Reserve Bank of India Act,
1934. Notwithstanding the Group's recommendation that LAF should operate
in a deficit liquidity mode, it is recognised that liquidity could turn into surplus
from time to time. Hence, there is need for a floor to contain volatility in the
overnight interest rate in the event of significant unanticipated movements
in liquidity. The Group, therefore, recommends that the reverse repo facility
at which the RBI absorbs liquidity from the system should constitute the
lower bound of the corridor. However, the reverse repo rate should not act
as a policy rate as at present. It should be determined as a negative spread
over the repo rate. Moreover, as the Group envisages the reverse repo
facility more in the nature of a standing deposit facility, the reverse repo rate
should be such that it does not incentivise market participants to place their
funds with the RBI. This needs to be kept in view while designing width of
the corridor.
9)
Width of the Corridor
The Group notes that the RBI has already articulated that the width of the
corridor should be based on the following two considerations. First, it should
not be so wide as to induce volatility in short-term money market rates.
Second, it should not be so narrow that it retards the development of the
short-term money market by taking away the incentive from market
participants to deal among themselves before approaching the central bank.
10)
The operation of the LAF during April 2001 to February 2011 indicates that
the repo and reverse repo rates were changed either separately or together
39 times, leading to changes in the corridor width 26 times. The RBI's policy
documents did not explicitly set out the reasons for changes in the width of
the corridor except in the July 2010 policy, which indicated that "the corridor
width was narrowed to 100 bps to contain interest rate volatility". The Working
Group concurs with this position as its own empirical work associates a
wider corridor with greater overnight interest rate volatility. Having said
that, the issue is what the ideal width of the corridor should be.
11)
An empirical exercise carried out by the Working Group showed a positive
significant correlation of corridor width with weighted average overnight
call rate. Controlling for liquidity, a wider corridor was associated with greater
volatility in the overnight interest rate. In India, the corridor width has varied
between 100 and 300 bps. An international survey suggests a corridor width
12)
of 50 to 200 bps. Calibration of the corridor width with overnight call money
rate with a probability distribution function reveals that the ideal corridor
width should be in the range of 150-170 bps with a 90 per cent confidence
interval and 180-190 bps with a 95 per cent confidence interval. Additional
calibration by controlling liquidity at (+)/(-) one per cent of NDTL, the Group's
recommended liquidity level, the corridor width works out to 150 bps at 90
per cent confidence interval and 180 bps at 95 per cent confidence interval
(Technical Appendix III). The Group also examined the effect of corridor
width on weighted average call money rate volatility using a GARCH model
which indicated that a corridor width in the range of 150-175 bps could be
optimal (Technical Appendix IV). Considering these estimates and keeping
in view the optimality at containing liquidity within (+)/(-) one per cent of
NDTL, the Group recommends 150 bps for the corridor width.
International experience suggests that the width of the corridor generally
remains fixed, but the recent global financial crisis saw countries changing
the width of the corridor. It has also been argued recently that the constant
width of the corridor is a waste of a good instrument (Goodhart, 2009)3.
Just as the spread between commercial banks deposit and lending rates is a
measure of the cost of bank intermediation, the spread between the
parameters of the corridor is measure of the cost of central bank
intermediation. This spread should narrow in the move from pre-crisis peacetime to war-time crisis conditions.
13)
The Group recommends that in the normal circumstance, the width of the
corridor should not be changed. Frequent changing of the width may create
uncertainty and may also make it difficult to keep the target rate aligned to
the policy rate. More importantly, it may be difficult to communicate such a
change. However, in extraordinary situations, when there is a need to
incentivise or disincentivise market participants from accessing the standing
lending facility or parking funds with the RBI, the width of the corridor could
be changed.
14)
Placement of Policy Rate in the Corridor
International evidence suggests that for most countries, except New Zealand,
the policy rate is placed symmetrically at the centre of the corridor. In fact,
for most of these countries, the corridor bounds are indicative as the overnight
interest rate fluctuates in a narrow informal corridor around the policy rate
as these systems operate in a deficit mode.
15)
While the Group envisages the LAF to operate in a deficit mode for effective
monetary transmission, the likelihood of the system moving to a surplus mode
is significant, given the robust growth prospects of the Indian economy in
the medium term. The Group recognised that if capital inflows are far above
the absorptive capacity of the economy and impart significant volatility to
the exchange rate, the RBI could intervene in keeping with the stated objective
of monetary policy. In such a situation, liquidity could turn into a surplus
mode. In order not to provide an incentive to banks to place their surplus
funds in the LAF window of the RBI, the Group recommends an asymmetric
corridor with the spread between the policy repo rate and reverse repo rate
twice as much as the spread between the policy repo rate and the Bank
Rate. That is, with a corridor width of 150 bps, the Bank Rate should be at
'repo rate plus 50 bps' and the reverse repo rate should be at 'repo rate
minus 100 bps'. This will ensure that market participants have an incentive
to deal among themselves before approaching the RBI.
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
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16)
The Group recommends that the repo rate should be the active policy rate to
be changed by the RBI to unambiguously signal the stance of monetary
policy to achieve the macroeconomic objectives of growth with price stability.
The repo rate will be based on fixed price daily auctions. However, the RBI
should reserve the right as at present to accept partially or fully the tenders
in the daily auctions. The Bank Rate and the reverse repo rate will change
automatically with a fixed spread as and when the repo rate changes. The
RBI at its discretion could conduct simultaneous auctions for longer period
if the liquidity situation so warrants. However, such actions should be at
variable prices as they will be for purely liquidity management rather than
for signaling the policy rate.
17)
Operating Target
The overnight call money rate has been the operating target of monetary
policy as the monetary transmission is the fastest to this segment. However,
in the past few years, the turnover in the uncollateralised (inter-bank money
market) segment has declined sharply, while that in the overnight collateralised
market segment, viz., the CBLO and market repo, has increased (Chart
IV.1). In this context, the Group examined whether the call money rate is
still the appropriate target.
18)
It is sometimes argued that a decline in the share of the call/notice money
market in the total turnover of the money market could be due to limits fixed
by the RBI on the unsecured borrowing and lending in the overnight market.
However, an analysis of the data suggests that borrowing by banks in October
2010 constituted 1 per cent of the limit fixed by the RBI. Likewise, lending
by banks constituted 6 per cent of the total limit sanctioned by the RBI. The
Group, therefore, is of the view that prudential limits as prescribed by the
RBI have not constrained the growth of the call money market; rather it has
increased the stability of the money market with an increasing share of the
collateralised segment.
19)
The substantial growth of the collateralised market vis-à-vis the
uncollateralised market reflects the result of the deliberate policy attempt to
mitigate risk in the wholesale financial market by increased use of collateral.
The increasing use of collateral has also been motivated by the need to
reduce funding costs as borrowing under the collateralised is cheaper than
that under the uncollateralised market. This phenomenon, however, is not
unique to India. The volume of collateralised transactions has also increased
markedly in major markets such as in the US, the UK, the Euro area and
Japan.
20)
Given the reduced share of the call money market in the overnight money
market, the Group examined the relative merits of the overnight call money
rate vis-à-vis the overnight money market rate, computed as the weighted
average of call money, CBLO and market repo rates as the operating target.
The empirical evidence suggests that the transmission of policy rate to the
overnight call money rate is stronger than the overnight money market rate.
Further, the stability properties of these two rates are not significantly
different. Moreover, the correlation between the overnight call money rate
and the collaterallised money market rate was high at 0.9. In addition, the
call money market is a pure inter-bank market and, hence, better reflects
the net liquidity situation. The Group, therefore, recommends that the weighted
average overnight call money rate should continue to be the operating target
of monetary policy of the RBI.
NOTES
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11.5 Evolution of the Operating Procedure of Monetary Policy in India
The operating procedure of monetary policy in India has evolved over
time. For analytical convenience, the period since 1935 to date can be divided
broadly into four phases, viz.,(i) formative phase (1935-1950), (ii) development
phase (1951-1990), (iii) early reform phase (1991-1997), and (iv) liquidity adjustment
facility phase (1998 onwards).
Formative Phase (1935-1950)
In the formative years during 1935-1950, the emphasis was on administering
the supply of and demand for credit in the economy. The Bank Rate, reserve
requirements and open market operations were the monetary policy instruments
for regulating the credit availability. As the RBI followed a passive interest rate
policy, the Bank Rate was used only once in November 1935 when it was reduced
from 3.5 per cent to 3.00 per cent. Further, although the RBI was vested with
adequate powers to resort to selective credit control, the need for it was not felt
due to the prevalence of price stability.
Development Phase (1951-1990)
During the development phase from 1951 to 1990, the role of monetary
and credit policy was emphasised as an instrument for maintaining price stability
and regulation of investment and business activity. During this period, the conduct
of monetary policy was influenced significantly by the need to support plan financing
and promote savings for its deployment to sectors in accordance with plan priorities.
The large plan financing led to the RBI accommodating deficit financing of the
government through the issue of ad hoc Treasury Bills from the beginning of Second
Five-Year Plan. This led to the conduct of monetary policy becoming a process of
passive accommodation of budget deficits by the early 1960s. Consequently, several
quantitative control measures were introduced to contain inflationary pressures
while ensuring credit to preferred sectors.
Selective credit control began to be actively used by the mid-1950s. With
a view to influencing the demand for and use of credit, the quota-cum-slab stipulating
minimum lending rates was introduced in October 1960. The credit authorisation
scheme (CAS) was introduced in 1965 to ration bank credit. Further, 'social control'
measures were introduced by the Government in December 1967 to enhance the
flow of credit to priority sectors like agriculture, small sector industries and exports.
During this period, the Bank Rate was used relatively more actively by raising it
successively from 3.5 per cent in 1957 to 6 per cent by 1965, before lowering it to
5 per cent in 1968 (Appendix Table AT.1).
With the nationalisation of the major commercial banks in July 1969, the
conduct of monetary policy began to focus mainly on credit planning, with nonfood credit as the policy indicator. Banks were provided funds through standing
facilities such as 'general refinance' and 'export refinance' to facilitate developmental
financing as per credit plans. Among the policy instruments, the SLR was used for
raising resources for the government plan expenditure from banks. The level of
SLR was progressively increased from the statutory minimum of 25 per cent in
February 1970 to 38.5 per cent by September 1990 (Appendix Table AT.1). The
CRR was mainly used to neutralise the inflationary impact of deficit financing and
was gradually raised from its statutory minimum of 3 per cent in September 1962
to 15 per cent by July 1989 (Appendix Table AT.1). During this period, the Bank
Rate had a limited role in monetary policy operations, as it was ineffective due to
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
CHECK YOUR
PROGRESS
What is Evolution of
the
Operating
Procedure?
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NOTES
the increasing prescription of differential rates for various sector-specific refinance
facilities and the lack of a genuine bill market.
Against this backdrop, it was considered necessary to comprehensively
review the functioning of the monetary system and carry out the necessary changes
in the institutional set-up and framework of monetary policy. This led to two landmark
Reports, viz., (i) the Committee to Review the Working of the Monetary System
(Chairman: Prof. S. Chakravarty, 1985) which made comprehensive
recommendations for the adoption of monetary targeting and the development of
the Indian money market; and (ii) the Working Group on Money Market (Chairman:
Shri N. Vaghul, 1987) which led to introduction of a number of money market
instruments such as inter-bank participation certificates (1988), certificates of deposit
(1989) and Commercial Paper (1990). Based on the recommendations of the
Chakravarty Committee, a flexible monetary targeting framework with feedback
from the real sector and with broad money as the nominal anchor evolved by the
mid-1980s. Under this framework, reserve money was the operating target and
the CRR was the key operating instrument. However, the efficient functioning of
the market continued to remain hindered by a number of other structural rigidities
in the system such as the skewed distribution of liquidity and the prevalence of
administered deposit and lending rates, besides the persistence of fiscal dominance.
Early Reform Phase (1991-1997)
Following another landmark Report - Report of the Committee on Financial
System (Chairman: Shri M. Narasimham, 1991) The process of financial liberalisation implemented in the early 1990s led
to a structural shift in the financing paradigm for the government and commercial
sectors. Liquidity absorption began to be carried out through reverse repos (then
called repos) introduced in 1992.
The government market borrowing through auctions since 1992-93 led to
development of a secondary market in government securities and the market
determination of interest rates. Furthermore, the exchange rate began to have a
bearing on monetary management with exchange rate liberalisation - the rupee
became fully convertible on the current account in 1994 - and the opening up of the
economy. By the second half of the 1990s, liquidity management operations by the
RBI moved away from direct instruments to indirect instruments. The CRR was
brought down from 15 per cent of net demand and time liabilities (NDTL) of banks
during July 1989-April 1993 to 9.5 per cent by November 1997. The SLR was
reduced to the statutory minimum of 25 per cent by October 1997.
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Liquidity Adjustment Facility Phase (1998 onwards)
Introduction of Interim Liquidity Adjustment Facility (ILAF)
In 1998, the Committee on Banking Sector Reforms (Narasimham
Committee II) recommended the introduction of a Liquidity Adjustment Facility
(LAF) under which the RBI should conduct auctions periodically. Accordingly, the
RBI introduced an Interim Liquidity Adjustment Facility (ILAF) in April 1999 to
minimise volatility in the money market by ensuring the movement of short-term
interest rates within a reasonable range. Under the ILAF, the Bank Rate acted as
the refinance rate (i.e., the rate at which the liquidity was to be injected) and
liquidity absorption was done through the fixed reverse repo rate announced on a
day-to-day basis. An informal corridor of the call rate thus emerged with the Bank
Rate as the ceiling and the reverse repo rate as the floor rate, thereby minimising
the volatility in the money market. ILAF was expected to promote stability in
money market activities and ensure that interest rates moved within a reasonable
range.
With the introduction of ILAF in April 1999, the general refinance facility1
was withdrawn and replaced by a collateralised lending facility (CLF) for scheduled
commercial banks. The entitlement under CLF was fixed at up to 0.25 per cent of
the fortnightly average outstanding aggregate deposits in 1997-98 for two weeks
at the Bank Rate. Additional collateralised lending facility (ACLF) for an equivalent
amount of CLF was made available at the Bank Rate plus 2 per cent. CLF and
ACLF availed for periods beyond two weeks were subjected to a further penal
rate of 2 per cent (i.e., Bank Rate plus 4 per cent) for an additional two-week
period. The Export Credit Refinance (ECR) facility for scheduled commercial
banks was provided at the Bank Rate. Liquidity support to Primary Dealers (PDs)
against collateral of government securities based on bidding commitment and other
parameters - termed as Level I support - was given at the Bank Rate with a
repayment period of 90 days. Additional liquidity support - termed as Level II
support - at the Bank Rate plus 2 per cent against collateral of government securities
was also made available for a period not exceeding two weeks.
It is important to note that during the phase of ILAF, the standing lending
facilities for banks included CLF, ACLF and ECR; and for PDs, it was Level I and
Level II liquidity support. Also, the entitlement and the rate at which these facilities
were available were different. Therefore, there were multiple standing lending
facilities available at multiple rates. These rates were administered in nature which
were rationalised subsequently.
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
Transition to Full-fledged LAF
Undertaken in three stages.
In the first stage, with effect from June 5, 2000, fixed rate reverse repo
gave way to variable rate reverse repo auctions. Also, the ACLF to banks and
Level II support to PDs were replaced by variable rate repo auctions of same day
settlement. As a result, unlike in the ILAF where the rates of interest and amount
for refinancing were fixed, in the LAF both were varied to respond to day-to-day
liquidity conditions. In the second stage, beginning in May 2001, the CLF and ECR
for banks and Level I liquidity support for PDs were divided into two parts of
approximately 2:1 ratio, viz., a normal facility at the Bank Rate and a backstop
facility at a variable rate at 1 per cent above the repo rate, i.e., at a market-related
rate. Incidentally, as at end-May 2001, the repo rate stood higher at 8.75 per cent
compared to the Bank Rate at 7 per cent. Some minimum liquidity support to PDs
was continued but at an interest rate linked to the variable rate in the daily repo
auctions as determined by the RBI from time to time.
Subsequently, the CLF was withdrawn in October 2002. The apportionment
of ECR as normal and backstop facilities was also gradually modified by increasing
the proportion of backstop facilities which was financed at variable market-based
rates linked to the repo rate. The ratio of normal to backstop facilities was changed
from 2:1 to 1:1 in November 2002 and further to 1:2 in December 2003. Finally,
with effect from March 29, 2004, with the repo rate unified to the Bank Rate at 6
per cent, the entire quantum of ECR and liquidity support to PDs was made available
at the repo rate, thereby completely de-linking the standing facilities to banks from
the Bank Rate. Thus, the repo rate emerged as the lending rate of the RBI for all
practical purposes. As a result, the importance of the Bank Rate as a monetary
policy instrument waned.
Current Operating Procedure
Subsequently, the LAF scheme was revised, taking into account the
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NOTES
recommendations of the Internal Group on LAF and suggestions from market
participants and experts. Accordingly, the 1-day reverse repo was phased out, and
in its place the 7-day fixed rate reverse repo on a daily basis and the 14-day
variable rate reverse repo on a fortnightly basis were introduced in March 2004.
Repo operation was, however, retained on an overnight basis. Also, the repo rate
was scaled down to 6 per cent and aligned with the Bank Rate under the revised
LAF scheme. Accordingly, a single liquidity injection facility available at a single
rate was introduced by merging the normal facility and backstop facility.
In order to restore flexibility in liquidity management, the RBI reintroduced
the 1-day fixed rate reverse repo in August 2004 while continuing with 7-day and
14-day reverse repos and overnight fixed rate repos. Eventually, in order to have
greater flexibility in liquidity management, the 7-day fixed rate and the 14-day
variable rate reverse repos were phased out and the LAF was operated through
overnight fixed rate repo and reverse repo effective from November 1, 2004. With
effect from October 29, 2004, the nomenclature of repo and reverse repo was
interchanged as per international usage.
The third stage of full-fledged LAF began with the full computerisation of
the Public Debt Office (PDO) and the introduction of the Real Time Gross
Settlement (RTGS) system enabling repo operations mainly through electronic
transfers and the operation of LAF at different times of the same day. Around this
time in 2005-06, the economy witnessed strong and sustained credit demand, lower
accretion of forex reserves, build-up of the centre's cash balances with the RBI
and the redemption of India Millennium Deposits (IMDs). All these led to the
injection of liquidity by the RBI. During this time, in order to fine-tune the
management of day-to-day liquidity and in response to suggestions from market
participants, the Second LAF (SLAF) was introduced on a daily basis in November
2005. SLAF is now used periodically, depending on liquidity conditions, rather than
as a regular facility.
The Group noted that the operating framework has undergone several
changes over the years with the widening and deepening of the money market and
changes in the institutional mechanism and technology. Under the current operating
framework in effect from November 2004, all liquidity injections are made at the
fixed repo rate and liquidity absorption at the fixed reverse repo rate, with the two
rates intended to act as the upper and lower bound of the corridor, respectively.
11.6 Summary
Values of specific economic variables that the monetary authority seeks
achieve with monetary policy. The three most noted monetary policy targets are
interest rates, monetary aggregates, and exchange rates. These targets are usually
intermediate targets that can be quickly achieved and easily measured, but then
move the economy toward the ultimate macroeconomic goals of full employment,
stability, and economic growth.
The operating procedure of monetary policy in India has evolved over
time. For analytical convenience, the period since 1935 to date can be divided
broadly into four phases, viz.,(i) formative phase (1935-1950), (ii) development
phase (1951-1990), (iii) early reform phase (1991-1997), and (iv) liquidity adjustment
facility phase (1998 onwards).
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11.7 Exercise & Questions
Fill in the blanks 1)
Values of specific economic variables that the monetary authority seeks
achieve with ---------------.
2)
The three most noted ---------------- targets are interest rates, monetary
aggregates, and exchange rates.
3)
--------- is the basic money supply, the financial assets used for actual
payments, including currency and checkable deposits.
4)
During the development phase from ------------ , the role of monetary and
credit policy was emphasized as an instrument for maintaining price stability
and regulation of investment and business activity.
Short Answer Questions 1)
Write down the targets of monetary policy.
2)
Explain the evaluation of monetary policy procedure since 1998.
3)
Write short notes on monetary aggregates.
FRAMEWORK AND
PROCEDURE OF
MONETARY POLICY
NOTES
Long Answer Questions 1)
Explain the targets of Monetary Policy.
2)
Explain any five provisions of monetary policy.
3)
Evaluate operating procedure of monetary policy.
11.8 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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UNIT - 12
MECHANISM OF MONETARY POLICY
NOTES
Structure
CHECK YOUR
PROGRESS
What is Transmission
mechanism
of
monetary policy?
12.1
Introduction
12.1
Objectives
12.3
Transmission mechanism of monetary policy
12.4
How does interest rate policy work?
12.5
Reforms in the Monetary Policy Framework
12.6
Press
12.7
New Monetary Policy framework
12.8
Summary
12.9
Exercise & Questions
12.1 Introduction
The transmission mechanism is characterised by long, variable and uncertain
time lags. Thus it is difficult to predict the precise effect of monetary policy actions
on the economy and price level.
According to the new framework, a part of which came into effect on
February 28, the target for retail inflation which is the nominal anchor, is set at six
per cent by January 2016. The target for 2016-17 and all the subsequent years will
be four per cent with a band of plus/minus two per cent.
12.1 Objectives
At the end of this unit, you will be able to 1) Understand the transmission mechanism of monetary policy.
2) Understand the framework of monetary policy.
12.3 Transmission mechanism of monetary policy
This is the process through which monetary policy decisions affect the
economy in general and the price level in particular. The transmission mechanism
is characterised by long, variable and uncertain time lags. Thus it is difficult to
predict the precise effect of monetary policy actions on the economy and price
level.
Change in official interest rates
The central bank provides funds to the banking system and charges interest.
Given its monopoly power over the issuing of money, the central bank can fully
determine this interest rate.
Affects banks and money-market interest rates
The change in the official interest rates affects directly money-market
interest rates and, indirectly, lending and deposit rates, which are set by banks to
their customers.
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Affects expectations
Expectations of future official interest-rate changes affect medium and
long-term interest rates. In particular, longer-term interest rates depend in part on
market expectations about the future course of short-term rates.
Monetary policy can also guide economic agents' expectations of future
inflation and thus influence price developments. A central bank with a high degree
of credibility firmly anchors expectations of price stability. In this case, economic
agents do not have to increase their prices for fear of higher inflation or reduce
them for fear of deflation.
MECHANISM OF
MONETARY POLICY
NOTES
Affects asset prices
The impact on financing conditions in the economy and on market
expectations triggered by monetary policy actions may lead to adjustments in asset
prices (e.g. stock market prices) and the exchange rate. Changes in the exchange
rate can affect inflation directly, insofar as imported goods are directly used in
consumption, but they may also work through other channels.
Affects saving and investment decisions
Changes in interest rates affect saving and investment decisions of
households and firms. For example, everything else being equal, higher interest
rates make it less attractive to take out loans for financing consumption or investment.
In addition, consumption and investment are also affected by movements
in asset prices via wealth effects and effects on the value of collateral. For example,
as equity prices rise, share-owning households become wealthier and may choose
to increase their consumption. Conversely, when equity prices fall, households may
reduce consumption.
Asset prices can also have impact on aggregate demand via the value of
collateral that allows borrowers to get more loans and/or to reduce the risk premia
demanded by lenders/banks.
Affects the supply of credit
For example, higher interest rates increase the risk of borrowers being
unable to pay back their loans. Banks may cut back on the amount of funds they
lend to households and firms. This may also reduce the consumption and investment
by households and firms respectively.
Leads to changes in aggregate demand and prices
Changes in consumption and investment will change the level of domestic
demand for goods and services relative to domestic supply. When demand exceeds
supply, upward price pressure is likely to occur. In addition, changes in aggregate
demand may translate into tighter or looser conditions in labour and intermediate
product markets. This in turn can affect price and wage-setting in the respective
market.
Affects the supply of bank loans
Changes in policy rates can affect banks' marginal cost for obtaining
external finance banks differently, depending on the level of a bank's own resources,
or bank capital. This channel is particularly relevant in bad times such as a financial
crisis, when capital is scarcer and banks find it more difficult to raise capital.
In addition to the traditional bank lending channel, which focuses on the
quantity of loans supplied, a risk-taking channel may exist when banks' incentive to
bear risk related to the provision of loans is affected. The risk-taking channel is
thought to operate mainly via two mechanisms. First, low interest rates boost asset
and collateral values. This, in conjunction with the belief that the increase in asset
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values is sustainable, leads both borrowers and banks to accept higher risks. Second,
low interest rates make riskier assets more attractive, as agents search for higher
yields. In the case of banks, these two effects usually translate into a softening of
credit standards, which can lead to an excessive increase in loan supply.
NOTES
12.4 How does interest rate policy work?
CHECK YOUR
PROGRESS
How does interest
rate policy work?
Interest rates are set so that the inflation target can be met in the future. It
takes up to two years for a rate change to affect inflation.
The interest rate transmission mechanism
Interest rates transmit their way to aggregate demand in the following
ways :
1. Household demand is affected because changes in interest rates affect
savings, which indirectly affect spending.
2. For households or firms with existing debt, such as a mortgage, a change
in rates affects repayments, and hence individuals have more (or less)
cash after servicing their debts. Changes in rates affect the cash-flow of
firms and households.
3. In the case of new debt to fund spending, borrowing is also encouraged
(or discouraged) following interest rate changes.
4. Interest rates also affect consumer and business confidence, which in
turn affects spending.
5. Asset values are also affected by interest rates. A fall in rates will tend to
increase the profitability of firms and they may pay higher dividends to
shareholders. This can trigger an increase in household spending. Similarly,
a rate fall makes savings less attractive and property more attractive,
increasing the value of property and household wealth.
6. Finally, interest rates may affect the exchange rate, which can also influence
export demand. For example, a rise in interest rates may raise the
exchange rate, pushing up export prices and reducing overseas demand.
Changes in the exchange rate also affect the price of imports, which also
affect the inflation rate.
Summary of the transmission mechanism of monetary policy
Recent UK interest rates
In recent years.interest rates have been adjusted to reflect changing
inflationary pressure, and general macro-economic conditions.
Time line
1999 - 2000
Rates were relatively high at 6% to restrict demand
2000 - 2003
In order to stimulate demand, between 2000 and 2003 rates were pushed
down to what was then their lowest level for 25 years.
2003 - 2007
Rates were pushed up into a neutral zone at around 5% and edged towards
the restrictive zone by the middle of 2007.
2008 - 2014
Rates were pushed down to a record low of 0.5% to stimulate household
spending in the wake of the credit crunch, financial crisis and recession.
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12.5 Reforms in the Monetary Policy Framework
Objectives
Twin objectives of "maintaining price stability" and "ensuring availability of
l
adequate credit to productive sectors of the economy to support growth"
continue to govern the stance of monetary policy, though the relative emphasis
on these objectives has varied depending on the importance of maintaining
an appropriate balance.
l
Reflecting the increasing development of financial market and greater
liberalisation, use of broad money as an intermediate target has been deemphasised and a multiple indicator approach has been adopted.
l
Emphasis has been put on development of multiple instruments to transmit
liquidity and interest rate signals in the short-term in a flexible and bi-directional
manner.
l
Increase of the interlinkage between various segments of the financial market
including money, government security and forex markets.
Instruments
l
Move from direct instruments (such as, administered interest rates, reserve
requirements, selective credit control) to indirect instruments (such as, open
market operations, purchase and repurchase of government securities) for
the conduct of monetary policy.
l
Introduction of Liquidity Adjustment Facility (LAF), which operates through
repo and reverse repo auctions, effectively provide a corridor for short-term
interest rate. LAF has emerged as the tool for both liquidity management
and also as a signalling devise for interest rate in the overnight market.
l
Use of open market operations to deal with overall market liquidity situation
especially those emanating from capital flows.
l
Introduction of Market Stabilisation Scheme (MSS) as an additional instrument
to deal with enduring capital inflows without affecting short-term liquidity
management role of LAF.
Developmental Measures
Discontinuation of automatic monetisation through an agreement between
l
the Government and the Reserve Bank. Rationalisation of Treasury Bill
market. Introduction of delivery versus payment system and deepening of
inter-bank repo market.
l
Introduction of Primary Dealers in the government securities market to play
the role of market maker.
l
Amendment of Securities Contracts Regulation Act (SCRA), to create the
regulatory framework.
l
Deepening of government securities market by making the interest rates on
such securities market related. Introduction of auction of government
securities. Development of a risk-free credible yield curve in the government
securities market as a benchmark for related markets.
l
Development of pure inter-bank call money market. Non-bank participants
to participate in other money market instruments.
l
Introduction of automated screen-based trading in government securities
through Negotiated Dealing System (NDS). Setting up of risk-free payments
and system in government securities through Clearing Corporation of India
Limited (CCIL). Phased introduction of Real Time Gross Settlement (RTGS)
System.
l
Deepening of forex market and increased autonomy of Authorised Dealers.
MECHANISM OF
MONETARY POLICY
NOTES
CHECK YOUR
PROGRESS
What is Reforms in
the Monetary Policy
Framework?
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NOTES
Institutional Measures
Setting up of Technical Advisory Committee on Monetary Policy with outside
l
experts to review macroeconomic and monetary developments and advise
the Reserve Bank on the stance of monetary policy.
l
Creation of a separate Financial Market Department within the RBI.
12.6 Press
Information Bureau
Government of India
Ministry of Finance
07-August-2015 17:43 IST
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PROGRESS
Describe Press?
Monetary Policy Framework Agreement
The Government of India and Reserve Bank of India signed a Monetary
Policy Framework Agreement on 20th February, 2015. The objective of monetary
policy framework is to primarily maintain price stability, while keeping in mind the
objective of growth. As per the agreement, RBI would set the policy interest rates
and would aim to bring inflation below 6 per cent by January 2016 and within 4 per
cent with a band of (+/-) 2 per cent for 2016-17 and all subsequent years. The
proposed reduction in fiscal deficit to 3.9 per cent of GDP in Budget Estimates
2015-16 is designed with a mix of reduction in total expenditure as percentage of
GDP and improvement in gross tax revenue as percentage of GDP.
This was stated by ShriJayantSinha, Minister of State in the Ministry of
Finance in written reply to a question in RajyaSabha today.
*****
DSM/MAM/KA
12.7 New Monetary Policy framework
With the government and the Reserve Bank of India (RBI) agreeing over
a new monetary policy framework with the primary objective of containing inflation,
making the latter accountable for it, policymakers feel this will give more autonomy
to the central bank.
According to the new framework, a part of which came into effect on
February 28, the target for retail inflation which is the nominal anchor, is set at six
per cent by January 2016. The target for 2016-17 and all the subsequent years will
be four per cent with a band of plus/minus two per cent.
"I have always held a view that price stability is the dominant objective of
the monetary policy. The framework reiterates that. Of course, controlling inflation
requires cooperation from many areas. Nevertheless, monetary authority has a
major role to play," said C Rangarajan, former chairman of the Prime Minister's
Economic Advisory Council, who also served as RBI governor from 1992 to 1997.
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"The agreement between the RBI and the finance ministry clearly says,
once inflation reaches beyond the comfort zone, both at high and low levels, RBI
should use whatever in its command to bring it to the comfort zone. That way, it
gives autonomy to RBI," Rangarajan added.
The new monetary policy framework was formed following the
recommendations of a committee headed by RBI Deputy Governor Urjit Patel.
Apart from inflation targeting as its prime objective, the committee suggested the
formation of a five-member monetary policy committee (MPC) headed by the
RBI governor. Out of the five members, three were suggested to be from RBI (the
deputy governor and the executive director in-charge of monetary policy).
MECHANISM OF
MONETARY POLICY
NOTES
"We are yet to see the formulation of the MPC. It is recognised the world
over that there should be consultation between the finance ministry and the central
bank, but the central bank should have autonomy on the monetary policy, though it
may consult outside experts," said a former central banker, who did not wish to be
named.
"It (the monetary policy framework) establishes an inflation target. That is
a good thing. Oddly enough, there is no monetary policy committee. The interest
rate is decided by one person - the RBI governor. This will lead to many infirmities.
But this is progress for the period until IFC (Indian Financial Code) is enacted,"
said Ajay Shah, professor, National Institute of Public Finance and Policy, and a
member of the Financial Sector Legislative Reforms Commission.
Finance Minister Arun Jaitley said in his Budget speech the government
would move to amend the RBI Act this year to provide for a MPC.
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What is New
Monetary Policy
framework?
Before amending the Act, there needs to be agreement between the
government and the central bank about the composition of the committee.
The previous United Progressive Alliance government was not comfortable
with the idea of the committee having most members from RBI on the ground that
it would not take an independent view. There were also proposals to increase the
number of members.
Another issue of contention was the Patel committee suggestion that the
two external members be selected by the chairman of the committee (the RBI
governor) and vice-chairman (RBI deputy governor). There was another view
that since the government appoints the RBI governor and deputy governor, it should
also appoint the committee members.
This theory was, however, challenged on the ground that if the government
appoints committee members - who would be bureaucrats - then the members'
view would be similar to the government's.
Experts have suggested members be professionals and not part of the
government. "It is still not clear whether there is a meeting of minds between the
government and RBI on how the MPC will be constituted. The entire process may
take at least six months to get completed," said A Prasanna, chief economist, ICICI
Securities Primary Dealership. He said the amendment could be introduced in the
next session of Parliament; even if it is passed in both Houses, it would take about
six months.
"India has paid a big price in the past for not having clarity on monetary
policy objectives. This is a step in the right direction. Now that the government has
given RBI a target for inflation and there will be a committee to take decisions,
ideally, all stakeholders should believe that the committee will objectively do its job.
As such, there should be less external pressure on RBI to pursue a particular
course of policy," Prasanna added.
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Financial Institutions - I
Money, Central Banking in
India and International
Financial Institutions - I
NOTES
12.8 Summary
Transmission mechanism of monetary policythe process through which
monetary policy decisions affect the economy in general and the price level in
particular. The transmission mechanism is characterised by long, variable and
uncertain time lags. Thus it is difficult to predict the precise effect of monetary
policy actions on the economy and price level.
"India has paid a big price in the past for not having clarity on monetary
policy objectives.
Apart from inflation targeting as its prime objective, the committee suggested
the formation of a five-member monetary policy committee (MPC) headed by the
RBI governor. Out of the five members, three were suggested to be from RBI (the
deputy governor and the executive director in-charge of monetary policy).
Finance Minister Arun Jaitley said in his Budget speech the government
would move to amend the RBI Act this year to provide for a MPC.
Before amending the Act, there needs to be agreement between the
government and the central bank about the composition of the committee.
12.9 Exercise & Questions
Fill in the Blanks 1)
Changes in interest rates affect saving and investment decisions of households
and firms
2)
When demand-------- supply, upward price pressure is likely to occur.
3)
Asset values are also affected by ------ rates.
4)
Formation of a five-member monetary policy committee (MPC) headed by
the ---------------.
Short Answer Questions 1)
How interest rate affect on asset value?
2)
How demand of household sector affected by interest rate?
3)
Explain the idea of MPC.
Long answer Questions 1)
Explain the Transmission mechanism of monetary policy.
2)
Explain the reform in monetary policy framework.
3)
Explain the new monetary policy framework.
12.10 Further Reference Books
l Indian Financial System
- Dr. S Gurusamy
l Central Banking for Emerging Market Economies
- A. Vasudevan
l Money & Banking : Theory with Indian Banking
- Hajela T.N.
l International Financial Institutions and Indian Banking
- Autar Krishen and Mihir Chatterjee
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Financial Institutions - I