Unit III: Monetary Policy | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


3.61 
 
MONETARY POLICY 
LEARNING OUTCOMES 
UNIT III: MONETARY POLICY 
At the end of 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 
 
 
Money Market
Monetary Policy
The Monetary Policy 
Framework
The Organisational 
Structure for 
Monetary Policy 
Decisions
UNIT OVERVIEW 
Page 2


3.61 
 
MONETARY POLICY 
LEARNING OUTCOMES 
UNIT III: MONETARY POLICY 
At the end of 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 
 
 
Money Market
Monetary Policy
The Monetary Policy 
Framework
The Organisational 
Structure for 
Monetary Policy 
Decisions
UNIT OVERVIEW 
3.62 ECONOMICS FOR FINANCE 
 3.1 INTRODUCTION 
As citizens of a free nation, we have many dreams about what ought to be the 
state of affairs in our economy. We value stable prices and low rates of inflation. 
We share a quest for well-being through high levels of growth which ensure jobs 
and prosperity and we work towards it. Unfortunately, in reality, we live in a crisis 
prone economy with nightmares of financial downturns, of being laid- off or 
being battered by financial crises. 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 
Monetary policy refers to the use of monetary policy instruments which are at the 
disposal of the central bank to regulate the availability, cost and use of money 
and credit to promote economic growth, price stability, optimum levels of output 
and employment, balance of payments equilibrium, stable currency or any other 
goal of government's economic policy. In other words, monetary policy is 
essentially a programme of action undertaken by the monetary authorities, 
normally the central bank, to control and regulate the demand for and supply of 
money with the public and the flow of credit with a view to achieving 
predetermined macroeconomic goals. 
Monetary policy encompasses all actions of the central bank which are aimed at 
directly controlling the money supply and indirectly at regulating the demand for 
money. Monetary policy   is in the nature of ‘demand-side’ macroeconomic policy 
and works by stimulating or discouraging investment and consumption spending 
on goods and services.  It is no surprise that monetary policy is regarded as an 
indispensable policy instrument in an economy.  
 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, 
Page 3


3.61 
 
MONETARY POLICY 
LEARNING OUTCOMES 
UNIT III: MONETARY POLICY 
At the end of 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 
 
 
Money Market
Monetary Policy
The Monetary Policy 
Framework
The Organisational 
Structure for 
Monetary Policy 
Decisions
UNIT OVERVIEW 
3.62 ECONOMICS FOR FINANCE 
 3.1 INTRODUCTION 
As citizens of a free nation, we have many dreams about what ought to be the 
state of affairs in our economy. We value stable prices and low rates of inflation. 
We share a quest for well-being through high levels of growth which ensure jobs 
and prosperity and we work towards it. Unfortunately, in reality, we live in a crisis 
prone economy with nightmares of financial downturns, of being laid- off or 
being battered by financial crises. 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 
Monetary policy refers to the use of monetary policy instruments which are at the 
disposal of the central bank to regulate the availability, cost and use of money 
and credit to promote economic growth, price stability, optimum levels of output 
and employment, balance of payments equilibrium, stable currency or any other 
goal of government's economic policy. In other words, monetary policy is 
essentially a programme of action undertaken by the monetary authorities, 
normally the central bank, to control and regulate the demand for and supply of 
money with the public and the flow of credit with a view to achieving 
predetermined macroeconomic goals. 
Monetary policy encompasses all actions of the central bank which are aimed at 
directly controlling the money supply and indirectly at regulating the demand for 
money. Monetary policy   is in the nature of ‘demand-side’ macroeconomic policy 
and works by stimulating or discouraging investment and consumption spending 
on goods and services.  It is no surprise that monetary policy is regarded as an 
indispensable policy instrument in an economy.  
 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, 
 
 
3.63 
 
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 policy makers.  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.  
There are significant differences among different countries in respect of the 
selection of objectives, implementation procedures and tools of monetary policy 
either due to differences in the underlying economies or due to differences in the 
financial systems and in the infrastructure of financial markets. Coverage of 
aspects related to monetary policies of different countries would be beyond the 
scope of this unit. Therefore, the following discussions relate to the monetary 
policy situations in the context of Indian economy.  
In the pre-Keynesian period, monetary policy, with its conventional objective of 
establishment and maintenance of stability in prices, was the single well-
acknowledged instrument of macroeconomic policy. The Great Depression in 
1930s and the associated economic crises marked a turning point resulting in a 
major shift in the objective of governments’ economic policy in favour of 
maintenance of full employment, more generally described as economic stability.   
The most commonly pursued objectives of monetary policy of the central banks 
across the world are maintenance of price stability (or controlling inflation) and 
achievement of high level of economy’s growth and maintenance of full 
employment  
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’. It is to be noted that though 
price stability as an objective is not explicitly spelt out, the monetary policy in 
India has evolved towards maintaining price stability and ensuring adequate flow 
of credit to the productive sectors of the economy. Price stability, as we know, is a 
necessary precondition for sustainable growth. Fundamentally, the primary 
objective of monetary policy has been maintenance of a judicious balance 
between price stability and economic growth.  
Page 4


3.61 
 
MONETARY POLICY 
LEARNING OUTCOMES 
UNIT III: MONETARY POLICY 
At the end of 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 
 
 
Money Market
Monetary Policy
The Monetary Policy 
Framework
The Organisational 
Structure for 
Monetary Policy 
Decisions
UNIT OVERVIEW 
3.62 ECONOMICS FOR FINANCE 
 3.1 INTRODUCTION 
As citizens of a free nation, we have many dreams about what ought to be the 
state of affairs in our economy. We value stable prices and low rates of inflation. 
We share a quest for well-being through high levels of growth which ensure jobs 
and prosperity and we work towards it. Unfortunately, in reality, we live in a crisis 
prone economy with nightmares of financial downturns, of being laid- off or 
being battered by financial crises. 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 
Monetary policy refers to the use of monetary policy instruments which are at the 
disposal of the central bank to regulate the availability, cost and use of money 
and credit to promote economic growth, price stability, optimum levels of output 
and employment, balance of payments equilibrium, stable currency or any other 
goal of government's economic policy. In other words, monetary policy is 
essentially a programme of action undertaken by the monetary authorities, 
normally the central bank, to control and regulate the demand for and supply of 
money with the public and the flow of credit with a view to achieving 
predetermined macroeconomic goals. 
Monetary policy encompasses all actions of the central bank which are aimed at 
directly controlling the money supply and indirectly at regulating the demand for 
money. Monetary policy   is in the nature of ‘demand-side’ macroeconomic policy 
and works by stimulating or discouraging investment and consumption spending 
on goods and services.  It is no surprise that monetary policy is regarded as an 
indispensable policy instrument in an economy.  
 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, 
 
 
3.63 
 
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 policy makers.  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.  
There are significant differences among different countries in respect of the 
selection of objectives, implementation procedures and tools of monetary policy 
either due to differences in the underlying economies or due to differences in the 
financial systems and in the infrastructure of financial markets. Coverage of 
aspects related to monetary policies of different countries would be beyond the 
scope of this unit. Therefore, the following discussions relate to the monetary 
policy situations in the context of Indian economy.  
In the pre-Keynesian period, monetary policy, with its conventional objective of 
establishment and maintenance of stability in prices, was the single well-
acknowledged instrument of macroeconomic policy. The Great Depression in 
1930s and the associated economic crises marked a turning point resulting in a 
major shift in the objective of governments’ economic policy in favour of 
maintenance of full employment, more generally described as economic stability.   
The most commonly pursued objectives of monetary policy of the central banks 
across the world are maintenance of price stability (or controlling inflation) and 
achievement of high level of economy’s growth and maintenance of full 
employment  
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’. It is to be noted that though 
price stability as an objective is not explicitly spelt out, the monetary policy in 
India has evolved towards maintaining price stability and ensuring adequate flow 
of credit to the productive sectors of the economy. Price stability, as we know, is a 
necessary precondition for sustainable growth. Fundamentally, the primary 
objective of monetary policy has been maintenance of a judicious balance 
between price stability and economic growth.  
  
 
3.64 ECONOMICS FOR FINANCE 
Multiple objectives, all of which are equally desirable, such as rapid economic 
growth, debt management, moderate long-term interest rates, exchange rate 
stability and external balance of payments equilibrium were incorporated as 
objectives of monetary policy by policy makers in later years. The need for 
simultaneous achievement of several objectives   brings in the possibility of 
conflict among the different monetary policy objectives. For example, there is 
often a conflict between the objectives of holding down both inflation and 
unemployment; a policy targeted at controlling inflation is very likely to generate 
unemployment. As such, based on the set national priorities, the monetary 
policymakers have to exercise appropriate trade-offs to balance the conflicting 
objectives.  
Given the development needs of developing countries, the monetary policy of 
such countries also incorporate explicit objectives such as:  
(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 increasing openness of the economy 
and the progressive economic and financial sector reforms.  
3.3.2 Analytics of Monetary Policy 
As we are aware, just as fiscal policy, monetary policy  is intended to influence 
macro- economic variables such as aggregate demand, quantity of money and 
credit , interest rates etc , so as to influence overall economic performance.   The 
process or channels through which the change of monetary aggregates affects 
the level of product and prices is known as ‘monetary transmission mechanism’. It 
describes how policy-induced changes in the nominal money stock or in the 
short-term nominal interest rates impact real variables such as aggregate output 
and employment.  
Generally central banks use the short-term interest rate as the policy instrument. 
Therefore, monetary policy transmission is the process through which a change in 
the policy rate gets transmitted primarily to the short-term money market rate 
and subsequently to the entire range of interest rates namely, banks’ deposit and 
lending rates and interest rates in bond markets. These interest rate changes 
(i) maintenance of economic growth, 
Page 5


3.61 
 
MONETARY POLICY 
LEARNING OUTCOMES 
UNIT III: MONETARY POLICY 
At the end of 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 
 
 
Money Market
Monetary Policy
The Monetary Policy 
Framework
The Organisational 
Structure for 
Monetary Policy 
Decisions
UNIT OVERVIEW 
3.62 ECONOMICS FOR FINANCE 
 3.1 INTRODUCTION 
As citizens of a free nation, we have many dreams about what ought to be the 
state of affairs in our economy. We value stable prices and low rates of inflation. 
We share a quest for well-being through high levels of growth which ensure jobs 
and prosperity and we work towards it. Unfortunately, in reality, we live in a crisis 
prone economy with nightmares of financial downturns, of being laid- off or 
being battered by financial crises. 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 
Monetary policy refers to the use of monetary policy instruments which are at the 
disposal of the central bank to regulate the availability, cost and use of money 
and credit to promote economic growth, price stability, optimum levels of output 
and employment, balance of payments equilibrium, stable currency or any other 
goal of government's economic policy. In other words, monetary policy is 
essentially a programme of action undertaken by the monetary authorities, 
normally the central bank, to control and regulate the demand for and supply of 
money with the public and the flow of credit with a view to achieving 
predetermined macroeconomic goals. 
Monetary policy encompasses all actions of the central bank which are aimed at 
directly controlling the money supply and indirectly at regulating the demand for 
money. Monetary policy   is in the nature of ‘demand-side’ macroeconomic policy 
and works by stimulating or discouraging investment and consumption spending 
on goods and services.  It is no surprise that monetary policy is regarded as an 
indispensable policy instrument in an economy.  
 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, 
 
 
3.63 
 
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 policy makers.  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.  
There are significant differences among different countries in respect of the 
selection of objectives, implementation procedures and tools of monetary policy 
either due to differences in the underlying economies or due to differences in the 
financial systems and in the infrastructure of financial markets. Coverage of 
aspects related to monetary policies of different countries would be beyond the 
scope of this unit. Therefore, the following discussions relate to the monetary 
policy situations in the context of Indian economy.  
In the pre-Keynesian period, monetary policy, with its conventional objective of 
establishment and maintenance of stability in prices, was the single well-
acknowledged instrument of macroeconomic policy. The Great Depression in 
1930s and the associated economic crises marked a turning point resulting in a 
major shift in the objective of governments’ economic policy in favour of 
maintenance of full employment, more generally described as economic stability.   
The most commonly pursued objectives of monetary policy of the central banks 
across the world are maintenance of price stability (or controlling inflation) and 
achievement of high level of economy’s growth and maintenance of full 
employment  
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’. It is to be noted that though 
price stability as an objective is not explicitly spelt out, the monetary policy in 
India has evolved towards maintaining price stability and ensuring adequate flow 
of credit to the productive sectors of the economy. Price stability, as we know, is a 
necessary precondition for sustainable growth. Fundamentally, the primary 
objective of monetary policy has been maintenance of a judicious balance 
between price stability and economic growth.  
  
 
3.64 ECONOMICS FOR FINANCE 
Multiple objectives, all of which are equally desirable, such as rapid economic 
growth, debt management, moderate long-term interest rates, exchange rate 
stability and external balance of payments equilibrium were incorporated as 
objectives of monetary policy by policy makers in later years. The need for 
simultaneous achievement of several objectives   brings in the possibility of 
conflict among the different monetary policy objectives. For example, there is 
often a conflict between the objectives of holding down both inflation and 
unemployment; a policy targeted at controlling inflation is very likely to generate 
unemployment. As such, based on the set national priorities, the monetary 
policymakers have to exercise appropriate trade-offs to balance the conflicting 
objectives.  
Given the development needs of developing countries, the monetary policy of 
such countries also incorporate explicit objectives such as:  
(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 increasing openness of the economy 
and the progressive economic and financial sector reforms.  
3.3.2 Analytics of Monetary Policy 
As we are aware, just as fiscal policy, monetary policy  is intended to influence 
macro- economic variables such as aggregate demand, quantity of money and 
credit , interest rates etc , so as to influence overall economic performance.   The 
process or channels through which the change of monetary aggregates affects 
the level of product and prices is known as ‘monetary transmission mechanism’. It 
describes how policy-induced changes in the nominal money stock or in the 
short-term nominal interest rates impact real variables such as aggregate output 
and employment.  
Generally central banks use the short-term interest rate as the policy instrument. 
Therefore, monetary policy transmission is the process through which a change in 
the policy rate gets transmitted primarily to the short-term money market rate 
and subsequently to the entire range of interest rates namely, banks’ deposit and 
lending rates and interest rates in bond markets. These interest rate changes 
(i) maintenance of economic growth, 
 
 
3.65 
 
MONETARY POLICY 
affect macro economic variables such as consumption, investment and exports 
which in turn influence aggregate demand, output and employment.  
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 
There are mainly five different mechanisms through which monetary policy 
influences the price level and the national income. These are:  
(a)  the interest rate channel, 
(b)  the exchange rate channel, 
(c)  the quantum channel (e.g., relating to money supply and credit),  
(d)  the asset price channel i.e.  via equity and real estate prices. and 
(e)  the expectations channel  
We shall have a brief discussion on each of the above transmission mechanisms. 
According to the traditional Keynesian interest rate channel, a contractionary 
monetary policy- induced increase in interest rates increases the cost of capital 
and the real cost of borrowing for firms with the result that they cut back on their 
investment expenditures. Similarly, households facing higher real borrowing costs, 
cut back on their purchases of homes, automobiles, and all types of durable 
goods.  A decline in aggregate demand results in a fall in aggregate output and 
employment. Conversely, an expansionary monetary policy induced decrease in 
interest rates will have the opposite effect through decreases in cost of capital for 
firms and cost of borrowing for households.  
In open economies, additional real effects of a policy- induced change in the 
short- term interest rate come about through the exchange rate channel. Changes 
in monetary policy cause differences between domestic and foreign interest rates 
leading to capital flows (inflow or outflow) and exchange rate. Typically, the 
exchange rate channel works through expenditure switching between domestic 
and foreign goods. Appreciation of the domestic currency makes domestically 
produced goods more expensive compared to foreign- produced goods. This 
causes net exports to fall; correspondingly domestic output and employment also 
fall.  
Two distinct credit channels- the bank lending channel and the balance sheet 
channel- also allow the effects of monetary policy actions to spread through the 
real economy.  Credit channel operates by altering access of firms and 
households to bank credit.   Most businesses and people mostly depend on bank