Indian Monetary Policy and Eurozone Crisis - Case Study Example

Running Head: Indian Monetary Policy and Eurozone Crisis Your name Course name Professors’ name Date Introduction The subject matter of this paper is definition of monetary policy and the 2011/2012 direction of the policy in India. To be explicit in addressing this subject, it is necessary to start by defining monetary policy then proceed to reflect on historical and modern concept of monetary policy. This will be succeeded by a discussion on effectiveness of monetary and instruments used in operation of monetary policy. Following this part is an integral discussion on 2011/2010 direction of monetary policy in India. Monetary policy is a tool deployed by national Government to influence operation of the economy. The mechanism takes the form of controlling money supply and demand to meet economic and political objectives.1 Often, the goal of monetary policy is to realise macroeconomic stability i.e. achieve low inflation and other macroeconomic objectives. In United States, Federal Reserve Bank administers monetary policy. Governments during early economies controlled money supply by minting precious metals with government stamp.2 The worth of currency was directly proportional to underlying precious metal. In the same vein, the country’s worth was weighed by looking at gold and silver in the national treasury. Even though monarchs and despots tried to make more coins by filling with other substances, those who depended on currency worth, discovered this activity. Paper money was invented in the industrial revolution consequently making it easy for countries to change the amount of money in circulation. As a substitute of gold and silver, countries only needed paper, ink, and printing press to produce more banknotes. Since people casted doubt on paper money, it was necessary to back it by promise to pay on demand. In this case, a holder of pound sterling note could demand pound of silver. In later years, gold standard came into being following the use of gold to back the promise to pay. The problem with this system was that nation’s wealth depended on availability to gold and silver thus deficiency of these metals made nation’s currency worthless.3 The modern concept of central banking can be traced back to the period of great depression in 1930. This was a time when governments in addition to Keynes thoughts, realised that amount of money in circulation played a role in the depression.4 This marked the beginning of active government involvement in influencing money supply through monetary policy. It was during this period that nations saw the need for central banks to control money supply by establishing monetary authority. Central banks were therefore created to influence actively money supply instead of just accepting what happens to it. As a result, the process of controlling money supply would eventually influence credit creation, interest rates, and economic activity. The year 1968 saw United States move away from “gold standard” system to a system where Federal Reserve controls money supply and credit in the economy. This modern mechanism of money supply and demand goes a long way in maintaining purchasing power of US Dollars against other leading world currencies. Overtime, economists have been debating over implementation and effectiveness of monetary policy. Countries, which print money to meet government expenditure usually, have a rapidly expanding money supply that devalues country’s currency. Devalued currency also means that the currency is worthless as compared to the value of goods and services it can buy. In the end, hyperinflation of 30-40% monthly rates is registered. Conversely, tight monetary policy was effectively deployed by Germany during their hyperinflation in Weimar Republic. This country succeeded in maintaining low inflation rate. Besides, the monetary breaks of 1980s applied by U.S. Federal Reserve Chairman Paul Volcker were accompanied by economic downturn in addition to deteriorating inflation rates. Bank of Canada, with its goal of 0-3% inflation rate in 1990s, reduced their economic activity such that inflation rate assumed a negative figure for the first time since 1930s. These figures demonstrate how central banks have been influencing economic activity by regulating money in circulation and credit availability. Open market operation, reserve requirements, and the discount window are the three critical instruments used by central bank when implementing monetary policy. Other tools are moral suasion, exchange rate, and prudential guidelines. In open market operations, FED or rather a central bank participates in buying and selling Government bonds in an open market. Where Government bonds are bought, money supply increases consequently lowering interest rates. On the other hand, the act of selling Government bonds reduces money in circulation, which eventually raises interest rates. This instrument is frequently employed following its ease of usage and interactivity with the entire economy. The second instrument of reserve requirements calls upon banks to fulfil their demand deposit liabilities. In this situation, commercial banks must keep a certain percentage of their accounts in central bank. This proposition is regulated by the central bank thus affecting money supply and conditions of credits. Briefly, a policy that increases reserve requirement percentage has the effect of decreasing money supply. The reason behind this is that the central authority holds large proportion of funds in addition to demand deposits. In the same vein, an increase in reserve requirement influences interest rate by raising it given that fewer funds are available for credit purposes. This instrument is seldom used, as its effects on money supply are adverse. Discount window is the third instrument used to execute monetary policy. Through this instrument, financial institutions including lenders borrow money from Central bank at a lower rate set beneath short-term market rate. As a result, institutions are enabled to regulate their credit conditions and eventual money supply. It is imperative to note that regulating money supply through monetary policy plays a role in checking inflation, unemployment rate, interest rate, and economic growth. Stability in financial market and the eventual economic growth can be realised by nurturing an environment that allows savings and investment to take place. The central focus of this paper is the 2011/12 monetary policy in India, which is assessed by looking at the results of major Indian rating agencies. SME Rating Agency of India Ltd presented a review of monetary policy statement of 2011-2012.5 According to this review, the Reserve Bank of India was optimistic that management of inflation rate would culminate to medium-term growth indicated by 50 basis points increase in repo and saving rates. The review further enumerates global factors, inflation, and demand side pressures as being influential in financial year 2011-2012. The year 2011/2012 saw RBI propose stringent provisioning rules for banks in that sub-standard advances attracted a provision of 15 % whereas the unsecured proportion of sub-standard assets attracted an additional 10% consequently summing up to 25%. Other amendments made were on secured portion of advances and restructured accounts that attracted a provision of 40% and 2% respectively. Concisely, the increase in saving rate and tighter provisioning rules significantly influences operation of financial sector. In RBI’s Second Quarter review of monetary policy 2011-2012, changes in inflation and economic growth determines policy direction6. The 2011/2012 monetary policy, according to STCI Primary Dealer Ltd, concentrated on macroeconomic variables. The regulatory institution lowered projected growth rate from 8% to 7.6% for the financial year 2011-12. In 2011, Subbarao presented Annual Monetary Policy on behalf of Reserve Bank of India.7 While delivering the statement, Subbarao affirms that 2010 policies were necessitated by the need to recover from a persistent global uncertainty that was mainly driven by high cost of food items. In response to this need, Reserve Bank initiated a tighter policy for 2010. Regulating growth in capital and investment spending is a clear indicator of effectiveness of policies taken by the Reserve bank. Subbarao notes three particular variables that have shaped monetary strategy for financial year 2011—2012.The first one is the increasing global commodity prices, which then suggest the possibility of persistent higher inflation. Secondly is the likelihood of moderating demand that has the effect of reducing pricing power. The last variable is headline and core inflation that have exceeded the past few month’s projections thus showing unbalanced nature of inflation. Succinctly, policy direction tabled by the Reserve Bank is based on the view that high inflation has a negative effect on long-term growth given that it destroys investment by nurturing uncertainty.8 The focal point for 2011-2012 monetary policy was therefore to contain high inflation. After considering the economic environment, Reserve Bank laid down three objectives including: keep an interest rate that checks on inflation, develop an environment of price stability that supports medium-term growth and financial stability, and manage liquidity to check on monetary surplus and deficit. To achieve these objectives, Reserve Bank outlined a number of measures beginning with an increased repo rate by 50 basis points as provided for by the liquidity adjustment facility (LAF).9 This culminates to 7.25 % up from 6.75. The repo rate simply shows the interest rate charged by central authority on borrowings made by commercial banks. In economic analysis, the process of increasing repo rate expands costs incurred by commercial banks when it borrows from Reserve Bank. Individuals and corporate bodies feel the impact of increased repo rate given that lending rates have been hiked. The reserve bank further anticipates an increase in interest rates charged on fixed deposits up from the current 7.25-9.40%. The second monetary measure revolves around reverse repo rate, which remained adjusted at 6.25%.10 It is essential to note that reverse repo rate is the interest charged when commercial banks store their surplus funds in the Reserve Bank. If this rate is increased, local financial institution will then continue earning the high interest rate for surpluses kept at RBI. This reverse repo is usually determined using 100 basis points distributed below repo rate. To supplement on its policies, RBI sought to keep Statutory Liquidity Rate at a constant rate of 24%.11 This SLR was reduced in 2010 from 25% to 24%. This rate indicates the amount that commercial banks must maintain in liquid form i.e. cash or gold before going ahead to loan out funds. Maintaining this liquidity ratio at a constant rate will not damage the tightening liquidity situation. A study by Munroe (2012) affirms that the third measure sought to calibrate Marginal Standing Facility rate at 8.25%, determined by distributing 100 basis points above the repo rate. Other steps taken by Reserve bank was to maintain Bank Rate at 6.0% while the cash reserve ratio also, CRR, remained at 6%.12 Reserve bank further paid attention to Saving Bank Deposit Interest rate by increasing the rate from 3.5% to 4.0%.13 However, this rate was bound to change depending on outcome of concept paper discussing advantages and disadvantages of Saving Bank Deposit interest. STCI Primary Dealer Ltd alluded to the possibility of government deregulating both saving deposits along with Small Savings Schemes. This will act as the beginning of a deregulated interest rates market. The monetary policy position in 2011/2012 is summarised in the table below. 2011/2012 Policy Position May 2011 July 2011 October 2011 Preserve interest rate that checks inflation and predicts inflationary prospects Nurture an environment with stable price, which has the eventual effect of ensuring medium term growth and stable financial environment. Keep liquidity at a balanced (too much surplus dilutes monetary transmission whilst large deficit affects flow of funds) Preserve interest rate that checks inflation and predicts inflationary prospects Evade a falling growth rate Keep liquidity at balanced proportion such that pressure is not felt by financial system Preserve interest rate that checks inflation and predicts inflationary prospects Stimulate investment Maintain moderate deficit that support monetary transmission. Source: RBI14 In the end, Reserve Bank anticipates that the monetary policy action will contain inflation rate by minimising demand side pressures and predicting inflation expectations15. Moreover, the policy will actualise sustained growth in the medium term given that inflation has been contained. To arrive, at aforementioned policy measures, Reserve Bank of India took note of local and global macroeconomic developments. In the global arena, growth in emerging market economies was anticipated to face a downward trend as monetary policies tighten and commodity prices rise.16 This rising commodity prices has inflationary effect on advanced economies. In terms of growth, India registered 8.6% growth in 2010. Even though agricultural sector grew, production in industrial sector deteriorated as capital goods production and investment spending diminished. Inflation is also at the centre of macroeconomic policy developed by RBI. In 2010, inflation was mainly driven by structural and transitory factors. Based on these drivers, 2010 was divided into three periods starting with April to July registering Wholesale Price Index of 3.5% food items.17 August to November 2010 was the second part where WPI of 1.8 was registered and driven by non-food primary articles. Finally, a period driven by non-food manufactured products began in December 2010 to March 2011and culminated into a sharp change of WPI of 3.4%. There is no doubt from this analysis that inflation that originated from a mere increase in food prices generally infiltrated into other critical sectors of Indian economy by the year 2011. According to Reserve Bank of India, both structural and frictional factors contributed to tight monetary conditions.18 Nonetheless, reserve bank instituted measures to relax the tight system in the financial year 2011/2012. Reduced cash balances, and moderation of credit deposit ratio of banks aided in reducing tightness in the system. As a result, the situation of liquidity in 2011/2012 financial year is within RBI recommended levels. Conclusion This essay began by defining monetary policy within the confines of money supply and demand. Monetary policy is a tool used by “Central Bank” i.e. Federal Reserve of India, to influence economic activity by regulating money in circulation through instruments such as open market operation. The paper then gave a detailed analysis of both classical and modern monetary policy before tackling its effectiveness in an economy. Lastly, the essay discussed 2011/2012 monetary direction proposed by Reserve bank of India. The driving forces behind the policy direction were also given due attention. owh Bibliography Ball, Laurence, and Sheridan, Niamh. “Does Inflation Targeting Matter? 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