Instruments of Monetary control - Central Banking, Indian Financial system Video Lecture | Indian Financial System - B Com

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monetary policy is primarily concerned
with the management of supply of money
but in an economy like India it is
managing the rate of growth of money
supply per period this supply of growth
serves certain well-defined social goals
universally the best ones are a
combination of growth with stability and
equity stability here primarily means
price stability and in an economy like
India it also means the growth of
employment or else the reduction in
unemployment and also a promotion of a
healthy balance of payment in the medium
run one also has to take into account
that there are a number of sources of
lags between the occurrence of an event
that brings forth a policy response and
the eventual response of the economy due
to this the RBI reacts cautiously to any
new development and it is no surprise
that policymakers decide the slow and
steady approach even to the point of
excessive caution over the speedy brash
approach after shutting this module you
will be able to understand the
effectiveness of monetary policy know
about the different sources of lags know
about the conflict among policymakers
monetary policy is primarily concerned
with the management of supply of money
but in an economy like India it involves
managing the rate of
growth of money supply per period the
supply of growth serves certain
well-defined social goals universally
the best ones are a combination of
growth with stability and equity one
also has to take into account that there
are a number of sources of lags between
the occurrence of an event that brings
forth a policy response and the eventual
response of the economy due to this the
RBI reacts cautiously to any new
development and it is no surprise that
policymakers choose the slow and steady
approach even to the point of excessive
caution over the speedy brash approach
we begin with the determination of the
optimal rate of growth of money supply
per period say a year for India which
the Zeeb RBI should pursue as a target
rate of growth of money supply we need
this target rate to guide RBI's monetary
policy and to serve as a criteria with
which the with which to compare the
actual rate of growth of money supply
such a comparison will allow us to
assess easily the degree and direction
of the departure of actual money supply
from its socially desired time path in a
growing economy the optimal conduct of
monetary policy requires that the supply
of money is grown to subserve certain
well-defined social goals talking in
terms of the annual rate of growth of
money supply the optimal monetary policy
requires that this rate of growth on
average is such as to be consistent with
the attainment of the desired social
goals
it is universally admitted that the best
combination of these social goals is
growth with stability and equity
stability here means overall economic
stability but for all practical purposes
is generally equated with general price
stability it has been argued cogently
that in the Indian context the pursuit
of the above set of goals will mean
maximum feasible output and employment
in very short run and also promotion of
a healthy balance of payment position in
the medium run at least three questions
need to be discussed here first what is
the appropriate empirical measure of
money second in the context of India's
growing economy what will be the optimal
rate of growth of money supply per year
and third how has the actual money
supply behaved over the past four
decades since 1951 and why behavior of
actual money supply over past four
decades how many supply changes relate
to the tainment of virtual goals the
explanation of this question is provided
by the public's demand for real money
this demand indicates the public's
absorptive capacity or willingness to
hold money in real terms given the
values of the several specifiable key
determinants of the public's demand for
money this point is central to the whole
concept of money targeting or monetary
policymaking how money supply changes
related to the attainment of social
goals the key to the explanation is
provided by the public's demand for real
money this demand indicates the public's
absorptive capacity or willingness to
hold money in real terms given the value
values of several specific key
determinants of public's demand for
money this point is central to the whole
concept of money targeting or monetary
policymaking
three solutions values three solution
values have been put forward first
drawing on the statistically derived
most common result that the real income
elasticity of demand for real money in
India is unity second that the best
estimate of the expected rate of growth
of Indian economy and third that the
planned or desired rate of inflation
should be predetermined for monetary
targeting for price stability what we
mean is long-run average stability not
absolutely stable price level for every
year in the context of differential
rates of growth of various important
sectors of the economy and the
inter-sectoral resources resource
transfers implied in the planning
process some price increase would be
inevitable in the process of growth but
correctly speaking the said resource
transfer requires appropriate changes in
relative prices and not increases in
absolute prices for growth industries a
correct policy could allow increase in
some prices with decrease in prices for
declining industries it should not try
to protect
the latter two necessary higher prices
for growth industries to attract
resources normally changes in technology
and in tastes and preferences of the
public as well as in the distribution of
income and wealth are responsible for
the growth of Sunrise industries
whereas opposite factors induce decay of
some other industries prices play a
second fiddle in the drama unless the
government chooses to intervene and
protect prices from falling external
shocks such as draughts may cause sharp
declines in agricultural output and may
raise their prices however such a
picture has already undergone
significant changes due to extension of
irrigation facilities in the country
buffer stock especially wheat and rice
and also of sugar and cotton operations
of the government and public
distribution system they can be
strengthened further it is interesting
as well as instructive to note that as
as a long-run phenomena as predicted by
the quantity theory of money the excess
rate of growth of money supply is
absorbed by increasing prices there are
a number of sources of lags between the
occurrence of an event that brings forth
a policy response and the eventual
response of the economy first is
implementation lags lags occur between
the time of policy action is needed and
the time the action occurs it can be
divided into three categories the first
category is information lags lags in the
availability of information about the
state of the
me the second is recognition lags or
lags in the recognition by the monetary
policy maker that a policy action is
needed based on the information
available to it
the third is legislative lags lags in
the enactment of the appropriate
legislation needed for a policy action
to occur to take the appropriate policy
action the policymaker must have
information about the state of the
economy for example consider a
policymaker with the final target for
inflation real output and unemployment
in this situation the policymaker must
know the price level real GDP and the
unemployment rate before it can respond
with an appropriate policy action but
lags occur between a change in the state
of the economy and the indicators of
that change
for instance the price level in the
United States is measured monthly in
case of consumer price index CPI and
quarterly in the case of GDP deflator
output can be measured by industrial
production measured monthly or the
broader measure that is real GDP
measured quarterly unemployment which is
related to output is measured monthly
thus the monetary policy maker is in a
situation where at best it can get only
monthly updates on prices and output and
quarterly updates on the broadest
measures of prices and output moreover
these updates occur quite sometime after
the month
or quarter they are measuring for
example the Consumer Price Index for a
given month is an ounce in the middle of
the following month that is the CPI for
January is announced in the middle of
February information of the GDP deflator
and real GDP is even more delayed GDP
and the GDP deflator for the first
quarter of the year January through
March are announced in a preliminary
release in the first week of May with
revisions in June and again in July
thus the monetary authority does not
have even a preliminary estimate of GDP
available until a month after the
quarter ends of course there are monthly
data on industrial production and
unemployment which give indications of
what is happening to real GDP but even
these are announced several weeks after
the end of the month to which they apply
thus these information lags cause lags
in the enactment of monetary policy
since the RBI can hardly respond to
events of which it is not aware even
after the data becomes available
lags occur in the policymakers
recognition of the state of the economy
this recognition lags are compounded by
the fact that some data arrived monthly
while the other data arrived only
quarterly sometimes it is clear that
output has fallen
or that the price level has increased
but other times that data give
conflicting messages for example the
Consumer Price Index might have
increased but the producer price index
decreased and the GDP deflator will not
be available for another month or more
or industrial production might have
fallen but unemployment remained
constant so the output situation is
uncertain and real GDP won't be known
for weeks or even months in such
situations there is a lag in recognition
by the monetary authority of the true
state of the economy finally for some
policymakers there may be significant
legislative lags let in policy actions
due to Lance in enacting any required
legislation the second type of lag is
the effectiveness lag it is the time
between when a policy action is made and
when the action results in changes in
the economy for example if the RBI is
trying to target the price level it
might respond to a decline in the
Consumer Price Index by increasing the
money supply in our theoretical models
this action immediately increases
aggregate demand and the price level but
in practical applications of monetary
policy things do not occur so quickly
lags in the effectiveness of monetary
policy actions are a severe problem for
the RBI the effectiveness like for
monetary policy can last a year or more
less in the effectiveness of monetary
policy actions are a severe problem for
the RBI the effectiveness lag for
monetary policy can last a year or more
on top of that the average length of
research
in the united states since world war ii
has been less than one year if a
recession started today we would expect
it to be over before any monetary policy
taken today could begin to counteract it
in fact the monetary policy action would
start exerting its stimulative effect
just as the economy was recovering from
the recession making policy procyclical
this is the type of reasoning that led
milton friedman to advocate increasing
the money supply at a constant rate of
3% regardless of business cycle
conditions one solution to the problem
of effectiveness lags would be for the
RBI to forecast where the economy will
be a year from now so that it can take
the appropriate action today an action
taken today would exert its influence a
year from now if the forecast was
accurate the policy action taken today
could help achieve the final targets for
the economy in a year's time
unfortunately economic forecasts over
horizons of a year or more are not very
accurate in particular it is difficult
to forecast business cycle turning
points that is precisely when the
economy will move from expansion to
recession and vice versa
thus the RBI cannot look ahead from
today and say with certainty that they
will or won't be a recession in a year
hence it doesn't know how it should
change monetary policy today to counter
any future business cycle movements we
might make the following analogy to
monetary policy making with
implementation and effectiveness lags an
analogy adapted from one made by Milton
Friedman the monetary policy maker is
like the driver of a car whose job is to
keep the car on the road
perhaps one that twists and turns around
mountain peaks
however this driver cannot see out of
the front window of the car
what is approaching in fact the driver
cannot even see out of the side windows
to see the current the road situation
instead the driver can see only out of
the rear window receiving data on where
she or he has already been this is the
information lag to make things worse the
driver has very slowly responding
instruments the brake starts working
only several seconds after the pedal is
depressed the steering wheel turns the
car only after several seconds and even
stepping on the accelerator starts
accelerating the car only after several
seconds this is the effectiveness lag
finally Friedman has emphasized that the
lugs between a monetary policy action
and changes in the macroeconomic
variables such as real GDP or the price
level are not only long but also
variable in length in terms of our
analogy this means that when our driver
steps on the brakes not only does the
car take several seconds to begin
slowing but the number of seconds varies
over time one time it may take five
seconds at another time it may take
eight seconds in monetary policymaking
reducing the money supply growth rate
sometimes seem to take seven months
to begin slowing the inflation rate
while at other times it seems to take 14
months
this obviously compounds the problems
the policymaker
faces this analogy is particularly
effective at communicating the
constraints faced by the RBI in such a
situation it is no surprise that the RBI
reacts cautiously to any new development
it is also no surprise that policymakers
prefer the slow and steady approach even
to the point of excessive caution over
the speedy but perhaps brash approach if
the RBI decides pursue an intermediate
target it will have to accordingly
adjust its instruments and operating
targets to achieve it instrument
instability arises when the change in
the instrument affects the targeted
variable over a number of future periods
let us take an example to understand
this instability suppose an open market
purchase causes price level intermediate
target to rise gradually over 12 months
an RBI wants price level to be constant
from quarter to quarter then if the
price level is below target today the
RBI will conduct an open market purchase
sufficient to raise the price level to
the targeted level within three months
if there are bi successful the price
level will be a target three months from
now however the increase in the money
supply adieu to the open market purchase
in the first three months continues to
exert its influence on prices causing
the price level to rise further
furthermore in the third three months
the initial increase in the money supply
continues to cause price to rise while
the reduction in the money supply during
the second three months causes prices to
fall this dynamic continues and the
required open market operations
necessary to merely counteract the
previous changes in the money supply to
keep the price level constant may dampen
down to zero as effects
pass changes gradually we're off the
latter case is a situation of instrument
instability where the RBI must tolerate
ever larger changes in the instrument to
hold the targeted variable at target the
instrument
instability can arise when a change in
the instrument effects that targeted
variable over a number of future periods
for instance suppose an open market
purchase causes the price level to rise
but not immediately instead this effect
takes place only gradually over a period
of 12 months suppose further that the
RBI wants to keep the price level
constant from quarter to quarter then if
the price level is below target today
the RBI will conduct an open market
purchase sufficient to raise the price
level to the targeted level within three
months
if the RBI is successful the price level
will be at target three months from now
this problem can be countered most
easily by lengthening the period over
which the price level is controlled so
that the price level is targeted to
achieve a growth rate of say three
percent over four quarters but it's
quarter to quarter growth rate is not
constrained further an alternative
solution is to attempt to adjust the
monetary instrumented a to keep
forecasted future levels of prices at
target this approach accepts some
failure to keep the current price level
a target while maintaining the overall
framework of price level targeting
however it works best when the price
level can be fairly well predicted which
may not be the case a final solution is
to use a variable that is more
controllable such as the money stock or
an interest rate instead of adopting an
intermediate price level target
another issue in any policymaking
activity is the recognition that the
policymaker works with the model of the
economy and our macroeconomic models are
imperfect
hence policy decisions that appear
correct based on a particular
macroeconomic model may turn out badly
because the model used to formulate the
policy is only an approximation of
reality and perhaps a poor one at that
following policy advice however nicely
derived from an inappropriate or
incorrect theoretical model is
potentially dangerous since the advice
may lead to exactly the wrong policy
action thus policy makers adopt a
gradual approach we have seen how
monetary policymakers
can have conflicting goals we have seen
how price level goals and output goals
cause conflict when a change in
aggregate supply occurs since the policy
action that achieves the price level
target exasperates
the failure to achieve the output target
and vice versa other goals can also
cause conflict and indeed then bergens
results suggest that conflict is
inevitable
whenever there are more goals than
independent instruments the conflict
among some of the RBI goals is caused by
changes in the identities of policy
makers over time conflict among some of
RBI's goals is caused by changes in the
identities of policy makers over time
not only can a single policymaker have
internal conflicts over goals but to
policy makers specifically the monetary
policy maker and the physical policy
maker can choose conflicting goals the
monetary policy maker the RBI controls
the money supply and can adjust it in
the pursuit of various macroeconomic
goals the fiscal policy maker government
controls government spending and tax
collections and can adjust them as it
pursues its macroeconomic goals the
monetary authority is largely in the
the fiscal policy maker this has both
benefits and cost but one cost is that
the monetary and fiscal policy makers
may disagree over the goals of policy
for example the fiscal authority might
have an output target and the monetary
authority a price level target if
aggregate supply increases the monetary
authority will want to raise aggregate
demand but the fiscal policy maker will
want to reduce it the net effect is
unclear but neither policy maker is
likely to achieve its target in this
module we have learned about optimal
operation of monetary policy we have
learnt about different sources of lags
between the occurrences of an event that
brings forth a policy response and the
eventual response of the economy we see
that the policy-making activity is the
recognition that policy makers works
with the model of the economy and
macroeconomic models are imperfect
this gives policymakers another reason
to move slowly policy actions are
influenced somewhat by theory but also
influenced by years of experience that
most policymakers have monetary
policymakers can have conflicting goals
not only can a single policymaker can
have internally conflicting goals but a
monetary policy maker and physical
policy maker can choose conflicting
goals one should hope that both of them
should move together
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