Monetary policy is the process by which the monetary authority of a country controls the supply...

8/8/2019 Monetary policyis the process by which themonetary authorityof a country controls thesupply of money

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MACRO-ECONOMIC FRAMEWORK STATEMENT

OVERVIEW OF THE ECONOMY

Sustained, high, and broad-based growth is essential for economic development

and poverty alleviation. What is needed for such growth is an increase in investment in

the economy. There are encouraging signs on both the growth and investment fronts in

recent years. The record in the recent past points to a pick up in investment and likely

upward shift in the trajectory of growth. The buoyancy of merchandise export growth

(25.6 per cent), in US dollar terms, in the first ten months of the current year, after a

continuous rise of more than 20 per cent in each of the previous two years, reflects a

sustained rise in exports with the revival of growth in the manufacturing sector and

increased export competitiveness. Despite the robust growth in exports, with even faster

growth in merchandise imports, the current account balance, after being in surplus for

the three previous years in succession, turned into a deficit in the first half of the current

year (AprilSeptember 2004-05).

2. There was a sudden bout of inflation in the first half of 2004-05, caused mainly by

the sharp rise in global petroleum and other commodity prices. The deficient rainfall and

monetary overhang from accretion of foreign exchange reserves could have also led to

a potential build up of inflationary expectations. The year 2004-05, after starting with a

point-to-point annual inflation rate of 4.5 per cent on April 3, 2004 witnessed a peak level


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of inflation at 8.7 per cent on August 28, 2004, the highest in the last four years. However,

as a result of the quick monetary and fiscal measures taken by the Reserve Bank of

India (RBI) and the Government, coupled with a slight easing of globa l petroleum prices,

inflation has been on a declining trend and stood at 5 per cent on February 5, 2005

compared to 6.1 per cent a year ago.

3. According to the second advance estimate of total foodgrains production, foodgrains

output is expected to decline to 206.4 million tonnes in 2004-05 from 212 million tonnes

in the previous year, with shortfalls in the output of coarse cereals and pulses. Output of

rice and wheat is projected to be higher than last year. Industrial sector, as per the Index

of Industrial Production (IIP), registered an impressive growth of 8.4 per cent in the first

three quarters of 2004-05, the highest after 1995-96.

4. Broad money (M3

), relative to its stock at the beginning of the year, grew by 9.5 per

cent (net of conversion) in the current year up to January 21, 2005, compared with the

high of 16.6 per cent in the whole of the previous year, and 12.1 per cent in the same

period last year. The equity market, which boomed in 2003-04, continued to be upbeat

through January 2005. The top 50 stocks (Nifty) generated returns of 11 per cent in

2004, following returns of 72 per cent in 2003. The second rung of smaller stocks (Nifty

Junior) generated returns of 31 per cent in 2004, following returns of 141 per cent in


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2003.

GDP GROWTH

5. The performance of the Indian economy in 2004-05 so far has exceeded expectations

formed at the beginning of the year. Buoyed by a rebound in the agriculture and allied

sector, and strongly helped by improved performance in industry and services, the

economy had registered a growth rate of 8.5 per cent in 2003-04, the highest ever except

in 1975-76 and 1988-89. Normally, strong growth is expected after anaemic growth, and

vice versa. Following the high growth in 2003-04, initial growth projections for 2004-055

Website: http://indiabudget.nic.in

were placed in the range of 6.2 per cent to 7.4 per cent. Modest expectations were

further pared down to around 6.1 per cent when rainfall, after remaining normal in June,

2004, became deficient in the crucial sowing month of July and the shortfall in the southwest monsoon

turned out to be 13 per cent. Deterioration in the benign world inflation

environment, particularly of petroleum, coal and steel, led to further apprehensions about

growth and inflation. In the event, according to the advance estimate of the Central

Statistical Organisation (CSO) released on February 7, 2005, the economy is likely to

grow by 6.9 per cent in 2004-05.

6. GDP grew by 7.4 per cent in the first quarter and 6.6 per cent in the second quarter

of the current year, compared with 5.3 per cent and 8.6 per cent in the corresponding

quarters of the previous year. The deceleration of growth in the second quarter is on


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account of a negative growth of 0.8 per cent in agriculture and allied sector and a lower

growth of 8.2 per cent in the services sector compared with 9.5 per cent in the first

quarter. The growth in industry accelerated from 6.9 per cent in the first quarter to 8.1

per cent in the second quarter. Within industry, growth in manufacturing accelerated

from 8.0 per cent in the first quarter to 9.3 per cent in the second quarter, the highest in

any quarter since 1997-98, when CSO started compiling quarterly estimates. Despite a

lower growth in the second quarter, the overall growth in the first half of the current year

at 7.0 per cent is marginally higher than the growth of 6.9 per cent achieved in the same period last

year.

EXTERNAL SECTOR

7. Foreign exchange reserves continue to maintain a rising trend with such reserves

(including gold, SDRs and reserve position in IMF) reaching an estimated level of US

$128.91 billion on February 4, 2005. There was a large merchandise trade deficit with a

rise not only in the POL import bill because of high prices, but also in non-bullion, nonPOL imports,

which overwhelmed the growth of exports in US dollar terms, in the first

ten months of the current year. Commodity-wise export growth continued to be broadbased with the

manufacturing sector in the lead. The estimated strong growth in nonPOL, non-bullion merchandise

imports was driven by buoyant domestic demand including

for investment, a mildly strengthening rupee in real terms, and greater import liberalization.

8. The capital account surplus in April-September 2004 was lower than that in AprilSeptember 2003 by

around US$1.5 billion. Buoyant foreign investment inflows along


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with robust inflows of commercial borrowings sustained the capital account. The balance

of payments surplus was around US$7 billion in the first half of 2004-05, roughly half of

what it was in April-September 2003.

MONEY, BANKING AND CAPITAL MARKETS

9. Compared to its stock at the beginning of the year, the growth in reserve money,

which had accelerated from 9.2 per cent during 2002-03 to a high of 18.3 per cent during

2003-04, declined to 6.4 per cent in the current year up to January 28, 2005. Nevertheless,

liquidity management remained a concern. This was because, after a sharp increase in

reserve money in the previous year, there was a liquidity overhang of over Rs.81,000

crore in the form of outstanding reverse repos under the Liquidity Adjustment Facility

(LAF), Government surplus balances and excess reserves of banks from the previous

year.

10. Despite lower growth of money supply in the current year, gross bank credit by

scheduled commercial banks, net of conversion, increased by 19.9 per cent up to January

21, 2005 compared to 9.3 per cent in the corresponding previous period. Growth was

observed in both food and non-food credit, more so in the case of the latter.

grew by 15.2 per cent in the current year up to January 21, 2005 compared to a decline

of 25.9 per cent last year, while non-food credit grew at an impressive 20.1 per cent

compared to 11.9 per cent in the same period last year, the highest growth registered


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since 1996-97. Priority sector advances by public sector banks reached 44.0 per cent of

net bank credit in 2003-04, exceeding the target of 40 per cent. There were, however,

shortfalls in meeting the sub-target under agriculture. Following the Governments

announcement of a comprehensive policy envisaging a 30 per cent increase in agriculture

credit in the current year and doubling of the credit flow to the sector in three years,

institutional credit to the sector is projected to go up from Rs.86,981 crore in 2003-04 to

Rs. 1,08,500 crore in 2004-05.

11. In the current year, there was a marginal northward movement in deposit rates of

five major banks by 25 basis points. Interest rates on housing loans witnessed a marginal

firming up as well. Call money rates moved up in the second half of the year, reflecting

higher growth of bank credit. Nevertheless, interest rates continue to be moderate. The

benchmark prime lending rates of five major banks were lower by 25 to 50 basis points

in December, 2004 compared to the rates prevailing a year ago.

12. Strong equity index returns in calendar 2003 led to a revival of the primary market

in 2004. Overall public issues grew by roughly five times to Rs. 35,859 crore in 2004. The

growth was concentrated in equity issues and particularly in equity initial public offerings

(IPOs).

CENTRAL GOVERNMENT FINANCES

13. The third quarterly review of trends in receipts and expenditure of the Government


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(during April-December 2004) is shortly being placed before both the Houses of

Parliament. The Revised Estimates for 2004-05 indicate that Revenue Deficit and Fiscal

Deficit during the year are estimated to be Rs.85,165 crore (2.7 per cent of GDP) and

Rs.139,231 crore (4.5 per cent of GDP) compared to Rs.76,171 crore (2.5 per cent of

GDP) and Rs.137,407 crore (4.4 per cent of GDP) contemplated in the Budget 2004 -05.

In 2003-04, these deficits were 3.6 per cent of GDP and 4.5 per cent of GDP, respectively.

Therefore, the minimum deficit reduction mandated under the Fiscal Responsibility and

Budget Management Act, 2003 is being achieved in 2004-05.

PROSPECTS

14. Good post-monsoon rains, especially during October 2004, which helped build

up of soil moisture, and the prevalence of cool weather conditions through the rabi

season, improved the prospects of rabi foodgrains, and is expected to help offset,

partly, the loss in kharif foodgrains production. Present trends indicate a positive

outlook for industrial growth because of increased capacity utilization, improved industrial

climate, expanding external and domestic demand and ease in availability of credit.

The strong performance of the capital goods sector coupled with increased imports

of capital goods also augur well for domestic capacity expansion in a large number

of industries. These observed trends in the major sectors of the economy, together

with the continued deceleration in WPI-inflation since August 28, 2004, indicate that


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a robust expansion may be underway and they corroborate the advance CSO estimate

of growth of 6.9 per cent in 2004-05.

Food creditMonetary policy is the process by which themonetary authorityof a country controlsthe supply of money, often targeting a rate of interestto attain a set of objectives oriented towards the

growth and stability of theeconomy.[1]These goals usually include stable prices and

lowunemployment. Monetary theoryprovides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being anexpansionary policy, or acontractionary policy, where

an expansionary policy increases the total supply of money in the economy rapidly, and a

contractionary policy decreases the total money supply, or increases it slowly. Expansionary policy is

traditionally used to combatunemploymentin arecessionby loweringinterest rates, while

contractionary policy involves raising interest rates to combatinflation. Monetary policy is contrasted

withfiscal policy, which refers to government borrowing, spending and taxation.[2]

Contents[hide ]

1 Overview

o 1.1 Theory

2 History of monetary policy

o 2.1 Trends in central banking

o 2.2 Developing countries

3 Types of monetary policy

o 3.1 Inflation targeting

o 3.2 Price level targeting

o 3.3 Monetary aggregates

o 3.4 Fixed exchange rate

o 3.5 Gold standard

o 3.6 Policy of various nations

4 Monetary policy tools

o 4.1 Monetary base

o 4. 2 Reserve requirements

o 4. 3 Discount window lending

o 4.4 Interest rates

o 4.5 Currency board

o 4.6 Unconventional monetary policy at the zero bound

5 See also

6 References

[edit]Overview


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Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price

at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools

to control one or both of these, to influence outcomes likeeconomic growth, inflation, exchange rates

with other currencies andunemployment. Where currency is under a monopoly of issuance, or where

there is a regulated system of issuing currency through banks which are tied to a central bank, themonetary authority has the ability to alter the money supply and thus influence the interest rate (to

achieve policy goals). The beginning of monetary policy as such comes from the late 19th century,

where it was used to maintain thegold standard.

A policy is referred to ascontractionaryif it reduces the size of the money supply or increases it only

slowly, or if it raises the interest rate. Anexpansionarypolicy increases the size of the money supply

more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows:

accommodative, if the interest rate set by the central monetary authority is intended to create economic

growth; neutral, if it is intended neither to cr eate growth nor combat inflation; or tight if intended to

reduce inflation.

There are several monetary policy tools available to achieve these ends: increasing interest rates by

fiat; reducing themonetary base; and increasingreserve requirements. All have the effect of contracting

the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has

generally been formed separately fromfiscal policy. Even prior to the 1970s, theBretton Woods

systemstill ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as theFederal Reserve Systemin the

United States, theBank of England, theEuropean Central Bank, thePeople's Bank of China, and

the Bank of Japan) exist which have the task of executing the monetary policy and often independently

of theexecutive. In general, these institutions are calledcentral banksand often have other

responsibilities such as supervising the smooth operation of the financial system.

The primary tool of monetary policy isopen market operations. This entails managing the quantity of

money in circulation through the buying and selling of various financial instruments, such as treasury

bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base

currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short term interest rate

target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate

relative to some foreign currency or else relative to gold. For example, in the case of the USA the

Federal Reserve targets thefederal funds rate, the rate at which member banks lend to one another

overnight; however, themonetary policy of Chinais to target theexchange ratebetween the

Chineserenminbiand a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i)Discount windowlending (lender of

last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion

(cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking

monetary policy with the market).


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[edit]TheoryMonetary policy is the process by which the government, central bank, or monetary authority of a

country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of

interest to attain a set of objectives oriented towards the growth and stability of the economy.[1]

Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price

at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools

to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates

with other currencies and unemployment. Where currency is under a monopoly of issuance, or where

there is a regulated system of issuing currency through banks which are tied to a central bank, the

monetary authority has the ability to alter the money supply and thus influence the interest rate (to

achieve policy goals).

It is important for policymakers to make credible announcements. If private agents

(consumersandfirms) believe that policymakers are committed to loweringinflation, they will anticipate

future prices to be lower than otherwise (how those expectations are formed is an entirely different

matter; compare for instancerational expectationswithadaptive expectations). If an employee expects

prices to be high in the future, he or she will draw up a wage contract with a high wage to match these

prices. Hence, the expectation of lower wages is reflected in wage -setting behavior between employees

and employers (lower wages since prices are expected to be lower) and since wages are in fact lower

there is nodemand pull inflationbecause employees are receiving a smaller wage and there is nocost

push inflationbecause employers are paying out less in wages.

To achieve this low level of inflation, policymakers must have credible announcements; that is, private

agents must believe that these announcements will reflect actual future policy. If an announcement

about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate

high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a

consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises.

Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not

have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an

expansionist monetary policy (where themarginal benefitof increasing economic output outweighs

the marginal costof inflation); however, assuming private agents haverational expectations, they know

that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an

expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers

can make their announcement of low inflation credible), private agents expect high inflation. This

anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation

(without the benefit of increased output). Hence, unless credible announcements can be made,

expansionary monetary policy will fail.


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Announcements can be made credible in various ways. One is to establish an independent central bank

with low inflation targets (but no output targets). Hence, private agents know that inflation will be low

because it is set by an independent body. Central banks can be given incentives to meet targets (for

example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal

a strong commitment to a policy goal. Reputation is an important element in monetary policyimplementation. But the idea of reputation should not be confused with commitment.

While a central bank might have a favorable reputation due to good performance in conducting

monetary policy, the same central bank might not have chosen any particular form of commitment (such

as targeting a certain range for inflation). Reputation plays a crucial role in determining how much would

markets believe the announcement of a particular commitment to a policy goal but both concepts should

not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to

have established its reputation through past policy actions; as an example, the reputation of the head of

the central bank might be derived entirely from his or her ideology, professional background, public

statements, etc.

In fact it has been argued[3]that to prevent some pathologies related to thetime inconsistencyof

monetary policy implementation (in particular excessive inflation), the head of a central bank should

have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a

particular central bank is not necessary tied to past performance, but rather to particular institutional

arrangements that the markets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of

credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be

the most beneficial. For example, capability to serve the public interest is one definition of credibility

often associated with central banks. The reliability with which a central bank keeps its promises is also a

common definition. While everyone most likely agrees a central bank should not lie to the public, wide

disagreement exists on how a central bank can best serve the public interest. Therefore, lack of

definition can lead people to believe they are supporting one particular policy of credibility when they

are really supporting another.[4] [edit]History of monetary policyMonetary policy is primarily associated withinterest rateandcredit. For many centuries there were only

two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to printpaper moneyto create

credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated

with the other forms of monetary policy during this time. Monetary policy was seen as an executivedecision, and was generally in the hands of the authority withseigniorage, or the power to coin. With the

advent of larger trading networks came the ability to set the price between gold and silver, and the price

of the local currency to foreign currencies. This official price could be enforced by law, even if it varied

from the market price.

Paper money called " jiaozi" originated frompromissory notesin 7th centuryChina. Jiaozi did not

replace metallic currency, and were used alongside the copper coins. The successiveYuan


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Dynastywas the first government to use paper currency as the predominant circulating medium. In the

later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they

began printing paper money without restrictions, resulting inhyperinflation.

With the creation of theBank of Englandin 1694, which acquired the responsibility to print notes and

back them with gold, the idea of monetary policy as independent of executive action began to beestablished.[5]The goal of monetary policy was to maintain the value of the coinage, print notes which

would trade at par to specie, and prevent coins from leaving circulation. The establishment of central

banks by industrializing nations was associated then with the desire to maintain the nation's peg to

the gold standard, and to trade in a narrowbandwith other gold-backed currencies. To accomplish this

end, central banks as part of the gold standard began setting the interest rates that they charged, both

their own borrowers, and other banks who required liquidity. The maintenance of a gold standard

required almost monthly adjustments of interest rates.

During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the

last being theFederal Reservein 1913.[6]By this point the role of the central bank as the "lender of last

resort" was understood. It was also increasingly understood that interest rates had an effect on the

entire economy, in no small part because of themarginal revolutionin economics, which demonstrated

how people would change a decision based on a change in the economic trade-offs.

Monetaristmacroeconomists have sometimes advocated simply increasing the monetary supply at a

low, constant rate, as the best way of maintaining low inflation and stable output growth.[7]However,

when U.S.Federal ReserveChairmanPaul Volcker tried this policy, starting in October 1979, it was

found to be impractical, because of the highly unstable relationship between monetary aggregates and

other macroeconomic variables.[8]EvenMilton Friedmanacknowledged that money supply targeting

was less successful than he had hoped, in an interview with theFinancial Timeson June 7,

2003.[9][10][11]Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates;

long term interest rates;

velocity of money through the economy;

exchange rates;

credit quality;

bondsand equities(corporate ownership and debt);

government versus private sector spending/savings;

internationalcapital flowsof money on large scales;

financialderivativessuch as options, swaps, futures contracts, etc.

A small but vocal group of people[who? ] advocate for a return to the gold standard (the elimination of the

dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that

monetary policy is fraught with risk and these risks will result in drastic harm to the populace should

monetary policy fail. Others[who? ] see another problem with our current monetary policy. The problem for

them is not that our money has nothing physical to define its value, but that fractional reserve lending of


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that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society

(including all governments) to be perpetually in debt.

In fact, many economists[who? ] disagree with returning to a gold standard. They argue that doing so

would drastically limit the money supply, and throw away 100 years of advancement in monetary policy.

The sometimes complex financial transactions that make big business (especially internationalbusiness) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to

different people/companies that specialize in monitoring and using risk can turn any financial risk into a

known dollar amount and therefore make business predictable and more profitable for everyone

involved. Some have claimed that these arguments lost credibility in the global financial crisis of 2008-

2009.[edit]Trends in central bankingThe central bank influences interest rates by expanding or contracting the monetary base, which

consists of currencyin circulation and banks' reserves on deposit at the central bank. The primary way

that the central bank can affect the monetary base is byopen market operationsor sales and purchases

of second hand government debt, or by changing thereserve requirements. If the central bank wishes to

lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation

or creditingbanks' reserve accounts. Alternatively, it can lower the interest rate on discounts or

overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest

rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to

meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing

the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up

funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when theexchange rateis

floating.[12]If the exchange rate is pegged or managed in any way, the central bank will have to

purchase or sellforeign exchange. These transactions in foreign exchange will have an effect on the

monetary base analogous to open market purchases and sales of government debt; if the central bank

buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a

purefloating exchange rate, central banks and monetary authorities can at best "lean against the wind"

in a world where capital is mobile.

Accordingly, the management of the exchange rate will influence domestic monetary conditions. To

maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange

operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the

exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must

also sell government debt to contract the monetary base by an equal amount. It follows that turbulent

activity in foreign exchange markets can cause a central bank to lose control of domestic monetary

policy when it is also managing the exchange rate.

In the 1980s, many economists[who? ] began to believe that making a nation's central bank independent of

the rest of executive governmentis the best way to ensure an optimal monetary policy, and those


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central banks which did not have independence began to gain it. This is to avoid overt manipulation of

the tools of monetary policies to effect political goals, such as re-electing the current government.

Independence typically means that the members of the committee which conducts monetary policy

have long, fixed terms. Obviously, this is a somewhat limited independence.

In the 1990s, central banks began adopting formal, public inflation targets with the goal of making theoutcomes, if not the process, of monetary policy more transparent. In other words, a central bank may

have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank

will typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government through the

Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smoothbusiness cyclesor not. A central

conjecture of Keynesian economicsis that the central bank can stimulateaggregate demandin the

short run, because a significant number of prices in the economy are fixed in the short run and firms will

produce as many goods and services as are demanded (in the long run, however, money is neutral, as

in theneoclassical model). There is also the Austrian school of economics, which includesFriedrich von

Hayekand Ludwig von Mises's arguments,[13]but most economists fall into either the Keynesian or

neoclassical camps on this issue.[edit]Developing countriesDeveloping countries may have problems establishing an effective operating monetary policy. The

primary difficulty is that few developing countries have deep markets in government debt. The matter is

further complicated by the difficulties in forecasting money demand and fiscal pressure to levy

the inflationtax by expanding the monetary base rapidly. In general, the central banks in many

developing countries have poor records in managing monetary policy. This is often because the

monetary authority in a developing country is not independent of government, so good monetary policy

takes a backseat to the political desires of the government or are used to pursue other non-monetary

goals. For this and other reasons, developing countries that want to establish credible monetary policy

may institute a currency board or adoptdollarization. Such forms of monetary institutions thus

essentially tie the hands of the government from interference and, it is hoped, that such policies will

import the monetary policy of the anchor nation.

Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks

and other financial institutions inNigeriaand elsewhere) are gradually providing the latitude required to

implement monetary policy frameworks by the relevant central banks.[edit]Types of monetary policyIn practice, all types of monetary policy involve modifying the amount of base currency (M0) in

circulation. This process of changing the liquidity of base currency through the open sales and

purchases of (government-issued) debt and credit instruments is calledopen market operations.

Constant market transactions by the monetary authority modify the supply of currency and this impacts

other market variables such as short term interest rates and the exchange rate.


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The distinction between the various types of monetary policy lies primarily with the set of instruments

and target variables that are used by the monetary authority to achieve their goals.

M onetary Policy: Target M arket Variable: Long Term Objective:

Inflation TargetingInterest rate on overnightdebt A given rate of change in the CPI

Price LevelTargeting

Interest rate on overnightdebt A specific CPI number

MonetaryAggregates

The growth in moneysupply A given rate of change in the CPI

Fixed ExchangeRate

The spot price of thecurrency The spot price of the currency

Gold Standard The spot price of gold Low inflation as measured by the gold price

Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel toexchange rate regimes. Afixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed

regime towards the currency of other countries on the gold standard and a floating regime towards

those that are not. Targeting inflation, the price level or other monetary aggregates implies floating

exchange rate unless the management of the relevant foreign currencies is tracking exactly the same

variables (such as a harmonized consumer price index).[edit]Inflation targetingMain article:Inflation targeting

Under this policy approach the target is to keepinflation, under a particular definition such asConsumer

Price Index, within a desired range.The inflation target is achieved through periodic adjustments to the Central Bankinterest ratetarget.

The interest rate used is generally theinterbank rateat which banks lend to each other overnight for

cash flow purposes. Depending on the country this particular interest rate might be called the cash rate

or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the

duration that the interest rate target is kept constant will vary between months and years. This interest

rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market indicators in an attempt to

forecast economic trends and in so doing keep the market on track towards achieving the definedinflation target. For example, one simple method of inflation targeting called theTaylor ruleadjusts the

interest rate in response to changes in the inflation rate and theoutput gap. The rule was proposed

byJohn B. Taylor of Stanford University.[14]

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is

currently used in Australia, Brazil, Canada, Chile, Colombia, theEurozone, New

Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and theUnited Kingdom.


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[edit]Price level targetingPrice level targeting is similar to inflation targeting except that CPI growth in one year is offset in

subsequent years such that over time the price level on aggregate does not move.[edit]Monetary aggregatesIn the 1980s, several countries used an approach based on a constant growth in the money supply.

This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA

this approach to monetary policy was discontinued with the selection of Alan Greenspanas Fed

Chairman.

This approach is also sometimes calledmonetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is focused

on monetary quantities.[edit]Fixed exchange rateThis policy is based on maintaining afixed exchange ratewith a foreign currency. There are varying

degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is

with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed

exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is

enforced by non-convertibility measures (e.g.capital controls, import/export licenses, etc.). In this case

there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary

authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a

fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy

or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange

rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the

bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency

must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the

local monetary base does not inflate without being backed by hard currency and eliminates any worries

about a run on the local currency by those wishing to convert the local currency to the hard (anchor)

currency.

Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely

as the medium of exchange either exclusively or in parallel with local currency. This outcome can come

about because the local population has lost all faith in the local currency, or it may also be a policy of

the government (usually to rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or government as

monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain

the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation

depends on factors such as capital mobility, openness, credit channels and other economic factors.See also:List of fixed currencies


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[edit]Gold standardMain article:Gold standard

Thegold standardis a system in which the price of the national currency is measured in units of gold

bars and is kept constant by the daily buying and selling of base currency to other countries and

nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic

growth and stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the

gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world, although a form of gold standard

was used widely across the world between the mid-19th century through 1971.[15]Its major advantages

were simplicity and transparency. (See also:Bretton Woods system)

The major disadvantage of a gold standard is that it inducesdeflation, which occurs whenever

economies grow faster than the gold supply. When an economy grows faster than its money supply, the

same amount of money is used to execute a larger number of transactions. The only way to make this

possible is to lower the nominal cost of each transaction, which means that prices of goods and

services fall, and each unit of money increases in value. Deflation can cause economic problems, for

instance, it tends to increase the ratio of debts to assets over time. As an example, the monthly cost of

a fixed-rate home mortgage stays the same, but the dollar value of the house goes down, and the value

of the dollars required to pay the mortgage goes up.William Jennings Bryanrose to national

prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the

argument that deflation caused by the gold standard made it harder for everyday citizens to start new

businesses, expand their farms, or build new homes.[edit]Policy of various nations Australia - Inflation targeting

Brazil - Inflation targeting

Canada - Inflation targeting

Chile - Inflation targeting

China- Monetary targeting and targets a currency basket

Colombia - Inflation targeting

Eurozone - Inflation targeting

Hong Kong - Currency board (fixed to US dollar)

India - Multiple indicator approach

New Zealand - Inflation targeting

Norway - Inflation targeting

Singapore - Exchange rate targeting

South Africa - Inflation targeting

Switzerland - Inflation targeting[16]

Turkey - Inflation targeting


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United Kingdom[17]- Inflation targeting, alongside secondary targets on 'output and employment'.

United States[18]- Mixed policy (and since the 1980s it is well described by the "Taylor rule," which

maintains that the Fed funds rate responds to shocks in inflation and output)

Further information:Monetary policy of the USA [edit]

Monetary policy tools[edit]Monetary baseMonetary policy can be implemented by changing the size of themonetary base. This directly changes

the total amount of money circulating in the economy. A central bank can useopen market operationsto

change the monetary base. The central bank would buy/sellbondsin exchange for hard currency.

When the central bank disburses/collects this hard currency payment, it alters the amount of currency in

the economy, thus altering the monetary base.[edit]Reserve requirementsThe monetary authority exerts regulatory control over banks. Monetary policy can be implemented by

changing the proportion of total assets that banks must hold in reserve with the central bank. Banksonly maintain a small portion of their assets as cash available for immediate withdrawal; the rest is

invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be

held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a

change in the money supply. Central banks typically do not change the reserve requirements often

because it creates very volatile changes in the money supply due to the lending multiplier.[edit]Discount window lendingDiscount window lending is where the commercial banks, and other depository institutions, are able to

borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term

market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money

they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the

only instrument which the Central Banks do not have total control over.

By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation,

unemployment, interest rates ,and economic growth. A stable financial environment is created in which

savings and investment can occur, allowing for the growth of the economy as a whole.[edit]Interest ratesMain article:Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing thenominal interest

rates. Monetary authorities in different nations have differing levels of control of economy-wide interest

rates. In the United States, theFederal Reservecan set thediscount rate, as well as achieve the

desiredFederal funds ratebyopen market operations. This rate has significant effect on other market

interest rates, but there is no perfect relationship. In the United States open market operations are a

relatively small part of the total volume in the bond market. One cannot set independent targets for both

the monetary base and the interest rate because they are both modified by a single tool open market

operations; one must choose which one to control.


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In other nations, the monetary authority may be able to mandate specific interest rates on loans,

savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary

authority can contract themoney supply, because higher interest rates encourage savings and

discourage borrowing. Both of these effects reduce the size of the money supply.[edit]Currency boardMain article:currency board

A currency board is a monetary arrangement that pegs the monetary base of one country to another,

the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local

currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to

grow the local monetary base an equivalent amount of foreign currency must be held in reserves with

the currency board. This limits the possibility for the local monetary authority to inflate or pursue other

objectives. The principal rationales behind a currency board are threefold:

1. To import monetary credibility of the anchor nation;

2. To maintain a fixed exchange rate with the anchor nation;

3. To establish credibility with the exchange rate (the currency board arrangement is the hardest

form of fixed exchange rates outside of dollarization).

In theory, it is possible that a country may peg the local currency to more than one foreign currency;

although, in practice this has never happened (and it would be a more complicated to run than a simple

single-currency currency board). Agold standardis a special case of a currency board where the value

of the national currency is linked to the value of gold instead of a foreign currency.

The currency board in question will no longer issuefiat moneybut instead will only issue a set number

of units of local currency for each unit of foreign currency it has in itsvault. The surplus on thebalance

of paymentsof that country is reflected by higher depositslocal banks hold at the central bank as well

as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the

domesticmoney supplycan now be coupled to the additional deposits of the banks at the central bank

that equals additional hardforeign exchange reservesin the hands of the central bank. The virtue of this

system is that questions of currency stability no longer apply. The drawbacks are that the country no

longer has the ability to set monetary policy according to other domestic considerations, and that the

fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic

differences between it and its trading partners.

Hong Kongoperates a currency board, as doesBulgaria. Estoniaestablished a currency board pegged

to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that

country's subsequent economic success (seeEconomy of Estoniafor a detailed description of the

Estonian currency board). Argentinaabandoned its currency board in January 2002 after a severe

recession. This emphasized the fact that currency boards are not irrevocable, and hence may be

abandoned in the face of speculationby foreign exchange traders. Following the signing of the Dayton

Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the

Deutschmark (since 2002 replaced by the Euro).


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Currency boards have advantages for small, open economies that would find independent monetary

policy difficult to sustain. They can also form acredible commitmentto low inflation.[edit]Unconventional monetary policy at the zero bound

Thi secti requ ires expans i n.

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there areconcerns about deflation or deflation is occurring, are referred to asunconventional monetary policy.

These includecredit easing, quantitative easing, and signaling. In credit easing, a central bank

purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling

can be used to lower market expectations for future interest rates. For example, during the credit crisis

of 2008, the US Federal Reserve indicated rates would be low for an extended period, and the Bank of

Canada made a conditional commitment to keep rates at the lower bound of 25 basis points (0.25%)

until the end of the second quarter of 2010.

n economics, fiscal policy is the use of government expenditure and revenue collection to influence the

economy.[1]

Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy,

which attempts to stabilize the economy by controlling interest rates and themoney supply. The two

main instruments of fiscal policy are government expenditure and taxation. Changes in the level and

composition of taxation and government spending can impact on the following variables in the

economy:

Aggregate demand and the level of economic activity;

The pattern of resource allocation;

The distribution of income.

Fiscal policy refers to the use of the government budget to influence the first of these: economic activity.Contents

[hi

e]

1 Stances of f isca l policy

2 Methods of fund ing

o 2 .1 Borrow ing

o 2 .2 Consum ing pr ior surp luses

3 Econom ic effec ts of f isca l policy

4 Fiscal Straitjacke t

5 See a lso

6 R eferences

7 Bi

liography

8 Externa l links

[edit]Stances of fiscal policyThe three possible stances of fiscal policy are neutral, expansionary and contractionary. The sim est

definitions of these stances are as follows:


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A neutral stance of fiscal policy implies a balanced economy. This results in a large tax revenue.

Government spending is fully funded by tax revenue and overall the budget outcome has a neutral

effect on the level of economic activity.

An expansionary stance of fiscal policy involves government spending exceeding tax revenue.

A contractionary fiscal policy occurs when government spending is lower than tax revenue.However, these definitions can be misleading because, even with no changes in spending or tax laws at

all, cyclical fluctuations of the economy cause cyclical fluctuations of tax revenues and of some types of

government spending, altering the deficit situation; these are not considered to be policy changes.

Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally

replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for

example, a government budget that is balanced over the course of the business cycle is considered to

represent a neutral fiscal policy stance.[edit]Methods of funding

Governmentsspend moneyon a wide variety of things, from the military and police to services likeeducation and healthcare, as well astransfer paymentssuch as welfare benefits. This expenditure can

be fundedin a number of different ways:

Taxation

Seigniorage, the benefit from printingmoney

Borrowing money from the population or from abroad

Consumption of fiscal reserves.

Sale of fixed assets (e.g., land).

All of these except taxation are forms of deficit financing.

[edit]Borrowing A fiscal deficit is often funded by issuingbonds, liketreasury billsor consolsand gilt-edged securities.These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too

large, a nation maydefaulton its debts, usually to foreign creditors.[edit]Consuming prior surpluses A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial

instruments, until needed. When income from taxation or other sources falls, as during an economic

slump, reserves allow spending to continue at the same rate, without incurring additional debt.[edit]Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort toachieve economic objectives of price stability, full employment, and economic growth.Keynesian

economicssuggests that increasing government spending and decreasing tax rates are the best ways

to stimulateaggregate demand. This can be used in times of recession or low economic activity as an

essential tool for building the framework for strong economic growth and working towards full

employment. In theory, the resulting deficits would be paid for by an expanded economy during the

boom that would follow; this was the reasoning behind theNew Deal.


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Governments can use a budget surplus to do two things: to slow the pace of strong economic growth,

and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from

the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

Economists debate the effectiveness of fiscal stimulus. The argument mostly centers oncrowding out, a

phenomena where government borrowing leads to higher interest rates that offset the stimulative impactof spending. When the government runs a budget deficit, funds will need to come from public borrowing

(the issue of government bonds), overseas borrowing, or monetizingthe debt. When governments fund

a deficit with the issuing of government bonds, interest rates can increase across the market, because

government borrowing creates higher demand for credit in the financial markets. This causes a lower

aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical

economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be

effective especially in aliquidity trapwhere, they argue, crowding out is minimal.

Someclassicaland neoclassical economistsargue that crowding out completely negates any fiscal

stimulus; this is known as theTreasury View[citation needed], which Keynesian economics rejects. The

Treasury View refers to the theoretical positions of classical economists in the British Treasury, who

opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated

by some neoclassical economists up to the present.

In the classical view, expansionary fiscal policy also decreases net exports, which has a mitigating

effect on national output and income. When government borrowing increases interest rates it attracts

foreign capital from foreign investors. This is because, all other things being equal, the bonds issued

from a country executing expansionary fiscal policy now offer a higher rate of return. In other words,

companies wanting to finance projects must compete with their government for capital so they offer

higher rates of return. To purchase bonds originating from a certain country, foreign investors must

obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal

expansion, demand for that country's currency increases. The increased demand causes that country's

currency to appreciate. Once the currency appreciates, goods originating from that country now cost

more to foreigners than they did before and foreign goods now cost less than they did before.

Consequently, exports decrease and imports increase.[2]

Other possible problems with fiscal stimulus include the time lag between the implementation of the

policy and detectable effects in the economy, and inflationary effects driven by increased demand. In

theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been

idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed,

there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had

a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage

inflation and therefore price inflation.[edit]Fiscal StraitjacketThe concept of a fiscal straitjacket is a general economic principle that suggests strict constraints on

government spending and public sector borrowing, to limit or regulate the budget deficit over a time


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period. The term probably originated from the definition of straitjacket: anything that severely confines,

constricts, or hinders.[3]Various states in theUnited Stateshave various forms of self-imposed fiscal

straitjackets.[edit]See also

Functional finance National fiscal policy response to the late 2000s recession

Fiscal union

Fiscal policy of the United States [edit]References

Monetary/Fiscal PolicyMonetary/Fiscal Policy

G overnment monetary and fiscal policies change all the time. These policies are installed or fixed for the betterment of trade, inflation, unemployment, the

budget, or many other economic factors. In my opinion, it seems like two people have the majority of the control when it comes to forming these policies. The first person who influences these policies is President Bill Clinton who proposes tax cuts, to balance the budget (Clinton's budget proposal should be given to congress soon), minimum wage increases, or other legislation to improve the economy. The second person who influences policy is the Federal Reserve Board Chairman Alan G reenspan who can truly destroy our economy by a slight miscalculation. G reenspan is so influential that the mere speculation of his making a move can cause panic buying or selling in the open markets. Alan G reenspan has the power to increase or decrease the money supply by changing

reserve requirements, by changing the discount rate, or by buying or selling U.S. Securities over the open market.


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Annual Policy Statement for the Year 2010-11ByDr. D. SubbaraoGovernor

The Monetary Policy for 2010-11 is set against a rather complex economicbackdrop. Although the situation is more reassuring than it was a quarter ago,uncertainty about the shape and pace of global recovery persists. Privatespending in advanced economies continues to be constrained and inflationremains generally subdued making it likely that fiscal and monetary stimuli inthese economies will continue for an extended period. Emerging market economies (EMEs) are significantly ahead on the recovery curve, but some of them are also facing inflationary pressures.

2. India s growth-inflation dynamics are in contrast to the overall global scenario.

The economy is recovering rapidly from the growth slowdown but inflationarypressures, which were triggered by supply side factors, are now developing intoa wider inflationary process. As the domestic balance of risks shifts from growthslowdown to inflation, our policy stance must recognise and respond to thistransition. While global policy co-ordination was critical in dealing with aworldwide crisis, the exit process will necessarily be differentiated on the basisof the macroeconomic condition in each country. India s rapid turnaround afterthe crisis induced slowdown evidences the resilience of our economy and ourfinancial sector. However, this should not di vert us from the need to bring back into focus the twin challenges of macroeconomic stability and financial sectordevelopment.

3. This statement is organised in two parts. Part A covers Monetary Policyand is divided into four Sections: Section I provides an overview of global anddomestic macroeconomic developments; Section II sets out the outlook andprojections for growth, inflation and monetary aggregates; Section III explainsthe stance of monetary policy; and Section IV specifies the monetarymeasures.Part B covers Developmental and Regulatory Policies and is organisedinto six sections: Financial Stability (Section I), Interest Rate Policy (Section II),Financial Markets (Section III), Credit Delivery and Financial Inclusion (SectionIV), Regulatory and Supervisory Measures for Commercial Banks (Section V) andInstitutional Developments (Section VI).

4. Part A of this Statement should be read and understood together with thedetailed review in Macroeconomic and Monetary Developments releasedyesterday by the Reserve Bank.

Part A. Monetary Policy

I. The State of the Economy

Global Economy


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5. The global economy continues to recover amidst ongoing policy support and improving financial market conditions. The recovery process is led by EMEs,especially those in Asia, as growth remains weak in advanced economies. Theglobal economy continues to face several challenges such as high levels of unemployment, which are close to 10 per cent in the US and the Euro area.Despite signs of renewed activity in manufacturing and initial improvement inretail sales, the prospects of economic recovery in Europe are clouded by theacute fiscal strains in some countries.

6. Core measures of inflation in major advanced economies are stillmoderating as the output gap persists and unemployment remains high. Inflationexpectations also remain well-anchored. In contrast, core measures of inflationin EMEs, especially in Asia, have been rising. This has prompted central banks insome EMEs to begin phasing out their accommodative monetary policies.

Domestic Economy

7. The Reserve Bank had projected the real GDP growth for 2009 -10 at 7.5per cent. The advance estimates released by the Central Statistical Organisation(CSO) in early February 2010 placed the real GDP growth during 2009-10 at 7.2per cent. The final real GDP growth for 2009-10 may settle between 7.2 and 7.5per cent.

8. The uptrend in industrial activity continues. The index of industrialproduction (IIP) recorded a growth of 17.6 per cent in December 2009, 16.7 percent in January 2010 and 15.1 per cent in February 2010. The recovery has alsobecome more broad-based with 14 out of 17 industry groups recordingaccelerated growth during April 2009-February 2010. The sharp pick-up in the

growth of the capital goods sector, in double digits since September 2009, pointsto the revival of investment activity. After a continuous decline for elevenmonths, imports expanded by 2.6 per cent in November 2009, 32.4 per cent inDecember 2009, 35.5 per cent in January 2010 and 66.4 per cent in February2010. The acceleration in non-oil imports since November 2009 furtherevidences recovery in domestic demand. After contracting for twelve straight months, exports have turned around since October 2009 reflecting revival of external demand. Various lead indicators of service sector activity also suggest increased economic activity. On the whole, the economic recovery, which beganaround the second quarter of 2009-10, has since shown sustained improvement.

9. A sharp recovery of growth during 2009 -10 despite the worst south-west monsoon since 1972 attests to the resilience of the Indian economy. On thedemand side, the contribution of various components to growth in 2009 -10 wasas follows: private consumption (36 per cent), government consumption (14 percent), fixed investments (26 per cent) and net exports (20 per cent). Themonetary and fiscal stimulus measures initiated in the wake of the globalfinancial crisis played an important role, first in mitigating the adverse impact from contagion and then in ensuring that the economy recovered quickly.


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10. However, the developments on the inflation front are worrisome. Theheadline inflation, as measured by year-on-year variation in Wholesale PriceIndex (WPI), accelerated from 0.5 per cent in September 2009 to 9.9 per cent inMarch 2010, exceeding the Reserve Bank s baseline projection of 8.5 per cent forMarch 2010 set out in the Third Quarter Review. Year-on-year WPI non-foodmanufactured products (weight: 52.2 per cent) inflation, which was ( -) 0.4 percent in November 2009, turned marginally positive to 0.7 per cent in December2009 and rose sharply thereafter to 3.3 per cent in January 2010 and further to4.7 per cent in March 2010. Year-on-year fuel price inflation also surged from (-)0.7 per cent in November 2009 to 5.9 per cent in December 2009, to 8.1 per cent in January 2010 and further to 12.7 per cent in March 2010. Despite someseasonal moderation, food price inflation remains elevated.

11. Clearly, WPI inflation is no longer driven by supply side factors alone. Thecontribution of non-food items to overall WPI inflation, which was negative at ( -)0.4 per cent in November 2009 rose sharply to 53.3 per cent by March 2010.Consumer price index (CPI) based measures of inflation were in the range of

14.9-16.9 per cent in January/February 2010. Thus, inflationary pressures haveaccentuated since the Third Quarter Review in January 2010. What was initiallya process driven by food prices has now become more generalised.

12. Growth in monetary and credit aggregates during 2009-10 remainedbroadly in line with the projections set out in the Third Quarter Review inJanuary 2010. Non-food bank credit expanded steadily during the second half of the year. Consequently, the year-on-year non-food credit growth recovered fromits intra-year low of 10.3 per cent in October 2009 to 16.9 per cent by March2010. The increase in bank credit was also supplemented by higher flow of financial resources from other sources. Reserve Bank s estimates show that thetotal flow of financial resources from banks, domestic non-bank and external

sources to the commercial sector during 2009-10 at Rs.9,71,000 crore, washigher than the amount of Rs.8,34,000 crore in the previous year.

13. Scheduled commercial banks (SCBs) raised their deposit rates by 25-50basis points between February and April 2010 so far, signalling a reversal in thetrend of reduction in deposit rates. On the lending side, the benchmark primelending rates (BPLRs) of SCBs have remained unchanged since July 2009following reductions in the range of 25-100 basis points between March andJune 2009. However, data from select banks suggest that the weighted averageyield on advances, which is a proxy measure for effective lending rates, isprojected to decline from 10.8 per cent in March 2009 to 10.1 per cent by March2010. The Base Rate system of loan pricing, which will replace the BPLR systemwith effect from July 1, 2010, is expected to facilitate better pricing of loans,enhance transparency in lending rates and improve the assessment of monetarypolicy transmission.

14. Financial markets functioned normally through the year. Surplus liquiditythat prevailed throughout the year declined towards the end of the yearconsistent with the monetary policy stance. The Reserve Bank absorbed about Rs.1,00,000 crore on a daily average basis under the liquidity adjustment facility


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(LAF) during the current financial year up to February 12, 2010, i.e., before thefirst stage of increase in the cash reserve ratio (CRR) came into effect. DuringFebruary 27- March 31, 2010, the average daily absorption of surplus liquiditydeclined to around Rs. 38,200 crore reflecting the increase in the CRR, year-endadvance tax outflows and higher credit demand from the private sector.However, as the overall liquidity remained in surplus, overnight interest ratesgenerally stayed close to the lower bound of the LAF rate corridor.

15. The large market borrowing by the Government put upward pressure onthe yields on government securities during 2009-10. However, this wascontained by active liquidity management by the Reserve Bank. Lower credit demand by the private sector also cushioned the yield. Equity markets generallyremained firm during the year with intermittent corrections in line with theglobal pattern. Resource mobilisation through public issues increased sharply.Housing prices rebounded during 2009-10. According to the Reserve Bank ssurvey, they surpassed their pre-crisis peak levels in Mumbai.

16. During 2009 -10, the Central Government raised Rs.3,98,411 crore (net)through the market borrowing programme while the state governmentsmobilised Rs.1,14,883 crore (net). This large borrowing was managed in a non-disruptive manner through a combination of active liquidity management measures such as front-loading of the borrowing calendar, unwinding of securities under the market stabilisation scheme (MSS) and open market operation (OMO) purchases.

17. The Union Budget for 2010 -11 has begun the process of fiscalconsolidation by budgeting lower fiscal deficit (5.5 per cent of GDP in 2010 -11 ascompared with 6.7 per cent in 2009-10) and revenue deficit (4.0 per cent of GDPin 2010-11 as compared with 5.3 per cent in 2009-10). As a result, the net

market borrowing requirement of the Central Government in 2010-11 isbudgeted lower at Rs.3,45,010 crore as compared with that in the previous year.

18. Historically, fiscal deficits have been financed by a combination of market borrowings and other sources. However, in 2009-10 and 2010-11, reliance onmarket borrowings for financing the fiscal deficit increased in relative terms. Thelarge market borrowing in 2009-10 was facilitated by the unwinding of MSSsecurities and OMO purchases, as a result of which fresh issuance of securitiesconstituted 63.0 per cent of the total budgeted market borrowings. However in2010-11, almost the entire budgeted borrowings will be funded by freshissuance of securities. Therefore, notwithstanding the lower budgeted net borrowings, fresh issuance of securities in 2010-11 will be Rs.3,42,300 crore,higher than the corresponding figure of Rs.2,51,000 crore last year. The largegovernment borrowing in 2009-10 was also facilitated by sluggish private credit demand and comfortable liquidity conditions. However, going forward, privatecredit demand is expected to pick up further. Meanwhile, inflationary pressureshave also made it imperative for the Reserve Bank to absorb surplus liquidityfrom the system. Thus, managing the borrowings of the Government during2010-11 will be a bigger challenge than it was last year.


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19. The current account deficit during April-December 2009 was US$ 30billion as compared with US$ 28 billion for the corresponding period of 2008.Net capital inflows at US$ 42 billion were also substantially higher than US$ 7billion in the corresponding period last year. Consequently, on a balance of payments basis (i.e., excluding valuation effects), foreign exchange reservesincreased by US$ 11 billion as against a decline of US$ 20 billion during thecorresponding period a year ago. Foreign exchange reserves stood at US$ 279billion as on March 31, 2010. The six -currency trade-based real effectiveexchange rate (REER) (1993-94=100) appreciated by 15.5 per cent during 2009-10 up to February as against 10.4 per cent depreciation in the correspondingperiod of the previous year.

II. Outlook and Projections

Global Outlook

Growth

20. In its World Economic Outlook Update for January 2010, the InternationalMonetary Fund (IMF) projected that global growth will recover from ( -) 0.8 percent in 2009 to 3.9 per cent in 2010 and further to 4.3 per cent in 2011.Organisation for Economic Co-operation and Development s (OECD) compositeleading indicators (CLIs) in February 2010 continued to signal an improvement in economic activity for the advanced economies. Three major factors that havecontributed to the improved global outlook a re the massive monetary and fiscalsupport, improvement in confidence and a strong recovery in EMEs.

21. US GDP rose by 5.6 per cent on an annualised basis during Q4 of 2009.However, household spending remains constrained by high unemployment at

9.7 per cent. Though business fixed investment is turning around and housingstarts are picking up, investment in commercial real estate is declining. Growthin the euro area, on a quarter-on-quarter basis, was 0.1 per cent in Q4 of 2009. It may remain moderate in 2010 because of the ongoing process of balance sheet adjustment in various sectors, dampened investment, low capacity utilisationand low consumption. Though exports are improving and the decline in businessfixed investment is moderating, several euro-zone governments are faced withhigh and unsustainable fiscal imbalances which could have implications formedium and long-term interest rates. In Japan, improved prospects on account of exports have been offset by the levelling off of public investment and rise inunemployment.

22. Amongst EMEs, China continues to grow at a rapid pace, led mainly bydomestic demand. Malaysia and Thailand have recovered to register positivegrowth in the second half of 2009. Indonesia recorded positive growththroughout 2009.

Inflation


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23. Globally, headline inflation rates rose between November 2009 andJanuary 2010, softened in February 2010 on account of moderation of food,metal and crude prices and again rose marginally in some major economies inMarch 2010. Core inflation continued to decline in the US on account of substantial resource slack. Inflation expectations in advanced countries alsoremain stable. Though inflation has started rising in several EMEs, India is asignificant outlier with inflation rates much higher than in other EMEs.

Domestic Outlook

Growth

24. The Indian economy is firmly on the recovery path. Exports have beenexpanding since October 2009, a trend that is expected to continue. Theindustrial sector recovery is increasingly becoming broad-based and is expectedto take firmer hold going forward on the back of rising domestic and externaldemand.

25. Surveys generally support the perception of a consolidating recovery.According to the Reserve Bank s quarterly industrial outlook survey, althoughthe business expectation index (BEI) showed seasonal moderation from 120.6 inQ4 of 2009-10 to 119.8 in Q1 of 2010 -11, it was much higher in comparison withthe level of 96.4 a year ago. The improved performance of the industrial sector isalso reflected in the improved profitability in the corporate sector. Service sectoractivities have shown buoyancy, especially during the latter half of 2009-10. Theleading indicators of various sectors such as tourist arrivals, commercial vehiclesproduction and traffic at major ports show significant improvement. A sustainedincrease in bank credit and in the financial resources raised by the commercialsector from non-bank sources also suggest that the recovery is gaining

momentum.

26. On balance, under the assumption of a normal monsoon and sustenance of good performance of the industrial and services sectors on the back of risingdomestic and external demand, for policy purposes the baseline projection of real GDP growth for 2010-11 is placed at 8.0 per cent with an upside bias (Chart 1).

.Inflation

27. Headline WPI inflation, which moderated in the first half of 2009 -10,firmed up in the second half of the year. It accelerated from 1.5 per cent inOctober 2009 to 9.9 per cent by March 2010. The deficient south-west monsoonrainfall accentuated the pressure on food prices. This, combined with the firmingup of global commodity prices from their low levels in early 2009 and incipient demand side pressures, led to acceleration in the overall inflation rate both of the WPI and the CPIs.


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28. The Reserve Bank s baseline projection of WPI inflation for March 2010was 8.5 per cent. However, some subsequent developments on both supply anddemand sides pushed up inflation. Enhancement of excise duty and restorationof the basic customs duty on crude petroleum and petroleum products and theincrease in prices of iron ore and coal had a significant impact on WPI inflation.In addition, demand side pressures also re-emerged as reflected in the sharpincrease in non-food manufactured products inflation from 0.7 per cent to 4.7per cent between December 2009 and March 2010.

29. There have been significant changes in the drivers of inflation in recent months. First, while there are some signs of seasonal moderation in food prices,overall food inflation continues at an elevated level. It is likely that structuralshortage of certain agricultural commodities such as pulses, edible oils and milk could reduce the pace of food price moderation. Second, the firming up of globalcommodity prices poses upside risks to inflation. Third, the Reserve Bank sindustrial outlook survey shows that corporates are increasingly regaining theirpricing power in many sectors. As the recovery gains further momentum, the

demand pressures are expected to accentuate. Fourth, the Reserve Bank squarterly inflation expectations survey for households indicates that householdinflation expectations have remained at an elevated level.

30. Going forwa rd, three major uncertainties cloud the outlook for inflation.First, the prospects of the monsoon in 2010-11 are not yet clear. Second, crudeprices continue to be volatile. Third, there is evidence of demand side pressuresbuilding up. On balance, keeping in view domestic demand-supply balance andthe global trend in commodity prices, the baseline projection for WPI inflationfor March 2011 is placed at 5.5 per cent (Chart 2).

31. It would be the endeavour of the Reserve Bank to ensure price stabil ityand anchor inflation expectations. In pursuit of these objectives, the ReserveBank will continue to monitor an array of measures of inflation, both overall anddisaggregated components, in the context of the evolving macroeconomicsituation to assess the underlying inflationary pressures.

32. Notwithstanding the current inflation scenario, it is important to recognisethat in the last decade, the average inflation rate, measured both in terms of WPIand CPI, had moderated to about 5 per cent from the historical trend rate of about 7.5 per cent. Against this background, the conduct of monetary policy willcontinue to condition and contain perception of inflation in the range of 4.0 -4.5per cent. This will be in line with the medium-term objective of 3.0 per cent inflation consistent with India s broader integration into the global economy.

Monetary Aggregates

33. During 2009-10, money supply (M3) growth decelerated from over 20.0per cent at the beginning of the financial year to 16.4 per cent in February 2010before increasing to 16.8 per cent by March 2010, slightly above the Reserve


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Bank s indicative projection of 16.5 per cent. This was reflected in non -foodcredit growth of 16.9 per cent, above the indicative projection of 16.0 per cent.

34. Keeping in view the need to balance the resource demand to meet credit offtake by the private sector and government borrowings, monetary projectionshave been made consistent with the growth and inflation outlook. For policypurposes, M3 growth for 2010-11 is placed at 17.0 per cent. Consistent with this,aggregate deposits of SCBs are projected to grow by 18.0 per cent. The growth innon-food credit of SCBs is placed at 20.0 per cent. As always, these numbers areprovided as indicative projections and not as targets.

Risk Factors

35. While the indicative projections of growth and inflation for 2010 -11 mayappear reassuring, the following major downside risks to growth and upsiderisks to inflation need to be recognised:

First, uncertainty persists about the pace and shape of global recovery. Fiscalstimulus measures played a major role in the recovery process in many countriesby compensating for the fall in private demand. Private demand in majoradvanced economies continues to be weak due to high unemployment rates,weak income growth and tight credit conditions. There is a risk that once theimpact of public spending wanes, the recovery process will be stalled. Therefore,the prospects of sustaining the recovery hinge strongly on the revival of privateconsumption and investment. While recovery in India is expected to be drivenpredominantly by domestic demand, significant trade, financial and sentiment linkages indicate that a sluggish and uncertain global environment can adverselyimpact the Indian economy.

Second, if the global recovery does gain momentum, commodity and energyprices, which have been on the rise during the last one year, may harden further.Increase in global commodity prices could, therefore, add to inflationarypressures.

Third, from the perspective of both domestic demand and inflation management,the 2010 south-west monsoon is a critical factor. The current assessment of softening of domestic inflation around mid-2010 is contingent on a normalmonsoon and moderation in food prices. Any unfavourable pattern in spatial andtemporal distribution of rainfall could exacerbate food inflation. In the current context, an unfavourable monsoon could also impose a fiscal burden anddampen rural consumer and investment demand.

Fourth, it is unlikely that the large monetary expansion in advanced economieswill be unwound in the near future. Accommodative monetary policies in theadvanced economies, coupled with better growth prospects in EMEs includingIndia, are expected to trigger large capital flows into the EMEs. While theabsorptive capacity of the Indian economy has been increasing, excessive flowspose a challenge for exchange rate and monetary management. The rupee hasappreciated sharply in real terms over the past one year. Pressures from higher


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capital flows combined with the prevailing rate of inflation will only reinforcethat tendency. Both exporters, whos

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