12-13

Monetary Policy

MACROECONOMICS
Macroeconomics

Prof. Rudra Sensarma

N. GregoryIndian
Mankiw
Institute of Management Kozhikode
www.rudrasensarma.info

PowerPoint Slides by Ron Cronovich

2013 Worth Publishers, all rights reserved

Learning objectives & outcomes

MonetaryPolicy
MoneyDemand,MoneySupply&InterestRate
QuantityTheoryofMoney
MonetaryPolicyTargets

SimplifiedBalanceSheetofRBI
Liabilities
Currencyincirculation(held
bypublic&somebybanks)

Assets
Domesticassets(government
bonds,loanstobanks,other
financialinstitutions)
Reserves
Foreignassets
(depositsbybanks CRR& (foreigngovernmentbonds,
excessreserves)
gold,forex reserves)
Nonmonetaryliabilities(paid Otherassets
upcapital,employeesPFetc.) (physicalassets)

Considermoney
supplyasthesumof
currencywiththe
publicanddemand
depositswithbanks

Interest rate, i

Moneysupply
Money Supply
MS

MoneySupply (M )=C+D

Thesupplyof
money
isfixedbythecentral
bank:ReserveBankof
India

Money

Demandfor
money:
Md =L(Y,i)
+

Whenincomeishigh,
expenditureishigh,so
peopleengageinmore
transactionsthatrequire
theuseof money.

Interest rate, i

Moneydemand

Interestrateisthe
opportunitycostofholding
money(paidbybonds or
banks)

Md
Money, M

MoneyDemand,MoneySupply,
andtheEquilibriumInterestRate
The interest rate
must be such that
the supply of money
be equal to the
demand for money.

TheEffectsofanIncreasein
NominalIncomeontheInterestRate

An increase in
nominal income
leads to an
increase in the
interest rate.

TheEffectsofanIncreaseinthe
MoneySupplyontheInterestRate
An increase in the
supply of money
leads to a
decrease in the
interest rate.

(b) Demand for

investment

(c) Aggregate demand

Price level

(a) Supply and demand

for money
Sm
Sm

Interest rate

Interest rate

EffectsofanIncreaseintheMoneySupplyon
InterestRates,Investment,andAggregateDemand

b
a

AD

Dm

AD

DI
0

M Money

An increase in the money

supply drives the interest
rate down to i'.

I I
Investment

With the cost of borrowing

lower, the amount invested
increases from I to I.

Y Real GDP

This sets off the spending

multiplier process, so the
aggregate output demanded
at price level P increases from
Y to Y

ExpansionaryMonetaryPolicytoCorrecta
Contractionary Gap
Price
level

Potential output
LRAS

At a, the economy is producing

less than its potential in the short
run, resulting in a contractionary
gap of $0.2 trillion.

SRAS130

130
a
125

AD
AD
0

13.8

14.0

Real GDP
(trillions of dollars)

Contractionary gap

If the Central Bank increases the

money supply by just the right
amount, the aggregate demand
curve shifts rightward from AD to
AD. A short-run and long-run
equilibrium is established at b,
with the pride level at 130 and
output at the potential level of
$14.0 trillion

MoneyandAggregateDemandinthe
LongRun
o Quantity Theory of Money
o M quantity of money in economy
o V velocity of money
o P average price level
o Y real GDP

M V P Y
P Y
V
M

IntheLongRun,anIncreaseintheMoneySupply
ResultsinaHigherPriceLevel,orInflation

Price level

Potential output
LRAS

140

130

The quantity theory of money

predicts that if velocity is stable,
then an increase in money
supply in the long run results in
a higher price level, or inflation.

AD
AD
0

14.0

Real GDP
(trillions of dollars)

Because the long-run

aggregate supply curve is fixed,
increases in the money supply
affect only the price level, not
real output.

HowdoesRBIchangemoneysupply?
RBIcanchangethesupplyofmoneythroughOMOs
(OpenMarketOperations)
IfRBIbuysbondsandpaysforitusingmoney,it
increasesmoneysupply(expansionarymonetary
policy).
IfRBIsellsbondsandreceivesmoneyforit,it
reducesmoneysupplyintheeconomy
(contractionary monetarypolicy).

HowdoesRBIchangemoneysupply?
Threemaininstrumentsofmonetarypolicy:
1. Thereporate
2. Cashreserveratio
3. Openmarketoperations

Reporate
definition:

TheinterestratethattheRBIchargesonshorttermloans(e.g.
overnight)itmakestobanksunderarepurchaseagreement
(8%).
howitworks:

Whenreporateislowered,banksborrowmorefromRBI,
whichallowsthemtomakemoreloansandcreatemore
money.
Howevertheprocessgetsreversedthenextdayasthisisonly

aliquidityadjustmentfacility(LAF).

RepolendingbyRBItobanks
Funds

CommercialBank
(sellsbond)

RBI
Govtbond

Nextdaythetransactionisreversed
Govtbond

CommercialBank
(repurchasesbond)

RBI
Funds

RBIchargesbanks8%(reporate)forthisliquidityadjustmentfacility

Repovs ReverseRepo
RepotransactionsareusedbyRBItoinjectliquidity
Reverserepoistheoppositeofarepotransactionwhichis

usedbyRBItoabsorbliquidity
Reversereporateis7%(repo 1%)
Ifbanksrunoutofgovernmentbondstouseforrepoloans
(i.e.excessSLR)theycanthenborrowatthemarginal
standingfacility(MSF)forwhichRBIchargesaninterestrate
calledbankrate(repo+1%=9%).
UnderMSF,SLRcanfallbelowtherequirementby2%
Banksusethecallmoneymarketforregularborrowing&
lending

LiquidityAdjustmentFacility

Cashreserveratio
definition:

RBIregulationthatrequiresbankstoholdaminimum
cashreservedepositratio.
howitworks:
IfRBIreducescashreserverequirements,
thenbankscanmakemoreloansand
createmoremoneyfromeachdeposit.

Openmarketoperations
definition:

Theoutrightpurchaseorsaleofgovernmentbondsby
theRBI.
howitworks:
IfRBIpurchasesbondsfrombanks,itreleasesliquidityin
exchangeforthebonds,whichallowsbankstomake
moreloansandcreatemoremoney.

Otherinstrumentsofmonetarypolicy
Interestrateregulation(nolongerinuse)

Selectivecreditcontrols(prioritysector
lending,marginrequirementsforlending,risk
ratingofsectors)
Moralsuasion(enlistingthecooperationof
bankstopursueRBIsobjectives)

MonetaryPolicyTargets
Instruments

Operating
Targets

Ultimate
Objectives

Intermediate
Targets

PrimaryInstrument:
Reporate
(undertheLAF)
Bankreserves
MoneySupply
Strengthofmoney
Secondaryinstruments:
multiplier,
CRR
ShortTerm
LongTerm
OMOs
InterestRate
InterestRate
Strengthof
IndirectInstruments:
(overnightcallrate) Relationship
(e.g.loanrate)
Interestrateregulation
b/wshort&
SelectiveCreditControl
longterminterestrates
MoralSuasion

Transmission
Channels
ofMonetary
Policy

GDP
Growth,
Price
Stability

Transmissionchannelsofmonetary
policy
Howhighermoneysupplyorlowerinterestrateinfluences

theultimateobjectives(output,prices):
Bankchannel(lowerinterestrate,morelending,investment

&GDPbuthigherprices)
Exchangeratechannel(lowerinterestrate,dollaroutflows,
weakerrupee,higherexports&GDPbuthigherprices)
Assetpriceschannel(lowerinterestratewillboostpresent
valueofshares,firmscanraisemorefundsthroughIPOs,
moreinvestment&GDPbuthigherprices)

Controversy:RBIsmonetarypolicyvsdebt
managementroles conflictofinterest?

Theconflictofinterest
Asdebtmanager(investmentbanker)togovt,RBIhasto

keepinterestratelow
Thisconflictwithitsmonetarypolicyrolewhichrequires
highinterestratetofightinflation
Govt&severalexpertcommitteesinfavourof
independentdebtmanagementoffice(DMO)
RBIresisted,nowsaysitwantstoheadDMO!

Controversy:RBIsrefusaltopayintereston
CRRbalances

Analyticsoftheproblem
Thebanksargument
Notpayinginterestamountstoanimplicittaxonbanks
RBIearnsprofitsfrominvestingthefunds,soshouldshare
it

RBIsargument

PayinginterestratesimplyreduceseffectiveCRR

Supposedepositsincreaseby1000croresleadingto
higherreservesby40crores(CRR=4%)
IfCRRbalancesarepaid7%interest,effectiveCRR
maintenance=40 7%of40=37.20cr or3.72%
RBIcansimplyincreaseCRRto4.3%andnothingwill
change!

Globaltrendsinmonetarypolicy
AlanGreenspan,ChairmanofUSFed,19872006

Gainedappreciationfortacklingthe1987crash

withinmonthsofjoining
Knownforsuperlowinterestrates&disdainfor
regulation
FeaturedinTimemagazineslistof25peopleto
blameforthecrisis

Theproblemwithlowinterestrates
Lowinterestratesfuelledaneconomicboomin

1990s early2000s
Lowinterestratesacrossthedevelopedworld

encouragedrecklessborrowing
Superlowinterestratesdidnotleaveroomfor

ratecutswhencrisisstruck

Monetarypolicyatthecrossroads
Newtoolsofmonetarypolicy:

Quantitativeeasing,Twistoperation
Thenwhataboutinflationtargets?
Inflationtargetabandoned(UK,EU)
IsInflationawayoftacklinggovernment
debt?!Seignorage (not discussedinclass
butyouareencouragedtoreadup)
NominalGDPtargetingisbeingtalked
aboutasanalternative (notdiscussedin
classbutyouareencouragedtoreadup)

Raghuram RajanonMonetarypolicy

https://www.youtube.com/watch?v=v7
LQcJbm3dE

Next
Macroeconomic Policy Debates
Active Policy Vs Passive Policy
The Role of Expectations
The Phillips Curve