Monetary Policy—Points to Remember

1. We started by defining money, money supply, demand for money, how monetary
targets are set and the rule vs. discretion arguments. Chapter 14 of your textbook
will help you further in understanding these concepts. But try to understand these
things in a simple way. For example, money is what we use to make payments.
Now ask yourself: What is it that we use to make payments? You will have the
answer that it is currency and the cheques that you write against various
purchases. Therefore, money supply is defined as currency + all bank deposits
(M3). Come now to demand for money. Funda is that you should know that when
we are talking about demand for money we are talking about desire to hold money
in idle resources, which either does not earn any interest (currency) or which
earns very low interest (chequeable deposits). Now you ask: why would anyone
like to hold money in an idle form when it is capable of earning a higher return?
And you have the answer: because of three motives, transaction, and
precautionary and speculative motives. Demand function for money, then is
specified as an increasing function of income and a decreasing function of interest
rates. Both income (e) and interest rates (f) are based on certain expectations
about the political and economic variables (see the table on determinants of
demand for money in chapter 14) in a country and therefore may not be very
stable. It is this uncertainty about the stability of these coefficients, which makes
actual setting of monetary targets a challenge to the policy maker. And, from the
demand side, this is the reason why monetary policy is discretionary. In a
discretionary monetary policy, credibility can be at stake, though, chapter 14 talks
about various ways through which you can get over this problem which you
should read carefully.
2. Next, we came to monetary policy transmission mechanism. Remember a few
things that will avoid confusion. An increase in money supply makes sense only if
there is an increase in real money balances (M/P). In other words, if an increase in
money supply is accompanied by an equal increase in prices then there is no
change in M/P and, no rightward shift in LM curve. And, if we extend this
argument, there is no change in real interest rate either (only nominal interest
rises, based on the formula that nominal interest rate is real interest rate +
inflation). So every time we are talking about the impact of an increase in money
supply on interest rate we are necessarily assuming that m>p. Can you guess
under what circumstances this will be the case? Yes, when increase in money
supply (m) is also accompanied by some increase in output (y), holding v
constant. Now, things should fall in place. When the money supply increases,
since the aggregate supply curve is neither horizontal nor vertical but upward
sloping, both output and prices increase. Increase in money supply is greater than
increase in prices. M/P increases; LM and AD shift to the right, and this causes,
other things being equal, the real interest rate to come down, asset prices to go up

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 and the rupee to depreciate. Changes in these financial variables, in turn, affect C
and I, and thus, the GDP.
3. We then went on to address the question: how does money supply grow? Here
also, get the funda straight. Money supply has two components: currency and
bank deposits. We are, therefore, wanting to know: how does currency grow and
how do bank deposits grow. And, thereby, how does money supply grow. There
are three players. RBI (central bank of the country), the commercial banks who
accept chequeable deposits and the people who decide how much of the proceeds
to keep in the form of currency and how much in the form of chequeable deposit.
Finally, money supply growth depends on RBI money (H, or base money, also
called reserve money) and the money multiplier, which in turn, depends on
currency deposit ratio (Cu) and reserve deposit ratio (r). Chapter 14 of the book is
disgustingly elaborate on the money supply process; so I will not add to your
disgust. But you should understand, additionally, what determines ‘r’ and what
determines Cu. You should also understand clearly the components of RBI
balance sheet, the Bank’s balance sheet and that when you combine the two
(reserves cancel out), you can also get M3 from a balance sheet perspective.
Money multiplier process should also be clear. All these are in my class handouts.
4. The next item was Conduct of Monetary Policy. This is pretty straightforward.
You will find some support to our class discussions in the text chapter also. The
only thing you need to keep in mind is that financial sector reforms are not a part
of monetary policy, as we commonly understand, though they may be achieving
the same objective of bringing the interest rates down. In case of financial sector
reforms, there is no change in money supply; the interest rate reduction is effected
through better cost cutting efficiencies achieved by the financial system.
5. Finally, we came to the policy dilemmas. This part is not dealt with in your text
chapter. There is a reference to dilemmas in YV Reddy’s speech of which you
have a copy (handout given in the class). Read that. But the issues are as follows:
6. First, assume a closed economy. By that we mean that there is no free inflow or
outflow of capital. Implication is that since as a part of monetary policy
transmission mechanism, exchange rate gets affected because of capital outflow
(assuming as we did in the class that we are studying the response to an increase
in money supply), change in money supply will not affect exchange rates. But
even if you ignore the exchange rate impact, there is a dilemma arising out of
domestic policy choices. What is that? If you want to give a push to growth you
must lower interest rates for which you must increase money supply, but if you
increase money supply that will also lead to an increase in prices. So you cannot
achieve growth and price stability at the same time. There is a trade off. And the
dilemma is where do I draw a line between growth and inflation.
7. Now, consider an open economy case. Here, we assume free inflow and outflow
of capital. In an open economy the goals of monetary policy are not just sustained
growth (through interest rate stability) and stability in prices but also stability in
exchange rates. Assume, for example, outflow of capital (demand for dollars) is
greater than inflow of capital (supply of dollars). Obviously, rupee will have a
tendency to depreciate. Now, suppose RBI wants to stabilize the exchange rate.
Since the problem is caused by excess of dollar demand over dollar supply, the

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 only way RBI can stabilize the currency is by increasing the dollar supply. This it
will do by selling dollars in the market. Go to the RBI balance sheet. If RBI sells
dollars in the market, foreign exchange reserves will come down, ‘H’ will come
down and M3 growth will come down. If money supply increases at a slower
pace, interest rates will go up and growth will come down. So, in an open
economy, if the currency is under pressure and you want to stabilize the exchange
rate, you cannot stabilize the interest rate. The dilemma thus, is do I stabilize the
exchange rate or do I stabilize the interest rate? Where do I draw the line between
growth and exchange rate stability? More important, if you want to stabilize
interest rate, you must allow the exchange rate to fluctuate; if you want to
stabilize the exchange rate, you lose your monetary independence (EURO
countries) in terms of ability to influence interest rates.
8. Turn the story around. We are still in an open economy. But the situation is that
inflow (supply of dollars) is greater than outflow (demand for dollars). Clearly,
rupee will have a tendency to appreciate. Now, if RBI wants to stabilize the
exchange rate it must wipe out the extra supply of dollars, which is causing the
rupee to appreciate. It will buy it up from the market. Once again, go back to the
RBI balance sheet. Foreign exchange reserves will increase, ‘H” will go up,
money supply growth will go up and prices will go up. The dilemma, therefore, is
between stability in prices and stability in exchange rates. You cannot have both.
You must draw a line between these two objectives. Once again, we come to the
conclusion that if you want to stabilize the exchange rate, you lose your monetary
independence in terms of ability to stabilize prices by keeping money supply
growth under check; and, if you want to retain monetary independence you must
allow exchange rate to find its own level.
9. Is there a way out? Yes, you can have both monetary independence and stable
exchange rates simultaneously if you impose controls on movement of capital.
(Can you see why? You must; otherwise all my efforts in the preceding
paragraphs are wasted). However, in today’s global economic scenario, capital
controls are not viewed favourably.
10. Are there any temporary palliatives? Yes. Keep the RBI balance sheet in front of
you. Now you will see that one way to stabilize the exchange rate without adding
to the money supply (we are considering the case outlined in paragraph 8 above,
which is the current Indian situation) is to resort to sterilized intervention. That is,
the addition to foreign exchange reserves (item 3 in the financial assets of RBI)
resorted to in order to stabilize the value of the rupee can be sterilized by selling
government securities (item 1 in the financial assets of RBI) in the market. Thus,
money supply will not increase. This is what we are doing in India today. That is
why you see that despite massive forex accumulation by RBI, money supply
growth is on trend. But is it sustainable? The answer is no. Because a) it is very
costly (the money you pay to buy foreign exchange could have given you a much
higher interest if lent to the domestic sector); b) you are substituting foreign credit
for domestic credit and, c) you are not allowing the interest rate to come down to
stem the inflow by keeping money supply growth constant; so, inflow keeps on
growing.

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 11. What are the options before RBI? RBI has three options: a) do not intervene; in
that case, rupee will appreciate based purely on market forces: b) intervene but do
not sterilize; in this case money supply will increase and could be inflationary: c)
intervene and sterilize; in this case sustainability is in question because of reasons
given towards the end of paragraph 10 above. Continuation of c), present practice,
is unlikely; b) is likely to be politically unacceptable, particularly with elections in
the offing. Therefore, a) is most likely. RBI will probably allow the rupee to
appreciate to the point that it does not appreciate relative to other competing
country currencies.
12. What is the scenario of interest rates in India? It will depend on the relative
importance RBI assigns to exchange rate/price stabilization vis-à-vis interest rate
stabilization. Go to the slide titled “RBI intervention in the Forex market” You
will notice that in the period when outflow had a tendency to exceed inflow,
thereby, putting a downward pressure on the rupee, the primary goal of RBI had
been stabilization of exchange rates. To do so it did not hesitate to raise interest
rates. If you look at the current situation, exchange rate stabilization and price
stability are the principle goals (sterilized intervention). Only when prices and
exchange rates have been stable RBI has signaled a softening of interest rates.
13. Where does it leave us about the future of interest rates in India? Do not expect
too much from monetary policy (except through financial sector reforms) by way
of reduction in interest rates, particularly when the value of ‘d’ is stable (if ‘d’ is
close to zero, monetary policy does not matter, anyway). The future of interest
rates in India will, therefore, depend on fiscal rather than monetary policy, though
interest rate is a monetary policy variable. As long as the government continues to
borrow excessively from the market (IS curve continues to shift to the right),
interest rates will rule ‘high’. In the absence of monetary policy support, for
reasons mentioned above, interest rates in India can come down only if the size of
fiscal deficit, resulting in excessive government borrowing from the market,
comes down.
14. Do send me a mail if you have any questions, clarifications or comments. All the
best.

Shyamal Roy
December2, 2003