Sources of Monetary Mismanagement

Variable time lags concerning the effect of money supply on the national income. Treating Interest rate as the target of monetary policy for influencing investment demand for stabilizing the economy. Expansionary or Easy Monetary Policy (under-taken during Recession and unemployment)

Measures

  • Central bank buys securities through open market operation.
  • It reduces cash reserves ratio. (3) It lowers the bank rate

Mechanism

Money supply increases Investment increases Aggregate demand increases Aggregate output increases by a multiple of the increase in investment.

Contractionary or Tight Monetary Policy (Undertaken During Inflation)

Measures

  • Central bank sells securities through open market operation.
  • It raises cash reserve ratio and statutory liquidity
  • It raises bank rate
  • It raises maximum margin against holding of stocks of goods

Mechanism

Money supply decreases Interest rate raises Investment expenditure declines Aggregate demand declines Price level falls

Major Monetary Policy Tools and Operating Procedure

Call Money Market

The call money market is an important segment of the money market where un-collateralised borrowing and lending of funds take place on overnight basis. Participants in the call money market in India currently include scheduled commercial banks (SCBs) (excluding regional rural banks), cooperative banks (other than land development banks), and primary dealers, both as borrows and lenders (RBI�s Master Circular dated 1 July 2011). Prudential limits in respect of both outstanding borrowing and lending transactions in the call money market for each of these entities are specified by the RBI.

Open Market Operations

OMOs are conducted by the RBI via the sale/purchase of government securities to/from the market with the primary aim of modulating rupee liquidity conditions in the market. OMOs are an effective quantitative policy tool in the armoury of the RBI, but are constrained by the stock of government securities available with it at a point in time.

Liquidity Adjustment Facility

The LAF is the key element in the monetary policy operating framework of the RBI. On daily basis, the RBI stands ready to lend to or borrow money from the banking system, as per the latter�s requirement, at fed interest rates. The primary aim of such an operation is to assist banks to adjust to their day-to-day mismatches in liquidity, via repo and reverse repo operations.� Under the repo or repurchase option, banks borrow money from the RBI via the sale of securities with an agreement to purchase the securities back at a fixed rate at a future date. The rate charged by the RBI to aid this process of liquidity injection is termed as the repo rate. Under the reverse repo operation, the RBI borrows money from the banks, draining liquidity out from the system. The rate at which the RBI borrows money is the reverse repo rate. The interest rate on the LAF is fed by the RBI from time to time (with crucial changes introduced recently in the operating procedure of Monetary Policy detailed in the next paragraph). LAF operations help the RBI effectively transmit interest rate signals to the market.

Written by princy

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