TERM PAPER

OF ECONOMICS IN DECISION MAKING {ECO 211}

TOPIC:-

REVIEW OF

MONETARY POLICY 2008

SUBMITTED TO: SUBMITTED TO:KAUR GILL. MISS. TAVLEEN AMITA MAHAJAN

ROLL NO.RE6801B31 TRADE:-BTECH ECE

INDEX
MONETARY POLICY: AN ABSTRACT TYPES OF MONETARY POLICY MONETARY POLICY: A BRIEF INTRODUCTION MONETARY POLICY: AN OVERVIEW HISTORY OF MONETARY POLICY POLICY OF VARIOUS NATIONS

REVIEW OF MONETARY POLICY 2008 MONETARY DEVELOPMENTS 2008

BIBLIOGRAPHY AN ABSTRACT

MONETARY POLICY:

The regulation of the money supply and interest rates by a central bank, such as the Federal Reserve Board in the U.S., in order to control inflation and stabilize currency. Monetary policy is one the two ways the government can impact the economy. By impacting the effective cost of money, the Federal Reserve can affect the amount of money that is spent by consumers and businesses. Monetary policy refers to how the Federal Reserve uses interest rates and the money supply to guide economic growth. The Fed generally uses the Fed Funds Rate to impact all other interest rates, including bank loan rates and mortgage rates. The Fed can also use other tools to increase the supply of money in the economy. The Fed's primary mandate is to manage inflation. The Fed reduces inflation by raising the Fed Funds rate or decreasing the money supply.

TYPES OF MONETARY POLICIES

There are basically two types of monetary policies. 1. Easy Monetary Policy 2. Tight Monetary Policy let us have a brief description of the two types of monetary policies. EASY MONETARY POLICY It is defined as a central bank policy designed to stimulate economic growth by lowering short term interest rates, making money less expensive to borrow. Easy monetary policy is also called accommodative monetary policy or loose credit. It is just opposite of tight monetary policy. TIGHT MONETARY POLICY Tight monetary policy is defined as a central bank policy designed to curb inflation by increasing the reserves of commercial banks (and consequently reducing the money supply, through open market operations), also called tight money it is just opposite of easy monetary policy.

MONETARY POLICY: A BRIEF INTRODUCTION

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money (ii) availability of money and (iii) cost of money or rate of interest In order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy,

and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

MONETARY POLICY: AN OVERVIEW

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A monetary policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. A Monetary policy is referred expansionary if it increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as accomodative , if the interest rate set by the central monetary authority is intended to create economic growth. Monetary policies are referred to as neutral, if it is intended neither to create growth nor combat inflation Monetary policy is referred to as tight if it intends to reduce inflation.

Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank, Reserve Bank of India, the Federal Reserve System in the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which have the task of executing the monetary policy and often independently of the

executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

HISTORY OF MONETARY POLICY

Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was

associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. Therefore, monetary decisions today take into account a wider range of factors, such as:

Short term interest rates; Long term interest rates; Velocity of money through the economy; Exchange rates; Credit quality; Bonds and equities (corporate ownership and debt); Government versus private sector spending/savings; International capital flows of money on large scales; Financial derivatives such as options, swaps, futures contracts, etc.

A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Developing countries Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in

managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation.

Monetary Policy: Inflation Targeting Price Level Targeting Monetary Aggregates Fixed Exchange Rate Gold Standard Mixed Policy

Target Market Variable: Interest rate on overnight debt Interest rate on overnight debt The growth in money supply The spot price of the currency The spot price of gold Usually interest rates

Long Term Objective: A given rate of change in the CPI A specific CPI number A given rate of change in the CPI The spot price of the currency Low inflation as measured by the gold price Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price. POLICY OF VARIOUS NATIONS

Australia - Inflation targeting

Brazil - Inflation targeting Canada - Inflation targeting Chile - Inflation targeting China - Monetary targeting and targets a currency basket Eurozone - Inflation targeting Hong Kong - Currency board (fixed to US dollar) India - Inflation targeting New Zealand - Inflation targeting Norway - Inflation targeting Singapore - Exchange rate targeting South Africa - Inflation targeting Switzerland - Inflation targeting Turkey - Inflation targeting United Kingdom - Inflation targeting, alongside secondary targets on 'output and employment'. United States - Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output)

REVIEW OF MONETARY POLICY 2008

Dr. D. Subbarao in his first policy presentation as the Governor of RBI left all key rates unchanged. Bank rate has been pegged at 6% whereas CRR stands unchanged at 5% of NDTL (Net Demand and time liabilities). Repo is kept unchanged at 5.5% and Reverse Repo at 4%. The Governor makes a note in his presentation that the theory of de-coupling has gone busted with this financial meltdown as it has spread its wings to emerging economies through all channels- financial channel, the real channel and importantly the confidence channel. The Governor commented that the global outlook continues to be uncertain. Economies across the globe will face liquidity crunch. According to the November 2008 update of the World Economic Outlook (WEO) issued by the International Monetary Fund (IMF), global real GDP growth, on a purchasing power parity basis, is projected to decelerate from 3.7 per cent in 2008 to 2.2 per cent in 2009. In market exchange rate terms, the projected deceleration is even sharper from 2.6 per cent in 2008 to 1.1 per cent in 2009. Emerging Economies whose GDP is mainly driven by domestic demand also came under the clout as the meltdown had deeper impact on aggregate demand reduction.

Following table brings out clearly how this year has been different from the previous fiscal year for different sectors.

Table 1: Real GDP Growth (%) Sector First Half Year (April-September) 2007-08 2008-09 4.5 2.9 9.1 5.0 10.6 9.9 9.3 7.8

Agriculture Industry Services Overall

POLICY STANCE
Keeping in view the above assessment of the global scenario and domestic economy, particularly the outlook on growth and inflation, the stance of monetary policy for the rest of 2008-09 will be as follows: 1) Provision of comfortable liquidity to meet the required credit growth consistent with

the overall projection of economic growth. 2) Respond swiftly and effectively with all possible measures as warranted by the

evolving global and domestic situation impinging on growth and financial stability. 3) Ensure a monetary and interest rate environment consistent with price stability, well-

anchored inflation expectations and orderly conditions in financial markets.

INFLATION PROJECTIONS
The Apex bank has projected WPI inflation to decelerate to below 3.0% by end march 2009 keeping in view global commodity prices.

Growth Projections
In mid year review, growth had been estimated in the range of 7.5-8%. But Keeping in view the slowdown in industry and services and with the assumption of normal agricultural production, the projection of overall real GDP growth for 2008-09 is revised downwards to 7.0 per cent with a downward bias.

Liquidity Impact

To ease the liquidity crunch for financial institutions, the apex bank has decided to extend the facility of re-financing under LAF route to mutual funds, NBFCs, housing finance companies (HFCs) and commercial banks(excluding RRBs) to September 30, 2009 from the earlier date of June 30, 2009.

Monetary Projection
Projection of Money Supply(M3) growth for 2008-09 is raised to 19.0 per cent from 16.517.0 per cent earlier. Consistent with this, the aggregate deposit growth for 2008-09 is revised to 19.0 per cent from 17.0 per cent earlier. The projection of growth of adjusted non-food credit or 2008-09 is revised to 24.0 per cent from 20.0 per cent earlier.

MONETARY DEVELOPMENTS DURING THE YEAR 2008

The Reserve Bank of India released the document about the year 2008. The highlights of monetary developments
during the year 2008 are given as follows..

An overview of Monetary developments

The global economic conditions deteriorated sharply during the year 2008 with several advanced economies experiencing their sharpest declines. The associated adverse shocks spread across emerging market economies (EMEs) particularly by the fourth quarter of the year and accentuated the synchronised global slowdown. Inflation conditions witnessed sharp volatility during the year as headline inflation in major advanced economies firmed up considerably up to July 2008, but declined sharply thereafter. The global financial environment entered a crisis phase in mid-September 2008, following the growing distress among large international financial institutions. An important challenge in the monetary policy making during 2008-09 has been to manage the volatility emerging in respect of several key economic indicators of the Indian economy. Notwithstanding several challenges, particularly from the global economy, the Indian economy remained relatively resilient, its financial

institutions and private corporate sector remained sound and solvent. Furthermore, the macroeconomic management helped in maintaining lower volatility in both the financial and the real sectors in India relative to several other advanced and emerging market economies.

MONETARY CONDITIONS
The monetary policy stance of the Reserve Bank shifted from concerns related to inflation in the first half of 2008 to maintaining financial stability and arresting the moderation of growth in the second half. While money supply evolved consistent with indicative projections, credit to private sector reflected the conditions evolving in the real sector of the economy.

Growth in broad money (M3), year-on-year (y-o-y), was 18.4 per cent at end-March, 2009 as compared with 21.2 per cent during the year 2008, reflecting deceleration in the expansion of bank credit and capital inflow.

Aggregate deposits of banks, y-o-y, was 18.8 per cent at end-March 2009 as compared with 21.7 per cent during year 2008.

Non-food credit growth (y-o-y) of SCBs to the commercial sector remained strong up to October 2008 on the backdrop of drying up of other sources of funds to industry but witnessed sustained deceleration thereafter. Non-food credit by SCBs was moderated to 17.5 per cent, y-o-y, at end-March 2009 as compared with 23.0 per cent during the year 2008.

A MONETARY OUTLOOK
An assessment of the economic conditions at the current juncture indicates that the global economic conditions have deteriorated sharply during 2008 and the forecasts of the various international agencies point to deepening of recessionary conditions during 2009 as well.

Reflecting global developments and their impact on the Indian economy, as well as domestic cyclical factors, the various surveys of economic activity point towards prevalence of less than optimistic sentiment for the outlook of the Indian economy in the coming months. The Professional Forecasters Survey conducted by the Reserve Bank in December 2008 suggested moderation in economic activity in 2008-09.

The Reserve Banks Industrial Outlook Survey of Manufacturing Companies in the Private Sector indicates that the business expectations indices based on the assessment for January-March 2009 and expectations for AprilJune 2009 declined sharply by 20.7 per cent and 13.9 per cent, respectively, over the previous quarters.

BIBLIOGRAPHY
The references have been taken from various sites like www.google.com www.sciencedirect.com

http://useconomy.about.com/od/glossary/g/Mon etary_policy.htm http://www.google.co.in/search? hl=en&source=hp&q=definition+of+monetary+p olicy&meta=&aq=f&oq= http://useconomy.about.com/sitesearch.htm? terms=an%20overview%20of%20monetary %20policy&SUName=useconomy&TopNode=99 http://en.wikipedia.org/wiki/Monetary_policy http://rbi.org.in/scripts/BS_PressReleaseDisplay .aspx?prid=20549 http://www.banknetindia.com/banking/artpol1.h tm http://rbi.org.in/scripts/BS_PressReleaseDispla y.aspx?prid=20549 http://ideas.repec.org/p/pri/cepsud/120.html http://rbi.org.in/scripts/AnnualPublications.aspx? head=Macroeconomic%20and%20Monetary %20Developments

http://www.banknetindia.com/banking/macro09. htm