MONETARY

POLICY AND
FINANCIAL

BY:
DHANISHTHA
ANAND
NIPUN
SEHRAWAT

MONETARY
I. WHAT IS MONETARY POLICY
POLICY

Monetary Policy refers to measures

employed by central banks, currency
boards or other regulatory committees
that determine the size and rate of
growth of the money supply, which in
turn affects interest rates.
Goals
of
monetary
policy:
achieve/maintain full employment, a
high rate of economic growth and to
stabilize prices and wages.

In India, the Reserve Bank of India is

in
charge
of
monetary
policy.
Monetary policy is one of the ways
that the Indian government attempts
to control the economy. If the money
supply grows too fast, the rate of
inflation will increase; if the growth of
the money supply is slowed too much,
then economic growth may also slow.

MONETARY POLICY
II. What is Money Supply
Money Supply refers to the entire stock
of currency and other liquid instruments in
a country's economy as of a particular
time. The money supply can include cash,
coins and balances held in checking and
savings accounts.
The various types of money in the money
supply are classified as "M"s such as M0,
M1, M2, M3, and M4, according to the type
and size of the account in which the
instrument is kept.

TYPES OF MONEY IN
MONEY SUPPLY
M0 (M-zero) is the most liquid measure of the money
supply. It only includes cash or assets that could quickly
be converted into currency. It only includes cash or
assets that could quickly be converted into currency.
This measure is known as narrow money because it is
the smallest measure of the money supply.
M1 (M-one) includes all physical money, such as coins
and currency, as well as demand deposits, checking
accounts and Negotiable Order of Withdrawal (NOW)
accounts.
M2(M-two) includes cash and checking deposits (M1)
as well as savings deposits, money market mutual funds
and other time deposits, which are less liquid and not as
suitable as exchange mediums but can be quickly
converted into cash or checking deposits.
M3(M-three) includes M2 as well as large time
deposits, institutional money market funds, short-term
repurchase agreements and other larger liquid assets.
M4(M-four) includes M3 as well as Post Office Deposits.
(Excluding National Savings Certificates)

FINANCIAL
MARKETS
I. WHAT ARE FINANCIAL MARKETS
A Financial Market is a market in
which people and entities can trade
financial securities, commodities,
and other fungible items of value at
low transaction costs and at prices
that reflect supply and demand.

FINANCIAL
MARKETS
II. FINANCIAL MARKETS FACILITATE:
The raising of capital (in the capital markets)
The transfer of risk (in the derivatives
markets)
Price discovery
Global transactions with integration of
financial markets
The transfer of liquidity (in the money
markets)
International trade (in the currency markets)

FINANCIAL
MARKETS

III. FUNCTIONS OF FINANCIAL MARKETS

Intermediary Functions
Transfer of Resources
Enhancing income
Productive usage
Capital Formation
Price determination
Sale Mechanism
Information
Financial Functions

AFFECT OF MONETARY
POLICY
ON FINANCIAL MARKETS
Monetary policy is aimed at preserving price
stability. In some countries, central banks
operate under mandates that refer to additional
objectives such as full employment, maximum
sustainable growth, stable interest rates or
stable exchange rates.
Financial markets are the connecting link in the
transmission mechanism between monetary
policy and the real economy.
The transmission process from monetary policy
to financial markets and finally to the real
economy has a single source: the monetary
policy instrument.

INVESTMENT
MULTIPLIER

WHAT IS INVESTMENT MULTIPLIER

Investment Multiplier examines the
increase in aggregate income due to an
increase in public or private spending. It
is observed that an increase in
investment spending has a greater than
proportionate impact on increase in the
National Income and the general
economy.

For example, let us assume that the government spends Rs 100

Crore on developing infrastructural facilities. Since the expenditure
of one entity is the income of another entity, which is assumed to
be entity A. Further assuming that the Marginal Propensity to
Consume is 0.5, i.e. 50 %, it is implied that every entity spends 50
% of its income, and the rest of it saved. Thus, entity A would
spend Rs 50 Crore and save Rs 50 Crore. Now, let us assume that
expenditure on consumption by entity A is earned by entity B. Now,
entity B has earned Rs 50 Crore, out of which, Rs 25 Crore would be
spent and Rs 25 Crore would be saved.
This cycle would continue up till the point where Consumption
becomes negligible and Total Savings become equal to the Initial
Investment Outlay.
Initial Outlay = Rs 100 Crore
MPC = 0.5 AND MPS = 0.5
Income (In Rs Crore)
Consumption (In Rs Crore)
Savings (In Rs Crore)
100
50
50
50
25
25
25
12.5
12.5
12.5
6.25
6.25
.
.
.
.
.
.
______________________________________________________
200
100
100
Investment Multiplier = 1/1-MPC

INCOME EFFECT
ON FINANCIAL MARKET

In the diagram, the demand

curve D shifts to D1 with an
increase in income. As a result of
this, the equilibrium point shifts
from E to E1, with the
equilibrium price increasing to
P1 and equilibrium quantity
increasing to P2.
As a result of increased income,
the interest rate in the economy
falls. This happens because of
the greater amounts of money
ready to be invested in limited

MONETARY POLICY
INSTRUMENTS
I.
II.
III.
IV.
V.

Reserve Ratios
Discount Rate
Open Market Operations
Discount Window
Moral Suasion

RESERVE
REQUIREMENTS
I. Cash Reserve Ratio (CRR)

is a
the total
which
hold as
deposits

specified minimum fraction of

deposits
of
customers,
commercial banks have to
reserves either in cash or as
with the central bank.
II. Statutory
Liquidity
Ratio(SLR)
refers amount that the commercial
banks require to maintain in the form of
gold or govt. approved securities before
providing credit to the customers.

RESERVE
REQUIREMENTS
o Considering
a
situation
wherein

the
government needs to intervene in order to
reduce the money supply in the economy,
the Central Bank may increase the reserve
requirements of banks. This would constraint
the liquid cash available with banks available
for lending, which would force banks to
increase the rate at which they lend loans,
thereby inhibiting the public from raising
loans at higher interest rates. This would
ultimately lead to a fall in the money supply.
o Since a fall in the money supply would imply
that people would have lesser money to
invest in financial instruments, it would lead
to a leftward shift in their demand curve.

EFFECT OF INCREASE IN
RESERVE REQUIREMENTS
In the diagram, the
ON
EQUILIBRIUM
PRICE OF
demand
curve D shifts
to
D1 with a fallINSTRUMENTS
in
FINANCIAL
money supply owing to
increase
in reserve

requirements . As a
result of this, the
equilibrium point shifts
from E to E1, with the
equilibrium price falling
to P1 and equilibrium
quantity falling to P2.

DISCOUNT RATE
One of the most important functions of the
RBI is its role as a lender of last resort to the
banking system. Banks in need of liquidity
may borrow from the RBI at the discount rate.
Repo rate is the rate at which the central
bank of a country lends money to commercial
banks in the event of any shortfall of funds.
Reverse repo rate is the rate at which the
central bank of a country borrows money
from commercial banks within the country.

DISCOUNT RATE
o Considering
a
situation
wherein
the
government needs to intervene in order to
increase the money supply in the economy, the
Central Bank may decrease the repo rate and
the reverse repo rate. This would encourage
banks to borrow money from the Central bank,
and would discourage them to lend money to
the Central bank, thereby leading to an
increase in the money supply.
o Since an increase in the money supply would
imply that people would have more money to
invest in financial instruments, it would lead to
a rightward shift in their demand curve.

EFFECT OF FALL IN REPO RATE

AND REVERSE REPO RATE ON
EQUILIBRIUM PRICE OF
In
the diagram,INSTRUMENTS
the
FINANCIAL
demand curve D shifts
to D1 with an increase
in income. As a result
of this, the equilibrium
point shifts from E to
E1,
with
the
equilibrium
price
increasing to P1 and
equilibrium
quantity
increasing to P2.

OPEN MARKET
OPERATIONS
WHAT IS OPEN MARKET OPERATIONS
An open market operation (also known
as OMO) is an activity by a central
bank to buy or sell government bonds
on the open market. A central bank
uses them as the primary means of
implementing monetary policy.

OPEN MARKET
OPERATIONS ON FINANCIAL
MARKETS
The governments most important and widely
used policy tool is open market operations.
The reserve requirement which necessitates
banks to keep 10% of the value of existing
deposits on reserve with the RBI. This gives
the govt. tremendous amounts of money with
which to engage in financial transactions.
Open market operations involve the buying
and selling of government debt (Treasury
Bills, Notes, and Bonds). The RBI makes these
debt transactions with banks in order to alter
total reserves in the banking system.

Example:
The RBI wants to use open market operations to increase bank
reserves. Banks use a portion of customer deposits (liabilities) to
buy assets in the form of government-issued debt. To increase
bank reserves, the RBI buys some of the government bonds from
banks.
When open market operations are used to implement a
restrictive monetary policy, the RBI sells bonds to banks. By
purchasing bonds from the RBI, banks have less money to loan
out and the monetary base shrinks. The result is a reduction in
the money supply by a factor of the money multiplier. The
reduction in the money supply and bank reserves raises the Fed
funds rate using the opposite of the process described above. As
long-term interest rates increase along with the RBI funds rate,
business investment and consumer borrowing both decrease,
resulting in slower GDP growth.

By applying the above logic

we see, as the since the
monetary base of the bank
shrinks, banks start to lend
less. Owing to this change in
supply of the currency, the
demand reduces.

MORAL SUASION
WHAT IS MORAL SUASION
Moral suasion is defined in theeconomicsphere
as "the attempt to coerce private economic
activity via governmental exhortation in
directions not already defined or dictated by
existing statute law." The 'moral' aspect comes
from the pressure for 'moral responsibility' to
operate in a way that is consistent with
furthering the good of the economy.
There are two types of moral suasion:
A. Pure Moral Suasion.
B. Impure Moral Suasion.

MORAL SUASION
Moral suasion differs from direct suasion using
laws and regulations in that penalties for noncompliance are not systematically assessed on
non-compliers.This has led some authors to
criticise moral suasion as immoral, since
compliers get penalised for cooperating with
the stated government agenda (thus incurring
extra costs) while non-compliers are not
punished. Other objections to the use of moral
suasion include the fact that it constitutes
extra-legal coercion by the government, that it
adds uncertainty to the regulatory process, and
that it can undermine or delay the
implementation of effective legislation