Monetary policy

The monetary policy stance of the reserve bank continued to be the provision of adequate liquidity to meet credit growth. Support investment demand in the economy while continuing a vigil on movement in the price level.

Liquidity management in India is a subject that is not widely discounted  but is the bread and butter of daily monetary management.

Conduct of monetary policy and management in the context of large and volatile capital flows has proved to be difficult for many countries.

The evolving policy mix involved careful calibration that book into account diverse objective of central banking changes in the monetary policy framework and operating procedures and widening of the set of instrument for liquidity management.

Liquidity management and management of capital flows

While in the macroeconomics context, liquidity management refers to overall monetary, conditions, reflecting the extent of mismatch between demand and supply of overall monetary resources.

For central bank, the concept of liquidity management typically refers to the framework and set of instruments that the central bank follows insuring the amount policy.

What is the price of bank reserves?

The price of bank reserve is fixed in terms of short-term interest rate. This is set in terms of overnight inter-bank borrowing and lending rates either secured or unsecured which affect the reserves do not clear offer an their own the central bank itself steps in by influencing the short-term repurchase obligation with banks.

Supply of monetary base depends on.

1) The public demand for currency as determined by the size of monetary transactions and the opportunity cost of holding money.

2) The banking system ‘s need for reserve to settle or discharge payment obligation control banks also attempt to contract and varying the supply of bank reserve to settle meet its are therefore influenced through reserve requirements or open market operation.

Role of central bank

1) The importance of central bank liquidity management lies in its ability to exercise considerable influence and control over short-term interest rate by small money market operation.

2) Central bank typically aim at a target overnight interest rate which at as a powerful economy wide signal.

3) The liquidity management function of a central bank involves a larger economy-wide perspective.

4) Central bank liquidity management has short-term effects in financial market.

5) Central bank attempt to influence money market liquidity in order to exercise control over the short-term interest rate.

6) The central bank may directly set at one of the short term interest rate that acts as its policy rate.

Money market instrument

1)  Repo rate– Repo is a collateralized short term borrowing and lending through sale/purchase operation in debt instrument. It is a temporary sale of debt. Transfer of ownership of the securities that is the assignment of voting and financial rights. The term of the contract is in terms of a repo rate, representing the money market borrowing lending rate. Repos are usually of 1-14 days .

The collateral security in the form of SGL is transferred from  the seller to the buyer. Generally ,repos transaction take place in market lots of Rs. 5 core. Repo transaction have very low credit risk due to the SGL mechanism and the existence of collateral in the form of the underlying security.

2) Reverse repo rate– A reverse repo ready forward repurchase (buy back) is a transaction in which two parties agree to sell and repurchase the same security. The seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price.

Likewise, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date and at a predetermined price.

Reverse repo are used to

1) Meet a shortfall in the cash position

2)  Increase return on fund held

3) Borrow securities to meet regulatory (SLR) requirements

4) By the RBI adjust liquidity in the financial system under the LAF

3) Statutory Liquidity Ratio(SLR)– While the CRR enables the RBI to impose primary reserve requirements. The SLR enables it to impose secondary and supplementary reserve requirements on the banking system.

The  objective of the SLR are three-fold i) To restrict the expansion of bank credit.ii) To augment a bank’s investment in Government securities and iii) To ensure solvency of banks.

The SLR is the ratio of cash in hand (excluding CRR) balances in current account with banks and RBI gold and unencumbered approved securities to the total demand and time liabilities of the banks. The SLR defaults result in restrictions on the access of refinance.

An increase in the SLR does not, however, restrain total expenditure in the economy it would restrict only private sector expenditure but it would also help increase the government sector expenditure. A decrease in the SLR would have the opposite effect. SLR is not a technique of monetary control it only distributes bank reserve in favour of the Government public sector.

4) Bank rate– The bank rate is the standard rate at which the RBI buys rediscounts Bill’s of exchange other eligible commercial paper.It is also the rate that the RBI charges on advances on specified collaterals to banks. An increase in the B/R would decrease /increase in the lending rate of banks.Thus the B/R technique regulate the cost/availability of finance and to that extent, the volume of funds available to banks and financial institutions.

5) Cash Reserve Ratio– The CRR refers to the cash which banks have to maintain with the RBI as a percentage of their demand and time liabilities. The objective is to ensure the safety and liquidity of bank deposits.The RBI is empowered to impose penal interest on banks in respect of their shortfall in the prescribed CRR.

The penal interest is a specified percentage above the bank rate.RBI can disallow fresh access to its refinance facility to defaulting banks and charge additional interest over and above the basic refinance rate on any accommodation availed of and which is equal to the shortfall in the CRR.

The RBI pays interest equal to the bank rate on all eligible cash balances. The CRR, as an instrument of monetary policy has been very actively used by the RBI recently in the downward direction. It is at its lowest level now.

6) Open market operation(OMOs)– The OMOs refer to the sale and purchase of securities of the central and state Government and treasury-bills (T-bills). The multiple objective of OMOs, i) To control the amount of and changes in bank credit and money supply through controlling the reserve base of banks.(ii) To make the bank rate policy more effective (iii) To maintain stability in the Government securities T-bills market(iv) To support the Government’s borrowing programme (v)To smoothen the seasonal flow of funds in the bank credit market.

Through the OMOs, the RBI can affect the reserve position of banks,yields on Government securities T-bills the volume and cost of credit.

In spite of the wide power to the RBI,the OMOs is not a widely-used technique of monetary control in India. There is no restriction on the quantity maturity of the Government securities which the RBI can buy/sell/hold.

Supply

The quantity supplied of a good is the amount that produces plan to sell in a given period of time.The quantity supplied is not the amount a firm would like to sell but the amount it definitely plans to sell. However the quantity supplied is not necessarily the same as the quantity a firm sales plan will be frustrated like quantity demanded,the quantity supplied is expressed as an amount per unit of time.

A change in supply now consider another change this time on the side of products. Begin as before by imagining a situation in with farmers are equally satisfied by producing sprouts and carrots and in which consumer are willing to buy at prevailing market prices, the quantities of these how commodities that are being produced.

A change in supply means that the willing of producers to sell a particular product has changed as a result of something other than a change in the price of the commodity.

Imagine that, at existing prices some change occurs so that farmers become more willing to produce sprouts them in the past and less willing to produce carrots production and lower that of carrot production an additional unit of the good increase as the quantity produced increases to include them to incur a higher cost and increases production firm must be compensated with a higher price.

   

Supply schedule and supply curve

A supply schedule lists the quantities supplied at each different firms plan to sell are held constant let’s construct a supply schedule to do so, we examine how the quantity supplied of a good varies,holding constant the prices of other goods, the price of factor of production used to produce it expected future prices and the state of technology.

A supply schedule can be illustrated by drawing a supply curve graphs the relationship between the quantity supplied and the price of good, holding everything else constant.

  A change in supply

 

The term supply refers to entire relationship between the quantity supplied of a good and its price.

1)Price of factors of production-The prices of the factors of production used to produce of a good influence it supply.

2)Price of related goods-The supply of good can be influenced by the prices of related goods, for example, if an automobile assembly line can produce either sports cars or sedans, the quantity of sports car produced will depend on the price of sedans.These two goods are substitutes in production.

An increase in the price of substitutes in production complements in production arise when two thing are of necessity, produced together for example extracting chemical from coal produce coke, coal tar, nylon. An increase in the price of any one of these by production of coal increase the supply of the other by products.

3) Expected future price– If the price of a good is expected to rise, it makes sense to sell less of the good today and more in the future, when it price is higher similarly, if its price is expected to fall, it pays to expand 10 day’s supply of the good.

4) The number of supplier– other things remaining the same, larger the number of firms supplying the good, the  larger is the supply of good

5) Technology-New technology to enable the producer to use fewer factor of production will lower the cost of production and increase the supply.

 

 

 

Demand

The quantity demanded of a goods or services is the amount that consumers plan to buy in a given period of time at a particular price.Demands are different from wants.

Wants are the unlimited desires or wishes that people have for goods and services.Security guarantees that many perhaps most of our wants will never be satisfied.Demand reflects a decision about which wants to satisfy.If you demand something then you have made a plan to buy it.

The quantity demanded is not necessarily the same amount as the quantity actually bought sometimes the quantity demanded is greater than the amount of goods available.So the quantity bought is less than the amount of goods available so the quantity bought is less than the quantity demanded.

The quantity demanded is measured as a an amount per unit of time.For example suppose a person consumes one cup of coffee a day.The quantity of coffee demanded by that person can be expressed as 1 cups per day or 7 cups per week or 365 cups per year without a time dimension, we can not tell whether a particular quantity demanded is large or small.    

  The law of Demand

 

Other things remaining the same,the higher the price of goods the lower is the quantity demanded.

Why does a higher price reduce the quantity demanded?The key to the answer lies in other things remaining the same.Because other things are being held constant, when the price of a good rises.It rises relative to the prices of all other goods. Although each good is unique. It has substitutes other goods that serve almost as well as the price of a good climbs higher, relative to the prices of its substitutes, people buy less that good and more of its substitutes. 

Demand schedule and demand curve

A demand schedule lists the quantities demanded at each different price, when all other influences an consumers planned purchase such as the prices of related goods of incomes expected future prices, population,and preference remain the same.              

               The point on the demanded curve labeled a through represent the row of the demand schedul.                     

                Willingness to pay

Another way of looking at the demand curve is as a willingness to pay curve.It tells us the higher price.that will be paid for the last unit available.If a large quantity is available, that price is low.If a small quantity is available that price is high

    A change in demand

The term demand refers to the entire relationship between the quantity demanded by both the demand schedule and the demand curve.

1)Price of related goods-The quantity of tapes that consumer plan to buy does not depend only on the price of types.It also depends in part on the prices of related goods fall in to two categories substitute and complement.

            A complement is a good used in conjunction with another good.Some example of complements are hamburger and French fries pastry snack and drink spaghetti and meat sauce running shoes and jogging paints.

2)Income -Another influence on demand is consumer income other things remaining the same when income increases decreases they buy less of most goods.It does consume with lower incomes demand less of most of goods rich people consume more food,clothing housing art,vacations and entertainment them do poor people.

        Although an increase in income leads to an increase in the demand for most goods.It does not lead to an increase in the demand as income increase are called normal goods.

               Goods that decrease in demand when income increase are called inferior goods.Eg of inferior goods are rice and potatoes.These two goods are a major part of the diet of people with very low income.Its income increase,the demand for these goods decline as major expensive meat and dairy products are substituted for them.

3)Expected future price-If the price of good is expected to rise,it make sense to buy more of the good today and less in the future when its price is higher.Similarly if its price is expected to fall.It pays to cut back on today’s purchase and buy more later when the price is expected to be lower.Thus the higher the expected future price of a good, the larger is today’s demand for the good.

4)Population-Demand also depends on the size of the population,the size of two population,the greater is the demand for all goods and services and the smaller the population, the smaller is the demand for all goods and services.

5)Preference-Finally demand depends on preference.Peeference are an individual attitudes towards goods and services for example a rock music fanatic has much greater than does a tone deaf workaholic 

         Preference are not observed. But preferences change.Slowly and so have little influence a change in demand.

Inflation

Inflation is an upward movement the average level of prices.Its opposite deflation,a downward movement in the average prices.The boundary between inflation and deflation is price stability.Prices is moving neither up or nor down.The average level of prices is called the price level.It is measured by a price index.

A price index measures the average level of prices in one period called the base period.

The Inflation rate and the price level.

The inflation rate is the percentage change in the price level.The formula for the annual inflation rate is

Inflation rate=\frac{current year's price level-last year price level}{last year's price level}

A common way of measuring the price level is to use the consumer price Index(CPI)

Inflation and the value of money

When inflation is present money is losing value.The value of money is the amount of goods and services that can be bought with a given amount of money falls you can not buy as many groceries with $50 this year.As last year.The rate at which the value of money falls is equal to the inflation rate.When the inflation rate is high,as it money loses it value at a rapid pace,when inflation is low the value of money falls slowly.

Inflation is a phenomenon that  all countries experience,but inflation rates vary from one country to another when inflation rate differ over a prolonged period of time,the result is a change in the foreign exchange value of money.A foreign exchange rate is the rate which one country is money or currency exchange another country’s money.

Is inflation a problem?

 

Is it a problem  if money loses its value and does so at a rate that varies from one year to describe the problem,we need to distinguish between anticipated and unanticipated inflation.

When prices are rising people are aware of the fact and have some idea about the rate at which prices are rising.The rate at which people believe that the price level is rising is called the expected inflation rate,But expectations may be right or wrong. If they turn out to the expected rate equals the expected inflation rate and inflation is anticipated.

Anticipated inflation is an inflation rate that has been correctly forecasted .To be extent,that the Inflation rate is misforecasted.It is said to be unanticipated.That is,unanticipated inflation is the part of the inflation rate that has caught people by surprise.

The problem of unanticipated inflation

With unanticipated inflation gains and losses occur because of unanticipated changes in the value of money.Money is used as measuring rod of the value of the transaction that we understake.Borrowers and lenders,workers and their employers.All make contracts in terms of money.If the value of money varies unexpectedly overtime then the amounts really paid and received differ from those that people intended to pay and receive when they signed the contracts.Measuring value with a measuring rod whose units vary is a bit like trying to measure a piece of cloth depends on how tightly the ruler is stretched.

The problem of anticipated inflation

Anticipated inflation is a problem when the inflation rate is high.At high inflation rates people know that money is losing value quickly.So they try to avoid holding on to money for too long.The inflation rate the rate at which money is losing value is part of the opportunity cost of holding money they recieved from the sale of their goods and services they pay it out in wages as quickly as possible.

High and variable Inflation

Even if inflation is reasonably well anticipated, and even if its rate is not as high as during a period of hyperinflation.It can still impose very high costs. A High and variable inflation rate causes resources to be diverted from productive activities to forecasting  inflation.

It becomes more profitable to forecast the inflation rate correctly than to invent a new product.