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Monetary Policy Transmission Mechanism

Group 6

Adarsh N ( PGP/16/060) Deepak Jangid(PGP/16/080) Eshnna V P Ekka ( PGP/16/081) Gaurav Chand (PGP/16/082) Hemant Kumar (PGP/16/083) Nishant S (PGP/16/096)

To meet the policy targets set by Central Bank Exert systematic influence on the economy in a forward looking sense To reflect the desired effect in desired time frame

Objective

Financial Market Prices


Interest Rates
Exchange Rates Yields Asset Prices Equity Prices

Financial Market Quantities


Money Supply

Credit Aggregates

Supply of governments bonds


Foreign denominated assets

Transmission Mechanisms

Major channels are : 1. Interest rate 2. Credit aggregates 3. Asset prices 4. Exchange rate

Interest rate channel is dominant transmission mechanism Credit channel amplify and propagate interest rate effects Fifth channel expectations

Transmission Channels

Transmission Channels

1) 2) 3) 4) 5)

Objectives of Monetary policy Framework and instruments of monetary policy guiding monetary policy transmission Monetary policy transmission channels and operating Procedures Assessment of monetary transmission Challenges and dilemmas of monetary policy

Key points to be discussed

Reserve Bank of India Act, 1934 sets out the objectives To regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.

1) Objectives of Monetary Policy

Twin objectives : A) Price stability B) Provision of adequate credit to productive sectors of the economy to support the aggregate demand Underlying philosophy- to establish the low and stable inflation environment that economic growth can sustain.

1) Objectives of Monetary Policy

Prior to Mid-1980s
No formal enunciation of Objectives Instruments Other than Administering the supply/allocation of and demand for credit

2) Framework and Instruments

1985-1997
Implementation of loose and flexible monetary targeting with feedback Growth in broad money supply (M3) was projected in a manner consistent with expected GDP growth and a tolerable level of inflation Operating target Reserve Money Operating Instrument Bank Reserves

2) Framework and Instruments

But.. Market deregulation increased the role of market forces

Capital flows led to :


increased liquidity Upward pressure on the money supply, prices and exchange rates

Result: Interest rates gained relative influence on the decision to hold money.

2) Framework and Instruments

Post 1998-99 Broad-based multiple indicator approach Policy objectives obtained by the combination of interest rate and other market rates Central objective - High economic growth Inflation targeting was made secondary

2) Framework and Instruments

Reasons for inflation being second concern


Record moderate inflation until the downturn of 2008 Absence of efficient financial market Interest rate distortions Supply shocks arising from Monsoon on agriculture Market imperfections with regional differences

2) Framework and Instruments

Need for efficient price discovery w.r.t. to interest rates and exchange rates Growing need for full financial market spectrum Pivotal in transmission of policies

Market Development

Developing call money market Introduction of Collateralised Borrowing and Lending Obligation (CBLO) in 2002 Clearing Corporation of India Limited (CCIL) acted as a central counter party Increased flexibility in CRR, SLR measures Fiscal Responsibility and Budget Management (FRBM) Act, 2003

Market Development

Fiscal Responsibility and Budget Management (FRBM) Act, 2003

Reserve Bank not allowed to subscribe G-Secs in Primary market Completed the transition to a fully market based system for Government securities

Raising of funds by State Governments was made market driven

Market Development

Key indicators short term interest rates Use of instruments directly under control of central bank like Interest rate, CRR Sterilization of exchange rates through OMO etc. Monetary policy is implemented by fixing operating target and policy instruments for short time horizon.

3) Operating Procedures

Variant
First

Example
US Federal Reserve

Operating Procedure
Estimates the demand for bank reserves and then carry out open market operations to target short-term interest rates; Estimate market liquidity and carry out open market operations to target bank reserves, while allowing interest rates to adjust

Second

Bank of Japan

Third

Bank of England

Modulates monetary conditions in terms of both quantum and price of liquidity, through a mix of OMOs, standing facilities and minimum reserve requirement and changes in the policy rate.

3) Operating Procedures

1. Money Markets and LAF 2. Market Stabilization scheme

3. Bank Credit and Lending rate channels


4. Debt Market Channel 5. Exchange Rate Channel

6. Communication and Expectation

channel

3) Operating Procedures

LAF - Liquidity Adjustment Facility, 2000 Reserve Bank

Sets its policy rates i.e. Repo/Reverse Repo rates Carries out Repo/Reverse Repo Operations

3.1 Money Market and LAF

Market Stabilization Scheme March, 2004


Needed to sterilize the large capital inflows RBI issues additional T-bills and securities to absorb the liquidity

Money goes into the Market Stabilization scheme Account The RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account

3.2 Market Stabilization Scheme

Unexpected monetary implications due to Government cash balance volatility Cash Balance volatility due to

1. 2. 3.

Operational Requirements salary payments etc. To meet the disbursements like redemption of bonds Inflows by direct tax revenues etc.

Government cash inflow/outflow could lead to unexpected/unintended tightening/expansion of monetary policy

3.2 Market Stabilization Scheme

Gaining strength due to increasing share of retail credit, household credit etc. A better tool of price discovery Highly important for RBI to ensure

Availability of bank credit to agriculture, exports, SSI, infrastructure, housing etc. Increasing share

Depends upon Interest pass-through ratio

3.3 Bank Credit & Lending Rate channels

Example:
For the period of Sept. 1998 to March 2004 Interest pass-through from changes in policy rate 0.61 for lending and 0.42 for deposit rates Meaning : Reduction/ Increase of 100 basis points(bps) in the Bank rate led to reduction/increase of almost 40 bps in the banks deposit rates and 60 bps in PLR(Prime Lending

3.3 Bank Credit & Lending Rate channels

Factors affecting pass-through ratio:


Policy efforts to impart greater flexibility to interest rate structure Guidance by RBI to introduce flexibility in new deposits Competition High competition will lead to higher pass-through ratio

3.3 Bank Credit & Lending Rate channels

Two functions Monetary Policy & Debt Management Pre-conditions for separation of both requires:

Fuller development of financial markets Reasonable control over the fiscal deficit

Necessary legislative changes Greater autonomy for the monetary policies

3.4 Debt market Channel

Steps towards autonomy:

Withdrawal of the RBI from the primary market of G-Sec

FRBM Act, 2003

Permitting a reduction in the statutory minimum SLR


Formation of FMD (Financial Market Department) to undertake

A) Monetary operations B) Regulation and development of money market instruments C) Monitoring of money, government securities and foreign exchange markets

3.4 Debt market Channel

While the government securities market is fairly well developed now Corporate debt market remains to be developed for facilitating monetary signalling across various market segments.

3.4 Debt market Channel

Guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene, if and when necessary.

3.5 Exchange Rate Channel

Interest Rate Arbitrage

Net Inflow until interest parity is achieved

Appreciating exchange rate

Need to carry out forex operations for stabilizing the market


Restricted exchange rate adjustments due to market volatility Dampening effect on Aggregate demand

Inflationary pressure

3.5 Exchange Rate Channel

Expectational hypothesis of the term structure of interest rates links the short term and long term real rates Credibility of the monetary authority drives the expectations channel

3.6 Communication and Expectation Channel

Dilemma faced by RBI about communication


What and to what degree of disaggregation? What stage of evolution of internal thinking and debate should there be dissemination timing of communication with reference to its market impact quality of information and the possible ways in which it could be perceived

3.6 Communication and Expectation Channel

More complex is the mandate for the central bank, the more is the necessity of communication Three kinds of communication

policy measures reasons behind such policy measures and analysis of the economy

3.6 Communication and Expectation Channel

Quarterly policy statement Governor explains the rationale behind the policy measures Technical Advisory Committees (TACs)

External experts Reviews macroeconomic and monetary developments Advises the Reserve Bank

3.6 Communication and Expectation Channel

Inflation statistics (Excel) Spreadsheet Analysis

4) How well do these channels do?

1. 2. 3. 4.
1. 2.

Volatility in agriculture sector Challenges in liquidity management Volatility in global financial market Evolving challenges:
Evolving Demography Financial innovations : e-banking

5. Challenges in efficient transmission

Caused by dependence on monsoon rainfall Volatility in share to GDP Supply shock impacts food inflation Since food items form part of price indices it result volatility in headline inflation

5.1 Volatility in agriculture sector

Buffer cash reserves kept by banks with RBI Governments surplus cash balances in RBI

5.2 Challenges in liquidity management

Withdrawal of funds from Indian equity markets Dollar liquidity in the domestic foreign exchange market Adverse expectations on the balance of payments Increased volatility in the foreign exchange market

5.3 Volatility in global financial market

As the proportion of elderly population to the total increases, the pattern of global savings will change Tends to reduce the natural rate of interest Elderly population richer in financial and real capital while young are richer in human capital With growing share of elderly population, the role of the wealth channel in monetary transmission might assume greater importance

5.4.1 Evolving Demography

e-banking reduces transactions costs for depositors Increases depositors access to a wide range of financial assets in addition to bank deposits Reduction in money demand flattening of the LM curve

5.4.2 Financial innovations : e-banking

Thank You