ICAI Notes- Unit 3: Monetary Policy | Business Economics for CA Foundation PDF Download

 Page 1


 1.45 
 
 
 
8.45 
MONEY MARKET 
LEARNING OUTCOMES 
UNIT - 3: MONETARY POLICY 
 
 
 
 
After studying this Unit, you will be able to – 
? Define monetary policy and describe its objectives 
? Elucidate different components of the monetary policy framework 
? Illustrate the analytics of monetary policy 
? Explain the operating procedures and instruments of monetary 
policy, and 
? Describe the organizational structure for monetary policy decisions 
 
 
 
 
  
Monetary Policy 
The Monetary Policy 
Framework 
The Organisational Structure 
for Monetary Policy Decisions 
 
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 2


 1.45 
 
 
 
8.45 
MONEY MARKET 
LEARNING OUTCOMES 
UNIT - 3: MONETARY POLICY 
 
 
 
 
After studying this Unit, you will be able to – 
? Define monetary policy and describe its objectives 
? Elucidate different components of the monetary policy framework 
? Illustrate the analytics of monetary policy 
? Explain the operating procedures and instruments of monetary 
policy, and 
? Describe the organizational structure for monetary policy decisions 
 
 
 
 
  
Monetary Policy 
The Monetary Policy 
Framework 
The Organisational Structure 
for Monetary Policy Decisions 
 
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
1.46  
 
BUSINESS ECONOMICS 
 
 8.46 
3.1 INTRODUCTION 
We observe that the Reserve Bank of India is occasionally manipulating policy rates for 
manoeuvring liquidity conditions with reasons thereof explicitly notified. In fact, we have only 
a limited understanding of the monetary phenomena which could strengthen or paralyse the 
domestic economy. The discussion that follows is an attempt to throw light on the well-
acknowledged monetary measures undertaken by governments to fight economic instability.  
3.2 MONETARY POLICY DEFINED 
Reserve Bank of India uses monetary policy to manage economic fluctuations and achieve 
price stability, which means that inflation is low and stable. Reserve Bank of India conducts 
monetary policy by adjusting the supply of money, usually through buying or selling securities 
in the open market. Open market operations affect short-term interest rates, which in turn 
influence longer-term rates and economic activity. When central banks lower interest rates, 
monetary policy is easing. When it raises interest rates, monetary policy is tightening. 
3.3 THE MONETARY POLICY FRAMEWORK 
The central bank, in its execution of monetary policy, functions within an articulated monetary 
policy framework which has three basic components, viz. 
(i) the objectives of monetary policy, 
(ii) the analytics of monetary policy which focus on the transmission mechanisms, and 
(iii) The operating procedure which focuses on the operating targets and instruments. 
3.3.1 The Objectives of Monetary Policy 
The objectives set for monetary policy are important because they provide explicit guidance 
to policymakers.  The monetary policy of a country is in fact a reflection of its economic policy 
and therefore, the objectives of monetary policy generally coincide with the overall objectives 
of economic policy.  
The Reserve Bank of India Act, 1934, in its preamble sets out the objectives of the Bank as ‘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’. Fundamentally, the primary objective of monetary policy has been the 
maintenance of a judicious balance between price stability and economic growth.  
© The Institute of Chartered Accountants of India
Page 3


 1.45 
 
 
 
8.45 
MONEY MARKET 
LEARNING OUTCOMES 
UNIT - 3: MONETARY POLICY 
 
 
 
 
After studying this Unit, you will be able to – 
? Define monetary policy and describe its objectives 
? Elucidate different components of the monetary policy framework 
? Illustrate the analytics of monetary policy 
? Explain the operating procedures and instruments of monetary 
policy, and 
? Describe the organizational structure for monetary policy decisions 
 
 
 
 
  
Monetary Policy 
The Monetary Policy 
Framework 
The Organisational Structure 
for Monetary Policy Decisions 
 
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
1.46  
 
BUSINESS ECONOMICS 
 
 8.46 
3.1 INTRODUCTION 
We observe that the Reserve Bank of India is occasionally manipulating policy rates for 
manoeuvring liquidity conditions with reasons thereof explicitly notified. In fact, we have only 
a limited understanding of the monetary phenomena which could strengthen or paralyse the 
domestic economy. The discussion that follows is an attempt to throw light on the well-
acknowledged monetary measures undertaken by governments to fight economic instability.  
3.2 MONETARY POLICY DEFINED 
Reserve Bank of India uses monetary policy to manage economic fluctuations and achieve 
price stability, which means that inflation is low and stable. Reserve Bank of India conducts 
monetary policy by adjusting the supply of money, usually through buying or selling securities 
in the open market. Open market operations affect short-term interest rates, which in turn 
influence longer-term rates and economic activity. When central banks lower interest rates, 
monetary policy is easing. When it raises interest rates, monetary policy is tightening. 
3.3 THE MONETARY POLICY FRAMEWORK 
The central bank, in its execution of monetary policy, functions within an articulated monetary 
policy framework which has three basic components, viz. 
(i) the objectives of monetary policy, 
(ii) the analytics of monetary policy which focus on the transmission mechanisms, and 
(iii) The operating procedure which focuses on the operating targets and instruments. 
3.3.1 The Objectives of Monetary Policy 
The objectives set for monetary policy are important because they provide explicit guidance 
to policymakers.  The monetary policy of a country is in fact a reflection of its economic policy 
and therefore, the objectives of monetary policy generally coincide with the overall objectives 
of economic policy.  
The Reserve Bank of India Act, 1934, in its preamble sets out the objectives of the Bank as ‘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’. Fundamentally, the primary objective of monetary policy has been the 
maintenance of a judicious balance between price stability and economic growth.  
© The Institute of Chartered Accountants of India
 1.47 
 
 
 
8.47 
MONEY MARKET 
Given the development needs of developing countries, the monetary policy of such countries 
also incorporates explicit objectives such as:  
(i) maintenance the economic growth, 
(ii) ensuring an adequate flow of credit to the productive sectors,  
(iii) sustaining - a moderate structure of interest rates to encourage investments, and   
(iv) creation of an efficient market for government securities. 
Considerations of financial and exchange rate stability have assumed greater importance in 
India recently on account of the increasing openness of the economy and the progressive 
economic and financial sector reforms.  
3.3.2 Transmission of Monetary Policy 
The transmission of the monetary policy describes how changes made by the Reserve Bank to 
its monetary policy settings flow through to economic activity and inflation. This process is 
complex and there is a large degree of uncertainty about the timing and size of the impact 
on the economy. In simple terms, the transmission can be summarised in two stages. 
1. Changes to monetary policy affect interest rates in the economy. 
2. Changes to interest rates affect economic activity and inflation. 
Although we know that monetary policy does influence output and inflation, we are not 
certain about how exactly it does so, because the effects of such policy are visible often after 
a time lag which is not completely predictable. 
CHANNELS OF MONETARY POLICY TRANSMISSION 
Saving and Investment Channel
Monetary policy influences economic activity by changing the incentives for saving and 
investment. This channel typically affects consumption, housing investment, and business 
investment. 
• Lower interest rates on bank deposits reduce the incentives households must save their 
money. Instead, there is an increased incentive for households to spend their money 
on goods and services. 
• Lower interest rates for loans can encourage households to borrow more as they face 
lower repayments. Because of this, lower lending rates support higher demand for 
assets, such as housing. 
 
© The Institute of Chartered Accountants of India
Page 4


 1.45 
 
 
 
8.45 
MONEY MARKET 
LEARNING OUTCOMES 
UNIT - 3: MONETARY POLICY 
 
 
 
 
After studying this Unit, you will be able to – 
? Define monetary policy and describe its objectives 
? Elucidate different components of the monetary policy framework 
? Illustrate the analytics of monetary policy 
? Explain the operating procedures and instruments of monetary 
policy, and 
? Describe the organizational structure for monetary policy decisions 
 
 
 
 
  
Monetary Policy 
The Monetary Policy 
Framework 
The Organisational Structure 
for Monetary Policy Decisions 
 
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
1.46  
 
BUSINESS ECONOMICS 
 
 8.46 
3.1 INTRODUCTION 
We observe that the Reserve Bank of India is occasionally manipulating policy rates for 
manoeuvring liquidity conditions with reasons thereof explicitly notified. In fact, we have only 
a limited understanding of the monetary phenomena which could strengthen or paralyse the 
domestic economy. The discussion that follows is an attempt to throw light on the well-
acknowledged monetary measures undertaken by governments to fight economic instability.  
3.2 MONETARY POLICY DEFINED 
Reserve Bank of India uses monetary policy to manage economic fluctuations and achieve 
price stability, which means that inflation is low and stable. Reserve Bank of India conducts 
monetary policy by adjusting the supply of money, usually through buying or selling securities 
in the open market. Open market operations affect short-term interest rates, which in turn 
influence longer-term rates and economic activity. When central banks lower interest rates, 
monetary policy is easing. When it raises interest rates, monetary policy is tightening. 
3.3 THE MONETARY POLICY FRAMEWORK 
The central bank, in its execution of monetary policy, functions within an articulated monetary 
policy framework which has three basic components, viz. 
(i) the objectives of monetary policy, 
(ii) the analytics of monetary policy which focus on the transmission mechanisms, and 
(iii) The operating procedure which focuses on the operating targets and instruments. 
3.3.1 The Objectives of Monetary Policy 
The objectives set for monetary policy are important because they provide explicit guidance 
to policymakers.  The monetary policy of a country is in fact a reflection of its economic policy 
and therefore, the objectives of monetary policy generally coincide with the overall objectives 
of economic policy.  
The Reserve Bank of India Act, 1934, in its preamble sets out the objectives of the Bank as ‘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’. Fundamentally, the primary objective of monetary policy has been the 
maintenance of a judicious balance between price stability and economic growth.  
© The Institute of Chartered Accountants of India
 1.47 
 
 
 
8.47 
MONEY MARKET 
Given the development needs of developing countries, the monetary policy of such countries 
also incorporates explicit objectives such as:  
(i) maintenance the economic growth, 
(ii) ensuring an adequate flow of credit to the productive sectors,  
(iii) sustaining - a moderate structure of interest rates to encourage investments, and   
(iv) creation of an efficient market for government securities. 
Considerations of financial and exchange rate stability have assumed greater importance in 
India recently on account of the increasing openness of the economy and the progressive 
economic and financial sector reforms.  
3.3.2 Transmission of Monetary Policy 
The transmission of the monetary policy describes how changes made by the Reserve Bank to 
its monetary policy settings flow through to economic activity and inflation. This process is 
complex and there is a large degree of uncertainty about the timing and size of the impact 
on the economy. In simple terms, the transmission can be summarised in two stages. 
1. Changes to monetary policy affect interest rates in the economy. 
2. Changes to interest rates affect economic activity and inflation. 
Although we know that monetary policy does influence output and inflation, we are not 
certain about how exactly it does so, because the effects of such policy are visible often after 
a time lag which is not completely predictable. 
CHANNELS OF MONETARY POLICY TRANSMISSION 
Saving and Investment Channel
Monetary policy influences economic activity by changing the incentives for saving and 
investment. This channel typically affects consumption, housing investment, and business 
investment. 
• Lower interest rates on bank deposits reduce the incentives households must save their 
money. Instead, there is an increased incentive for households to spend their money 
on goods and services. 
• Lower interest rates for loans can encourage households to borrow more as they face 
lower repayments. Because of this, lower lending rates support higher demand for 
assets, such as housing. 
 
© The Institute of Chartered Accountants of India
1.48  
 
BUSINESS ECONOMICS 
 
 8.48 
• Lower lending rates can increase investment spending by businesses (on capital goods 
like new equipment or buildings). This is because the cost of borrowing is lower, and 
because of increased demand for the goods and services they supply. This means that 
returns on these projects are now more likely to be higher than the cost of borrowing, 
helping to justify going ahead with the projects. This will have a more direct effect on 
businesses that borrow to fund their projects with debt rather than those that use the 
business owners' funds. 
Cash-flow Channel 
• Monetary policy influences interest rates, which affects the decisions of households 
and businesses by changing the amount of cash they have available to spend on goods 
and services. This is an important channel for those that are liquidity constrained (for 
example, those who have already borrowed up to the maximum that banks will 
provide). 
• A reduction in lending rates reduces interest repayments on debt, increasing the 
amount of cash available for households and businesses to spend on goods and 
services. For example, a reduction in interest rates lowers repayments for households 
with variable-rate mortgages, leaving them with more disposable income. 
• At the same time, a reduction in interest rates reduces the amount of income that 
households and businesses get from deposits, and some may choose to restrict their 
spending. 
These two effects work in opposite directions, but a reduction in interest rates can be 
expected to increase spending in the Indian economy through this channel (with the 
first effect larger than the second) 
Asset Prices and Wealth Channel 
• Asset prices and people's wealth influence how much they can borrow and how much 
they spend in the economy. The asset prices and wealth channel typically affects 
consumption and investment. 
• Lower interest rates support asset prices (such as housing and equities) by encouraging 
demand for assets. One reason for this is that the present discounted value of future 
income is higher when interest rates are lower. 
• Higher asset prices also increase the equity (collateral) of an asset that is available for 
banks to lend against. This can make it easier for households and businesses to borrow. 
 
© The Institute of Chartered Accountants of India
Page 5


 1.45 
 
 
 
8.45 
MONEY MARKET 
LEARNING OUTCOMES 
UNIT - 3: MONETARY POLICY 
 
 
 
 
After studying this Unit, you will be able to – 
? Define monetary policy and describe its objectives 
? Elucidate different components of the monetary policy framework 
? Illustrate the analytics of monetary policy 
? Explain the operating procedures and instruments of monetary 
policy, and 
? Describe the organizational structure for monetary policy decisions 
 
 
 
 
  
Monetary Policy 
The Monetary Policy 
Framework 
The Organisational Structure 
for Monetary Policy Decisions 
 
UNIT OVERVIEW 
 
© The Institute of Chartered Accountants of India
1.46  
 
BUSINESS ECONOMICS 
 
 8.46 
3.1 INTRODUCTION 
We observe that the Reserve Bank of India is occasionally manipulating policy rates for 
manoeuvring liquidity conditions with reasons thereof explicitly notified. In fact, we have only 
a limited understanding of the monetary phenomena which could strengthen or paralyse the 
domestic economy. The discussion that follows is an attempt to throw light on the well-
acknowledged monetary measures undertaken by governments to fight economic instability.  
3.2 MONETARY POLICY DEFINED 
Reserve Bank of India uses monetary policy to manage economic fluctuations and achieve 
price stability, which means that inflation is low and stable. Reserve Bank of India conducts 
monetary policy by adjusting the supply of money, usually through buying or selling securities 
in the open market. Open market operations affect short-term interest rates, which in turn 
influence longer-term rates and economic activity. When central banks lower interest rates, 
monetary policy is easing. When it raises interest rates, monetary policy is tightening. 
3.3 THE MONETARY POLICY FRAMEWORK 
The central bank, in its execution of monetary policy, functions within an articulated monetary 
policy framework which has three basic components, viz. 
(i) the objectives of monetary policy, 
(ii) the analytics of monetary policy which focus on the transmission mechanisms, and 
(iii) The operating procedure which focuses on the operating targets and instruments. 
3.3.1 The Objectives of Monetary Policy 
The objectives set for monetary policy are important because they provide explicit guidance 
to policymakers.  The monetary policy of a country is in fact a reflection of its economic policy 
and therefore, the objectives of monetary policy generally coincide with the overall objectives 
of economic policy.  
The Reserve Bank of India Act, 1934, in its preamble sets out the objectives of the Bank as ‘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’. Fundamentally, the primary objective of monetary policy has been the 
maintenance of a judicious balance between price stability and economic growth.  
© The Institute of Chartered Accountants of India
 1.47 
 
 
 
8.47 
MONEY MARKET 
Given the development needs of developing countries, the monetary policy of such countries 
also incorporates explicit objectives such as:  
(i) maintenance the economic growth, 
(ii) ensuring an adequate flow of credit to the productive sectors,  
(iii) sustaining - a moderate structure of interest rates to encourage investments, and   
(iv) creation of an efficient market for government securities. 
Considerations of financial and exchange rate stability have assumed greater importance in 
India recently on account of the increasing openness of the economy and the progressive 
economic and financial sector reforms.  
3.3.2 Transmission of Monetary Policy 
The transmission of the monetary policy describes how changes made by the Reserve Bank to 
its monetary policy settings flow through to economic activity and inflation. This process is 
complex and there is a large degree of uncertainty about the timing and size of the impact 
on the economy. In simple terms, the transmission can be summarised in two stages. 
1. Changes to monetary policy affect interest rates in the economy. 
2. Changes to interest rates affect economic activity and inflation. 
Although we know that monetary policy does influence output and inflation, we are not 
certain about how exactly it does so, because the effects of such policy are visible often after 
a time lag which is not completely predictable. 
CHANNELS OF MONETARY POLICY TRANSMISSION 
Saving and Investment Channel
Monetary policy influences economic activity by changing the incentives for saving and 
investment. This channel typically affects consumption, housing investment, and business 
investment. 
• Lower interest rates on bank deposits reduce the incentives households must save their 
money. Instead, there is an increased incentive for households to spend their money 
on goods and services. 
• Lower interest rates for loans can encourage households to borrow more as they face 
lower repayments. Because of this, lower lending rates support higher demand for 
assets, such as housing. 
 
© The Institute of Chartered Accountants of India
1.48  
 
BUSINESS ECONOMICS 
 
 8.48 
• Lower lending rates can increase investment spending by businesses (on capital goods 
like new equipment or buildings). This is because the cost of borrowing is lower, and 
because of increased demand for the goods and services they supply. This means that 
returns on these projects are now more likely to be higher than the cost of borrowing, 
helping to justify going ahead with the projects. This will have a more direct effect on 
businesses that borrow to fund their projects with debt rather than those that use the 
business owners' funds. 
Cash-flow Channel 
• Monetary policy influences interest rates, which affects the decisions of households 
and businesses by changing the amount of cash they have available to spend on goods 
and services. This is an important channel for those that are liquidity constrained (for 
example, those who have already borrowed up to the maximum that banks will 
provide). 
• A reduction in lending rates reduces interest repayments on debt, increasing the 
amount of cash available for households and businesses to spend on goods and 
services. For example, a reduction in interest rates lowers repayments for households 
with variable-rate mortgages, leaving them with more disposable income. 
• At the same time, a reduction in interest rates reduces the amount of income that 
households and businesses get from deposits, and some may choose to restrict their 
spending. 
These two effects work in opposite directions, but a reduction in interest rates can be 
expected to increase spending in the Indian economy through this channel (with the 
first effect larger than the second) 
Asset Prices and Wealth Channel 
• Asset prices and people's wealth influence how much they can borrow and how much 
they spend in the economy. The asset prices and wealth channel typically affects 
consumption and investment. 
• Lower interest rates support asset prices (such as housing and equities) by encouraging 
demand for assets. One reason for this is that the present discounted value of future 
income is higher when interest rates are lower. 
• Higher asset prices also increase the equity (collateral) of an asset that is available for 
banks to lend against. This can make it easier for households and businesses to borrow. 
 
© The Institute of Chartered Accountants of India
 1.49 
 
 
 
8.49 
MONEY MARKET 
• An increase in asset prices increases people's wealth. This can lead to higher 
consumption and housing investment as households generally spend some share of 
any increase in their wealth. 
Exchange Rate Channel 
The exchange rate can have an important influence on economic activity and inflation. It is 
typically more important for sectors that are export-oriented or exposed to competition from 
imported goods and services. 
• If the Reserve Bank lowers the cash rate it means that interest rates in India have fallen 
compared with interest rates in the rest of the world (all else being equal). 
• Lower interest rates reduce the returns investors earn from assets in  India (relative to 
other countries). Lower returns reduce demand for assets in India (as well as for Indian 
rupees) with investors shifting their funds to foreign assets (and currencies) instead. 
• A reduction in interest rates (compared with the rest of the world) results in a lower 
exchange rate, making foreign goods and services more expensive compared with 
those produced in India. This leads to an increase in exports and domestic activity. A 
lower exchange rate also adds to inflation because imports become more expensive in 
Indian rupees.  
3.3.3 Operating Procedures and Instruments  
Quantitative tools – 
The tools applied by the policy that impact money supply in the entire economy, including 
sectors such as manufacturing, agriculture, automobile, housing, etc. 
Reserve Ratio 
Banks are required to keep aside a set percentage of cash reserves or RBI approved assets. 
Reserve ratio is of two types: 
Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the RBI. 
The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR. 
Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid assets 
such as gold or RBI approved securities such as government securities. Banks are allowed to 
earn interest on these securities, however it is very low. 
Open Market Operations (OMO) 
In order to control money supply, the RBI buys and sells government securities in the open 
market. These operations conducted by the Central Bank in the open market are referred to 
as Open Market Operations. 
© The Institute of Chartered Accountants of India