ABM FREE NOTES 2022 CAIIB EXAMS | MONETARY POLICY | TYPES OF MONETARY POLICIES
In this article, we will read about the monetary policy which is part of the syllabus of Advanced Bank Management, the First paper from the CAIIB June Exam 2022. Just give a 5-minute read to this article & all your concepts related to monetary policy will get cleared & you will be able to answer the ABM MCQs correctly on the mentioned topic in CAIIB Papers.
With the help of Monetary Policy the Government, and Central Bank, controls
- The supply of money,
- Availability of money in the economy, &
- Rate of interest or cost of money
It is a set of tools which a nation’s central bank has available at its end to promote sustainable economic growth. This control is exercised by having control over the overall supply of money available to its banks, consumers, and businesses.
Its main aim is to maintain the balance in the demand and supply of money. The dates of interest are lowered or raised with the intention either to increase the supply or decrease the supply or in other words, to control the bowling power of customers of businesses.
The economy is sensitive to interest rates and therefore, tends to borrow money when interest rates are low and will avoid borrowing money when interest rates are higher. This way it is used as a tool to achieve the objective of growth and stability of the economy.
Monetary policy is also sometimes referred to as expansionary policy or a contractionary policy.
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TYPES OF MONETARY POLICIES
Broadly speaking, monetary policies can be divided into two types:
- Expansionary Monetary Policy
- Contractionary Monetary Policy
EXPANSIONARY MONETARY POLICY
It is a tool to combat unemployment due to recession by lowering interest rates and increasing the supply of money. The increase in money supply helps in economic growth & expansion of economic activity.
So, to promote spending money and make savings unattractive, monetary authorities often lower the rates of interest. It also increases the level of investment and spending by consumers. Lower interest rates mean that loans are available on favorable terms to people.
Since the 2008 financial crisis, there have been some nations that followed the expansionary policy by keeping interest rates at ‘0’ or ‘near 0’.
CONTRACTIONARY MONETARY POLICY
It is a tool to deal with the increasing prices in the economy. In this policy, interest rates are increased so that the growth of the money supply can be slowed & inflation can be brought down.
Even though this policy/tool slows the economic growth and even increases unemployment in the country, sometimes it is necessary to put a hold on the growth of the economy & to keep prices level.
TOOLS OF MONETARY POLICY:
- Bank Rate: Often referred to as Discount rate, it is the interest rate which a central bank (basically RBI) charges on the loans & advances which are offered to commercial banks & other financial intermediaries. Although one should note that the Bank Rate as an instrument/tool of Monetary policy has been very limited in India due to the following reasons:
- The structure of interest rates offered to the public is not automatically linked to the bank rate offered by RBI to commercial banks.
- There are specific refinance facilities enjoyed by Commercial banks, & they do not necessarily rediscount their eligible securities at the Bank rate with the RBI.
- The Indian bill market is under-developed and the various sub-markets of the money market do not have any influence on the bank rate.
- Cash Reserve Ratio: The current system of banking is also referred to as the “Fractional Reserve Banking System”, because of the requirement to keep a fraction of their deposit liabilities in the form of liquid assets or cash by banks with the RBI, central bank, to ensure the safety and liquidity of deposits. The concept of CRR was introduced in 1950 as a way to ensure that the deposits remain safe and liquid with the bank for repayment.
This minimum ratio is always prescribed by the central bank, RBI, & in short, is known as the CRR.
- Statutory Liquidity Ratio: This ratio, in short, SLR, means the amount which all banks are required to maintain either in cash or in the form of Gold or approved securities.
Approved securities include dated securities, shares of different companies, and government bonds. It is basically a % of ‘Total Demand & Time Liabilities
Note: The maximum limit of SLR that RBI can stipulate is 40% & the minimum limit of SLR is 0%’.
Demand Liabilities’ are all those liabilities that are liable to be paid on demand and they include current deposits, margins held against letters of credit/guarantees, Demand Drafts (DDs), demand liabilities portion of savings bank deposits, unclaimed deposits, balances in overdue FDs, cash certificates and cumulative/recurring deposits, outstanding TTs (Telegraphic Transfers), Mail Transfer (MTs), credit balances in the Cash Credit account (CC A/C) and deposits held by banks as security for the advances which are payable on demand.
Time Liabilities are those liabilities which are required to be paid otherwise than on-demand. They include fixed deposits (FDs), cumulative & recurring deposits, cash certificates, Gold Deposits, time liabilities portion of savings bank deposits, staff security deposits, a margin which is held against LCs if it is not payable on demand, deposits held as securities for advances which are not payable on demand, etc.
- Market Stabilization Scheme: This Scheme was introduced by RBI after consulting with the Government of India (GOI) to mop up liquidity which has a more enduring nature. In this scheme, to absorb the liquidity from the economy/system, the GOI issues existing instruments (Treasury Bills (T-Bills)/ and or dated securities by auctioning them off under the MSS, in addition to the normal borrowing requirements.
- Repo Rate: Repo or we can say it to be the Repurchase interest rate, is the rate at which the Reserve Bank of India lends money to the banks for a short-term period. Please note that the Bank lending rates are determined by the changes in Repo Rate.
- Reverse Repo Rate: Reverse Repo Rate is the rate of interest at which commercial banks keep their short-term funds (excess liquidity) with the Reserve Bank of India. This tool is used by RBI when it felt that there is too much money floating in the System of Banking.
An Increased Reverse Repo means that the RBI is ready to borrow money from the Commercial Banks at a higher rate of interest, so banks would prefer to keep their money with the RBI instead of floating it in the system.
- Open Market Operations: In this measure, RBI buys or sells government bonds in the secondary market. If the bonds are bought, it raises the bond yields and injects money into the market, on the other hand when it sells the bonds, the money is drawn out of the system.
Refinance Facilities: RBI also provides Sector-specific refinance facilities whose main aim is to achieve sector-specific objectives by making provisions of liquidity at a cost which is linked to the policy repo rate.
LAF – Liquidity Adjustment facility: This facility consists of overnight & term repo or reserve repo auctions.
Term Repos: It was from October 2013 that the RBI introduced term repos (ranging from tenors – 7 to 14 to 28 days so that liquidity can be injected over a period that is longer than overnight. This facility aims to help in the development of the inter-bank money market.
Marginal Standing Facility (MSF): It is a kind of offer or facility given to commercial banks to borrow from RBI against approved government securities in emergencies. For example Acute cash shortage. MSF is available at rate > Repo rate.
TOOLS TO IMPLEMENT MONETARY POLICY
Central banks have several tools to shape and implement monetary policy as mentioned above but if we were to explain them in short & highlight the important ones, then it is written down below:
In the first case, newly created bank reserves are used to buy and sell short-term bonds on the open market. This is referred to as open market operations. The target remains on short-term interest rates. The central bank injects money into the banking system by purchasing assets or removes it by selling them-and the banks respond by lending more easily at lower rates-or more dearly at higher rates-until its target interest rate is met. By purchasing a specified amount of assets, open market operations can also specifically increase the money supply to make loans to banks easier. This whole process is known as quantitative easing (QE).
In the second case, as a lender-of-last-resort, the central bank may choose to change the interest rate or collateral requirement for direct emergency loans to banks. Depending on the interest rate, banks will lend more freely or less freely.
Authorities are also able to manipulate the reserve requirements. To be able to meet their obligations, banks must retain a portion of the deposits they receive from their customers. Banks can offer loans and buy other assets with more capital if the reserve requirement is lowered. Raising the reserve requirement discourages lending by banks and slows economic growth.
Through their public announcements about possible future policies, central banks have a powerful tool to shape market expectations. Markets move in response to central bank announcements, and investors who correctly predict what will happen can profit handsomely.
Objectives of RBI’s monetary policy:
- Monitoring the global and domestic economic conditions and responding as swiftly as required/needed.
- To ensure that credit expansion is high to achieve higher growth in the economy while at the same time trying to protect the quality of credit
- Maintaining the price as well as financial stability
- Give thrust/importance to Interest Rate Management, Liquidity Management & Inflation Management
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