Meaning of monetary policy

Monetary policy is the management of money supply and interest rates by central banks
to influence prices and employment. Monetarypolicy works through expansion or
contraction of investment and consumption expenditure.Monetary policy is the process
by which the government, central bank (RBI in India), or monetary authority of a country
controls :

(i) The supply of money

(ii) Availability of money
(iii) Cost of money or rate of interest

In order to attain a set of objectives oriented towards the growth and stability of the
economy. Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary
policy, where an expansionary policy increases the total supply of money in the
economy, and a contractionary policy decreases the total money supply. Expansionary
policy is traditionally used to combat unemployment in a recession by lowering interest
rates, while contractionary policy involves raising interest rates in order to combat
inflation. Monetary policy is contrasted with fiscal policy, which refers to government
borrowing, spending and taxation.Credit policy is not only a policy concerned with
changes in the supply of credit but it can be and is much more than this.Credit is not
merely a matter of aggregate supply, but becomes more important factor since there is
also issue of its allocation among competing users. There are various sources of credit
and other aspects of credit that need to be looked into are its cost and other terms and
conditions, duration, renewal, risk of default etc. Thus the potential domain of credit
policy is very wide. Where currency is under a monopoly of issuance, or where there is a
regulated system of issuing currency through banks which are tied to a central bank, the
monetary authority has the ability to alter the money supply and thus influence the
interest rate in order to achieve policy goals.Monetary policy, also described as money
and credit policy, concerns itself with the supply of money as so of credit to the economy.

Objective of monetary policy

The objectives are to maintain price stability and ensure adequateflow of credit to the
productive sectors of the economy. Stability ofthe national currency (after looking at
prevailing economicconditions), growth in employment and income are also looked
into.The monetary policy affects the real sector through long and variable periods while
the financial markets are also impacted through shorttermimplications. Major objectives
can be summarized as under:

i) To promote and encourage economic growth in the economy & ensure the economic
stability at full employment or potential level of output.It aims to achieve the twin
objectives of meeting in full the needs of production and trade, and at the same
time moderating the growth of money supply to contain the inflationary pressures
in the economy.

ii) Sectorial deployment of Funds. Depending upon the priorities laid down in the plans,
the RBI has determined the allocation of funds, as also the interest rates among
the different sectors.

There are four main 'channels' which the RBI looks at:
 Quantum channel: money supply and credit (affects real outputand price level
through changes in reserves money, moneysupply and credit aggregates).
 Interest rate channel.
 Exchange rate channel (linked to the currency).
 Asset price.

Price stability has evolved as the dominant objective of monetary policy for sustaining
economic growth and ensuring orderly conditions in the financial markets with increasing
openness of the Indian economy... The fundamentalidea is that it is only in a low and
stable inflation environment that economic growth can be continued. Monetary policy
also aims to be directly supportive of growth by ensuring that the credit requirements of
various segments are met adequately through an appropriate credit delivery and credit
pricing mechanism and a conducive credit culture.

Monetary decisions today take into account a wider range of factors,

such as:
 short term interest rates;
 long term interest rates;
 velocity of money through the economy;
 exchange rate
 credit quality
 bonds and equities (corporate ownership and debt)
 government versus private sector spending/savings
 international capital flow of money on large scales
 financial derivatives such as options, swaps and future contracted.
Monetary policy tools
The monetary authority uses various instruments of monetary control in order to
influence the goal variables in desired directions and degrees. The target variables are
variables which the monetary authority tries to control or influence so as to influence the
goal variables in the desired manner. To serve the target function well, a chosen target
variable should possess the following four qualifications:

a) It should be closely related to goal variables and this relation should be well
understood and reliably estimable,
b) It should be rapidly affected by policy instruments,
c) Non-policy influences on it should be relatively small,i.e, small relative to policy
influences, and
d) It should be readily observable (a measurable) with little or no time lag.

Traditionally three variables have served as candidates for monetary-policy targets. They
are: money supply, bank credit, and interest rates in securities market.

Various Monetary policy tools are:

i. Monetary base
Monetary policy can be implemented by changing the size of the monetary base. This
directly changes the total amount of money circulating in the economy. A central
bank can use open market operations to change the monetary base. The central bank
would buy/sell bonds in exchange for hard currency. When the central bank
disburses/collects this hard currency payment, it alters the amount of currency in the
economy, thus altering the monetary base.

ii. Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in
reserve with the central bank. Banks only maintain a small portion of their assets as
cash available for immediate withdrawal; the rest is invested in illiquid assets like
mortgages and loans. By changing the proportion of total assets to be held as liquid
cash, the Federal Reserve changes the availability of loanable funds. This acts as a
 change in the money supply. Central banks typically do not change the reserve
requirements often because it creates very volatile changes in the money supply due
to the lending multiplier.

iii. Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial
institutions within their country. By calling in existing loans or extending new loans,
the monetary authority can directly change the size of the money supply.

iv. Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the
nominal interest rates. Monetary authorities in different nations have differing levels
of control of economy-wide interest rates. The Federal Reserve can set the discount
rate, as well as achieve the desired Federal funds rate by open market operations. This
rate has significant effect on other market interest rates, but there is no perfect
relationship. In the United States open market operations are a relatively small part of
the total volume in the bond market. One cannot set independent targets for both the
monetary base and the interest rate because they are both modified by a single tool —
open market operations; one must choose which one to control. In other nations, the
monetary authority may be able to mandate specific interest rates on loans, savings
accounts or other financial assets. By raising the interest rate(s) under its control, a
monetary authority can contract the money supply, because higher interest rates
encourage savings and discourage borrowing. Both of these effects reduce the size of
the money supply.

v. Currency board
A currency board is a monetary arrangement which pegs the monetary base of a
country to that of an anchor nation. As such, it essentially operates as a hard fixed
exchange rate, whereby local currency in circulation is backed by foreign currency
from the anchor nation at a fixed rate. Thus, to grow the local monetary base an
equivalent amount of foreign currency must be held in reserves with the currency
board. This limits the possibility for the local monetary authority to inflate or pursue
other objectives.
1. Instruments of monetary policy in India
The monetary policy is nothing but controlling the supply of Money. The RBI takes a look at
the present levels and also takes a call on what should be the desired level to promote growth,
bring stability of price (low inflation) and foreign exchange.
 The Reserve Bank of India (RBI) as a designated monetary authority has no control over the
deficit financing of the central government and only limited control over its foreign exchange
assets, we discuss below in detail the instruments of control used by the RBI:
:
A. Quantitative measures:

1. Open Market operations: It means the purchase and sale of securities by central
bank of the country.
The sale of security by the central bank leads to contraction of credit and purchase
thereof to credit expansion. It is useful for the developed countries. In India, the RBI
enters into sale and purchase of government securities and treasury bills. So the RBIcan
pump money into circulation by buying back the securities and vice versa. In absence of
an independent security market (all Banks are state owned); this is not really effective in
India.

The major Limitations are that

 When the central bank purchases the securities the cash reserve of member bank will be
increased and vice versa.
 The bank will expand and contract credit according to prevailing economic and political
circumstances and not merely with reference to their cash reserves.
 When the commercial bank cash balance increase the demand for loan and advance
should increase. This may not happen due to economic and political uncertainty.
 The circulation of bank credit should have a constant velocity.

2. Bank rate policy:Popularly known as repo rate and reverse repo rate, it is the rate
at which the RBI and the Banks buy or exchange money.
This results into the flow of bank credit and thusaffects the money supply.

Bank rate- It is the minimum rate at which the central bank of a country provides loan to
the commercial bank of the country. Bank rate is also called discount rate because bank
provides finance to the commercial bank by rediscounting the bills of exchange. When
general bank raises the bank rate, the commercial bank raises their lending rates;it results
in fewer borrowings and reduces money supply in the economy.

Reverse repo rate– It is the rate that RBI offers the banks for parking their funds with it.
Reverse repo operations suck out liquidity from the system.

Major limitation is that :

  Well organized money market should exist in the economy.

Repo rate -
 It is introduced through which RBI can add to liquidity in the banking system.
Through repo system RBI buys securities from the bank and there by provide
funds to them.
 Repo refers to agreement for a transaction between RBI and banks through which
RBI supplies funds immediately against government securities and
simultaneously agree to repurchase the same or similar securities after a specified
time which may be one day to 14 days.
 A repurchase agreement or ready forward deal is a secured short-term (usually 15
days) loan by one bank to another against government securities.
 Legally, the borrower sells the securities to the lending bank for cash, with the
stipulation that at the end of the borrowing term, it will buy back the securities at
a slightly higher price, the difference in price representing the interest.

3. Cash Reserve ratio (CRR): This is the percentage of total deposits that the banks
have to keep with RBI. And this instrument can change the money supply overnight.
 Changing cash reserve ratio is an excellent instrument of control. The bank has to
keep certain amount of bank money with themselves as reserves against deposits.
 The increase in the cash rate leads to the contraction of credit only when the banks
excess reserves.
 The decrease in the cash rate leads to the expansion of credit and banks tends to make
more available to borrowers.

4. Statutory Liquidity Requirement (SLR)&liquidity adjustment facility ( LAF )-this is

the proportion of deposits which Banks have to keep liquid in addition to CRR.
 This also has a bearing on money supply.
 LAF is the instrument of monetary policy from June 2000 to adjust on daily basis
liquidity in the banking system.
 Through LAF, RBI regulates short-term interest rates while its bank rate policy serves
as a signaling device for its interest rate policy in the intermediate period.

RRBs are required to maintain SLR at 25 per cent of their NDTL in cash or gold or in
unencumbered government and other approved securities. Unlike in the case of scheduled
commercial banks, balances maintained in call or fixed deposits by RRBs with their
sponsor banks are treated as “cash” and hence, reckoned towards their maintenance of
 SLR. As a prudential measure, it is desirable on the part of all RRBs to maintain their
entire SLR portfolio in government and other approved securities, which many of them
are already doing. All RRBs may maintain their entire SLR holdings in government and
other approved securities.

B. Qualitative measures:

1. Credit rationing: Imposing limits and charging higher/lower rates of interests in

selective sectors are what you see is being done byRBI.

2. Moral suasion: We hear of RBI's directive of priority lending in Agriculture sector.

Seems more of a directive rather than persuasion.It implies the central bank exerting pressure
on banks by using oral and written appeals to expand or restrict credit in line with its credit
policy. It is a combination of persuasion and pressure which RBI is always in a position to
use on banks in general and errant banks in particular. This is exercised through discussions,
letters, speeches, and hints thrown to banks. This can be used by the RBI to urge banks to
keep a large proportion of their assets in the form of government securities, lend their helping
hand to develop a broad and active market in treasury bills and government securities, and
not borrow excessively from the bank when it is engaged in fighting the forces of inflation.

The main interst sensitive sectors are banking sector,automobile sectorand real estate sector

Let me examine how the monetary policy impact on the major interast sensitive sectors ie banking sector
and automobile sector.both sectors are linked with the policy measurs of the RBI.the change in interst rate
casues a big impact on the profit earning capacity of the two sector companies

Firstly the banking sector

. 
This analysis takes a look at Indian monetary policy and how it will impact:
    a. Banks  Profitability
    b. Availability  of   funds   to  trade  and   industry
    c. Other  factor

Interest on loans are the main income of the banks. when the reserve bank take an action which
effect interest rate it will affect the banks income and profitability. It may be positive or negative.
Cost of fund will increase and it will reduce banks net interest margin to keep the net interest
margin all banks raises lending rates

When RBI hikes CRR it will directly affect by the profitability of banking companies. When RBI
increase the CRR it will cause reducing the deposits available with the banks to make loans
.Banks charge a very high interest rate on the loans they give. Banks take this measurer to retain
the profit rate which earned during former CRR rate..when the lending rate are high, general
public and corporate postpone their work to future period.so this cause to reduse the lending
from banks,then the profit will decrease

If the RBI reduce the CRR and SLR rate ,the banks can give more loans at lower interest rate.the
low interst rate attract more companies and people to take loan.so this cause to increase the profit
of the banks

Increased from 5.00%

to 5.50% wef
13/02/2010; and then
6.00% (w.e.f.
Cash Reserve Ratio (CRR) again to 5.75% wef
24/04/2010)
27/02/2010; and now
to 6.00% wef
24/04/2010
Now the CRR is 6.00%.it from 24-4-2010.RBI increased CRR from 5.00% to 6.00% during the
4th quarter of 2009-2010 and 1st quarter of 2010-11.this change also change the net interest
margin of the banks.1% increase caused a negative impact of the profitability of the banks.

Decreased from 25%

24%(w.e.f.
Statutory Liquidity Ratio (SLR) which was continuing
18/12/2010)
since 07/11/2009
No more change in the SLR rate after 7-11-2009 have made an impact on the profit earning
capacity of the banks

Bank rate impact

It is the minimum rate at which central bank provides loan to commercial banks. It is also called
discounting rate because bank provides finance to the commercial banks by rediscounting the bill
of exchange.

When central banks raises bank rate commercial banks raises lending rate and vice-versa

When RBI rises the bank rate ,the commercial banks rasies rasies its lending rates, it will
adversely impact on the profitability of banks. Bank’s net interest margin will reduce.

Repo rate impact

When ever there is deficient of the fund with the banks then the banks barrow money from RBI,
Repo rate is the rate at which all banks barrow rupees from RBI. When RBI increase repo rate
,no banks ready to take loan from RBI.IF the RBI decrease the repo rate, bank will go to RBI to
take loan at lower interest rate. If the RBI increase the rate it will reduce the profit margin.

Reverse repo effect

If the RBI increase the reverse repo rate banks get high interest by putting money to safe hands.
but it reduce the money supply in the economy .bank not have money to give loans to public and
get interest on loan. so interest earned on loans will decrease and the net interest margin reduced.

Increased from 5.75%

which was continuing
since 17/03/2011 [Till
03/05/2011, reverse
repo rate was an
independent rate and
announced by RBI.  
However, in the
6.25% monetary policy
Reverse Repo Rate (w.e.f. announced on
03/05/2011) 03/05/2011, RBI has
decided that now the
reverse repo rate will
not be announced
separately, but will be
linked to Repo rate.  
Reverse Repo rate will
be 100 bps below the
repo rate]
How monetary policy affect on the returns of auto sector

The automotive industry remains one of the highest revenue-earning industries in India and
contributed over 5% to India’s GDP in 2009, providing direct and indirect employment to more
than 13 million people. The market outlook for the industry remains promising, especially in the
small car segment. The Indian automobile market is currently dominated by the two-wheeler
segment but with an expanding middle class population, growing earning power and industrial
development, the demand for passenger cars and commercial vehicles will increase
exponentially.

Also, the low vehicle presence (with passenger car stock of only around 11 per 1,000 population
in 2008) indicates a very low base with significant growth potential. As per ‘Just-Auto’ analyst
reports, sales of passenger cars in 2008-2016 are expected to grow at a CAGR of around 10%.

In addition to increased domestic demand, there is also likely to be increased investment by

global auto manufacturers to India due to its strong technological capability and availability of
trained manpower at competitive prices. Currently, the foreign auto companies with assembly
plants in India include, General Motors, Ford, Hyundai, Honda, Suzuki, Nissan Motors, Toyota,
Volkswagen, Audi, Škoda, BMW, Fiat and Mercedes Benz.
With the introduction of the Tata Nano, the cheapest car in the world at USD 2200, and FDI
from Suzuki Motor Corp, Hyundai Motor Co, and Nissan Motor Co to make India their
manufacturing hub for small cars, India has made huge inroads in the compact car segment. In
fact, in 2009, India overtook China in the global auto exports of compact cars for the first time.

Increase or decrease in interest rate will directly affect the automobile industry because a
majority of people are depending on car loans or two wheeler loans for buying vehicle. So if the
interest rates are increasing, people won’t be able to afford this and normally the demand for
automobiles will come down this will have a very bad impact on the industry

Rising interest rates had a negative impact on company because when interest rates was raised,
the cost of borrowing money rosed. Ultimately, the company profitability and ability to grow
was reduced. When a company profits (or earnings) dropped, its stock became less desirable, and
its stock price falled . A company success comes when it sells its products . But increased
interest rates negatively impact its customers. The financial health of its customers directly
affected the company ability to grow sales and earnings. When interest rates rise, investors start
to rethink their investment strategies i.e Investors sell shares in interest-sensitive stocks that they
hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector.
Interest rates rises –sales effects - profitability is affected - dividend payments too effected. The
price of a stock depends on the earnings of the company. If the earnings slow down (because of
higher interest rate payments), the prices of the stocks will dip and overall, the stock market will
be hit. A rise in interest rates also cools down the economy . demand for goods and services rise.
If the supply is not immediately forthcoming, the price of those goods and services rise. That
leads to inflation.

Low interest rates are good for business, it makes it cheaper to borrow funds, invest in new
projects, expand supply, etc. Low interest rates also increases consumption as debt finance
becomes cheaper and people’s disposable income rises as existing interest payments are reduced.
A decrease in interest rates therefore increases revenue expectations for most businesses. car
sales down as compared to the previous year. reducing costs wherever possible, consolidating
brands and dropping model lines and deferring R&D projects to conserve funds.