MONETARY POLICY

The recent crisis had a deep impact on the Indian economy as well s.t. the economic growth rate came down to 6.4% from 9%. Business confidence had hit rock bottom. Though very less, but still it seemed that there was credit demand in the economy. The banks and financial institutions were reluctant to lend (looking at the scenario in US). RBI decided that it will have to step in and increase the availability of credit in the market, infuse liquidity and lower the interest rates so that credit can be made easily available. Thus, in multiple phases RBI reduced key interest rates s.a. CRR was brought down to 5% from 9%, SLR was reduced to 24% (down by 1%), repo and reverse repo rates were reduced etc. It infused liquidity near Rs. 2 lakh crores (approx. 3% of the GDP) in the market. It also conducted open market operations for sale of bonds. All this was also necessary to bring down the call rates that had reached 20% and hence were making it difficult for the real sector to grow.

All of these measures were aimed at creating a market environment conducive for the smooth availability of credit to the productive sectors of the economy at viable rates. This was essential as the credit markets had dried up post the US subprime crisis. Mentioned above are various means through which a country’s central bank conducts its monetary policy. Monetary policy deals with the management of money supply in the economy which in turn has its bearing on the economic activity. Not only ecoomic activity, it has influence on the exchange rates, inflation rate, capital flows by means of affecting interest rates which ultimately affect economic growth. The central thrust of India’s monetary policy has been sustained economic growth with price stability.

The nominal supplies of money and bank credit growth are highly fragile to policy manipulations by the central banks. Any change in these variables can have a significant impact on the availability, allocation and offtake of credit in an economy, thus affecting its growth rate. This will in turn affect employment, real output, price level and distribution of income and wealth in the society.

Say in an economy the consumers are reluctant to spend leading to fall in demand, also the lending institutions are not willing to lend due to loss of business confidence (which may lead to an increase in call market rates of interest since the demand for credit still exists). In such a situation the economic activity comes to a standstill as the projects stand waiting in the absence of capital, output has to be lowered and hence unemployment rate increases. It is at this time that the monetary authority needs to intervene and introduce changes in policy through the various tools mentioned above. The central bank can increase the money supply by cutting down some of the key rates i.e. Repo rate, reverse repo rate, Cash Reserve Ratio, Statutory liquidity ratio etc. When the money supply in the economy increases, there is a danger of inflation going up while at the same time it helps increase the level of output and reduces interest rates. When open market operations are conducted by the central bank in which it buys bonds in exchange for money, thus increasing the stock of money (as it may pay for this purchase of bonds by printing money). Due to purchase of bonds their price in the market increases and hence the yield reduces (return/price). It is only in this situation people are prepared to hold a smaller fraction of their wealth as bonds and a larger fraction as money. So in case of expansionary monetary policy the output level increases as due to a reduction in interest rates the investment spending increases. A point to be noted here is that if money demand is highly sensitive to rate of interest then in such cases a given change in money supply requires a small change in interest rates for the change to be absorbed. Thus, the effect of open market operations conducted above would be very small on investment.

Continued in the post titled "Transmission Mechanism of Monetary Policy"......