Continued from previous post "MONETARY POLICY"
The transmission mechanism of monetary policy changes looks like a stepwise process. Due to change in real money supply people find their portfolios in disequilibrium due to which adjustments take place and finally the asset prices and interest rates change. If interest rates become unattractive then demand for money increases i.e. people hold larger part of their wealth as money. Lower interest rates encourage investment and spending, leading to an increase in aggregate output.Therefore, the decision to lower CRR and SLR is an attempt by the RBI to make more funds available for lending. While when it reduces other rates s.a. reverse repo, bank rate etc. then it is trying to reduce the cost at which the credit is made available to the borrowers. Thus, all these instruments affect credit creation in the system. Inflationary pressures arise when there is too much liquidity chasing too little goods. In such a case the monetary authority has to reconsider its policy stance and decide whether it needs to tighten the policy or not.
During 1980 to 1985 US monetary authority excersised tight control over money supply which resulted in high rates of interest as compared with the rest of the world. This led to capital inflows into the economy due to high retuns provided by US financial assets. As a result dollar saw a constant appreciation during this time period. Currency appreciation became a concern for Fed as US began losing its competitive advantage in the international markets and the domestic market was flooded with cheap imported goods. This led to job-losses and hence the government was forced to reconsider its policy stance. In such a scenario the central bank can intervene, conduct monetary policy operations such that the supply of domestic currency increases to normal levels and hence the exchange rates would eventually come down.
There have been such situations where inspite of a favouravle monetary policy, the central bank could not influence the eonomic situation and the credit offtake remained poor. India too witnessed such a situation.
Also, there is a situation known as liquidity trap when monetary policy becomes ineffective. What do you understand by liquidity trap? Do you think the fiscal policy could be a relief in such a case as that of India’s (i.e. very little credit offtake), if it is used to supplement the effects of monetary policy?
I would also like you all to think about the role of monetary policy in the financial markets stability and exchange rate management !!! Hopefully some of you would ponder over it and write back….It can answer the needs of checking inflation, growth as well as stability of the capital markets by this process.
More to come on this topic.....
cant the central bank also use open market operations to conduct the monetary policy apart from the crr,slr,repo and reverse repo?
ReplyDeleteliquidity trap is a situation where there are no investments taking place and the interests rates are very low.in terms of money holdings we can say that people are ready to hold as much money as they want to at the prevailing interest rates.such situation occurs mostly at zero interest rate or a low positive interest rate.so increasing the money supply would be of no help since people already have money.hence monetary policy would not bring the required changes.it is here when government can increase its own expenditure.this would increase aggregate demand with full multiplier effects as we are not changing the rates of interest initially and investment will not be crowded out.
regarding the effects of monetary policy on different variables,for instance the government is tightening the money supply then people would have lesser money holdings due to which their demand for liquidity will go up.due to the portfolio disequilibrium there will be a rise in the rates of interest.for a closed economy this would increase the investments and thus the aggregate demand and therefore the price level will also go up.for an open economy this would lead to greater foreign investments in the country and will lead to higher demand for their goods and services which will push up their prices and hence lead to appreciation of the currency.however,currency appreciation looks favorable,it is not since it leads to fall in the exports of the country and a rise in the imports as well since the consumers at home find imported goods cheaper.
India witnessed rupee appreciation against dollar in 2007 which led to fall in the exports.textile sector was one sector that faced huge loses due to this.
Monetory policies are announced during one of the two situations:
ReplyDelete1. When the economy is going through a boom, When the level of production in an economy exceeds the level attainable using the factors of production in a sustainable manner, production costs rise, which ultimately leads to price increases, and thus to inflation. To avoid inflation, monetary authorities take up measures to curb demand by raising short-term interest rates.
2. On the other hand, when the economy faces a downturn, it produces below the sustainable level. Demand for goods and services is weak, leading businesses to lay off workers and offer price reductions in order to boost sales and reduce inventory. As a consequence Overall, production costs tend to remain stable or fall, leading to reduced inflation. In order to stimulate demand, monetary authorities lower very short-term interest rates. In response, economic output approaches its sustainable level.
Both of these approaches aim at easing the economy in good and bad times by keeping a check on inflation. However, monetory policies might not always result in easing of the economy. For instance it might cause a liquidity trap, i.e. when interest rates are reduced, consumers might choose to avoid investments and keep their funds in idle savings because of the prevailing belief that interest rates will soon rise. Japan is a perfect example to illustrate this, where monetory expansion resulted in people hoarding funds in idle savings knowing from experience that the authority would withdraw money from circulation as soon as inflation reappeared. Also monetory policies fail to have the impact that they should in countries like U.S and Japan where short term interest rates are already close to 0% and there is no scope to reduce it any further. Even in a country like our’s where the credit offtake is too low, easing interest rates does not produce the expected impact. Therefore, as a economy revival tool, Fiscal stimulus in the form of investments in infrastructure by the government and tax incentives to private businesses has undoubtedly a higher impact due to the accelerator effect as opposed to the monetary policies.
Although, Monetory policies play a key role as tools that keep a check on inflation and ensure economic stability from time to time. In times of economic crisis it is the fiscal policies that act as tools of economy revival.
ReplyDeleteHii....
ReplyDeleteI wanna address this comment to Ashwini. What she has written is perfectly correct but she has analyzed only on side of the coin. There are two schools of thought on Inflation and the use of monetary policy:-
a. The DD side view as explained by Ashwini
b. And the SS side view which we call Supply side Economics.
What she has explained is perfectly correct in theoretical terms but in practical its a much broader picture. Inflation not only occurs Due to DD shocks but there is a different contention too ie SS shocks. Prices of commodities increase not only when there is excess DD chasing few goods therbey causing spiralling prices but another contention over here is that of Speculation. Speculation of commodity prices also causes prices to shoot up rapidly. You must all remenber how the on set of crisis led to crash of commodity prices all over the world Crude which was hovering around $140-149 crashed to little less than $30 thereby forcing the GOI to slash prices dramatically but the same crude is now hovering around $70-79 and is threatning to touch the $100 mark soon. All this ie more than 200% rise in the price of crude is merely a result of speculation and "hot money" chasing returns on the so called liquid gold. The matter of concern is that there has not been any significant or dramatic improvement in the economic conditions though there have been green shoots in the economy. But none the less it causes inflationary pressures the world over as fuel prices have to be revised therbey leading to inflation even when there has not been any significant/dramatic changes in Domestic DD/conditions. This is the effect of the so called SS side economics. Further export of domestic commoditites abroad also causes inflationary pressures. You must be aware that about 90% of the premium quality basmati produced in India is exported to middle east and other countries, similarly India exports Steel, Cement and other materials which are essential for domestic activities but these find a place abroad as they fetch a higher price out there. Thus these leakages also causes inflationary pressures even when domestic dd is unchanged. You must recollect how the GOI had banned steel exports, basmati/rice exports during the boom of 2007 when inflation breached the 10% mark to minimize the effect of SS related shocks.
To add to your point on use of monetary policy during boom and recessionary periods there is another condition called Stagflation ie Falling output and rising prices. The proper use of Monetary and fiscal policies during such a period become imperative as in the US in 70's and 80's.
~~~@bhishek Jhunjhunwala~~~~