November 13, 2018 CFA Level 1Admin

Monetary Policy Decoded – CFA® Program Level I

What is ‘Monetary Policy?’

Monetary policy consists of the actions of a central bank, currency board or another regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of currency banks are required to keep in the vault (bank reserves).

Monetary policy is an integral part of the economic development strategy in any economy due to its significant impact on economic sustainability. It has been an effective tool for regulating the economy through several tools. Nowadays the use of monetary policy tools to manage economic growth processes is a common practice in all market economies by balancing money supply and demand in domestic markets, increasing the benefits from foreign trade by exchange rate and overall financial flows by monitoring inflation rate trends. However, most effective tools are refinancing rate, mandatory reserve requirements and sterilization operations, which have direct linkages to financial flows, money supply, inflation, and exchange rate.

U.S. Federal Reserve

Most central banks are independent of other policymakers. This is the case with the Federal Reserve and Congress, reflecting the separation of monetary policy from fiscal policy. The latter refers to taxes and government borrowing and spending.

The Federal Reserve has what is commonly referred to as a “dual mandate”: to achieve maximum employment (in practice, around 5% unemployment) and stable prices (2-3% inflation). In addition, it aims to keep long-term interest rates relatively low, and since 2009 has served as a bank regulator. Its core role is to be the lender of last resort, providing banks with liquidity in order to prevent the bank failures and or panics in the financial services sector.

The Effectiveness of Monetary Policy

According to the Keynesians, monetary policy is ineffective and less reliable because of the following reasons. Monetary policy is only among many factors that determine the level of nominal national income in the short-run. Changes in the money supply may lead to opposite changes in velocity and thereby limit the effectiveness of the monetary policy.

Finally, during the recession, investment is unresponsive to interest rate changes. Keynesians believe that the economy operates under liquidity trap range (horizontal LM curve). The IS curve is vertical or interest inelastic. It is a depressed economy in which prices, income level, the rate of interest and velocity of money are very low and speculative demand for money is very high. In such a situation, monetary policy is ineffective. An increase in the money supply does not shift the LM Curve and therefore, there will be no change in the income level and interest rate.

The Monetarists consider the monetary policy to be effective at least in the short period. They have produced empirical evidence to show that changes in nominal national income, employment and the price level are more closely related to changes in the money stock than to changes in Government expenditures and taxes.

Monetary Policy and Price Stability

The RBI is now more capable and more responsible for controlling the overall growth of money and credit in a manner best suited for moderating inflation while meeting the genuine credit needs of the economy. Its capacity for effective money management or any inflation control needs to be further strengthened through rapid deepening and broadening of primary and secondary markets for Government securities.

With greater autonomy comes more responsibility. The role of monetary policy has too long been a passive one, confined to financing the fiscal deficit at administered interest rates in order to minimize the cost to the Government. This has in the past encouraged fiscal profligacy with growing fiscal deficits, and larger and larger components of monetization which in turn has generated inflationary pressure and has distorted the financial system raising interest rates to the productive sector. It was necessary to make a decisive break from this pattern.

With the reduction in the fiscal deficit, the Government was working towards a situation where interest rate distortions were reduced and monetary policy could be actively used for short-term macroeconomic management. The Government has progressed towards this aim in the past years with a number of initiatives. The statutory liquidity ratio has been reduced, releasing resources to the banks for deploying additional funds in the commercial sector. Government borrowing was also being shifted to market-related rates; the 364-day bills were introduced with market-related interest rates. Other interest rates on securities were raised to bring them closer to market rates. Reserve Bank of India also conducted repurchase operations in securities for short-term liquidity management.

Monetary Policy Instruments:

Monetary policy is a way for the RBI to control the supply of money in the economy. So these credit policies help control the inflation and in turn help with the economic growth and development of the country. So now let us take a look at the various instruments of monetary policy that the RBI has at its disposal.

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