Sunday, January 23, 2011

Monetary policy and Monetary Aggregates

One of the most important functions of any central bank is to formulate and implement monetary policy. At a macro level, the importance and impact of this policy is felt when the overall prices tend to go up as, as we are witnessing now.

Looking at the earlier development in India from the mid-1980s till 1997-98, it can be characterized as a monetary targeting framework on the lines recommended by Chakravarty Committee (1985). By the late 1990s, the process of financial liberalization necessitated a re-look at the framework of monetary targeting and the efficiency of using broad money as an intermediate target of monetary policy. Because of the reasonable stability of the money demand function, the annual growth in broad money (M3) was used as an intermediate target of monetary policy to achieve the final objectives.

The monetary operations are conducted in the Money market by the central bank in its pursuit of monetary policy objectives. Banking sector plays a critical role in transmitting monetary policy action to spending decisions of consumers and investors, and ultimately affecting output and prices. The picture below based on a paper by Amaresh Samantaraya, Assistant Advisor, RBI depicts broad outline of monetary policy framework and sequence of steps involved

Definition of Money

'money' is the set of assets in the economy that is used regularly by the people to purchase goods and services from other people conveniently. RBI (1998) provides detailed discussion on the conceptual and methodological issues related to monetary aggregates in India.

Technically, two forms of money stock viz. (i) narrow money, and (ii) broad money are widely used in the discussion of monetary policy. However, the RBI Working Group recommended compilation of four monetary aggregates on the basis of the balance sheet of the banking sector in conformity with the norms of progressive liquidity:

1. M0(monetary base),

M0 = Currency in Circulation + Bankers' Deposits with the RBI + 'Other' Deposits with the RBI

2. M1 (narrow money),

M1 = Currency with the Public + Current Deposits with the Banking System + Demand Liabilities Portion of Savings Deposits with the Banking System + 'Other' Deposits with the RBI

3. M2 and M3 (broad money)

M2 = M1 + Time Liabilities Portion of Savings Deposits with the Banking System + Certificates of Deposit issued by Banks + Term Deposits of residents with a contractual maturity of up to and including one year with the Banking System (excluding CDs)

M3 = M2 + Term Deposits of residents with a contractual maturity of over one year with the Banking System + Call/Term borrowings from 'Non-depository' Financial Corporations by the Banking System

However, besides broad money which remains as an primary variable, a host of other macroeconomic indicators including interest rates or rates of return in different markets (money, capital and government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high frequency basis are used with output data for drawing policy perspectives

It is a very interesting to see monetary policy shocks (actions) administered through changes in policy instruments and operating targets influencing the final objectives. This is called Transmission Mechanism of Monetary Policy.