Financial system & Monetary Policy

Financial System

Financial system includes the institutions involved in moving savings from households and firms whose income exceeds their expenditures and transferring it to other households and firms who would like to spend more than their current income flows.

Financial intermediaries are the institutions which transform funds gathered from many individuals into financial assets:
1. Banks
2. Life insurance companies
3. Pension funds
4. Mutual funds etc.
Financial market are where financial assets the claims by one party over another party i.e. financial assets are bought and sold. There are many types of financial asset, the popular ones are as below:
1. Money
2. Loans
3. Bonds
4. Stocks etc

For each of the financial assets there are associated interest rate or rate of returns. It is important to note that in the financial market, firms & people takes loan when expected rate of return is higher than the rate of interest on loan. In developed countries there are scenario where rate of return is so low that people do not take loans even at close to zero percent interest rate.

Money

Money is what money does. Money is something that people accept as "money". It is a financial asset
that can be easily used to purchase goods and services. Money plays three major roles:
1. Medium of exchange i.e. an asset that individuals acquire for the purpose of trading
rather than for their own consumption.
2. A store of value i.e. means of holding purchasing power over time
3. A unit of account i.e. measure used to set prices and make economic calculations

Money form in India

M1 = Currency (notes & coins) with public + demand deposits with banks ("checking deposits) (narrow money)

M2 --> post office

M3 = M1 + time deposits with banks (broad money)

Money creation in financial system
1. Central bank determines the monetary base also known as reserve money, base money, high powered money
2. Banks create money through multiple expansion of bank deposits based on cash reserves

The monetary base is the sum of currency in circulation and cash reserves of banks (cash in vaults plus deposits with RBI) .
The money supply is the sum of bank deposits plus currency in circulation.
Each rupee of bank reserves backs several rupees of bank deposits, making the money supply larger than the monetary base.

Money multiplier = money supply / monetary base

Monetary Policy

In essence, monetary policy does following:
 1. manage liquidity (lend/borrow funds)
 2. change interest rate (to make it attractive)

Monetary policy instruments

1. Reserve requirements are the minimum cash reserves required to be maintained by banks. In India, Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. In USA, there is no system of changing CRR whereas in India RBI revise the CRR quite often.

 Reserve requirement ↓  --> Liquidity in the banking system ↑

Statutory Liquidity Ratio (SLR) refers to the amount that the commercial banks require to maintain in the form of safe and liquid assets such as gold, cash, government approved securities, bonds, and shares before providing credit to the customers. SLR typically remain unchanged for longer duration.

2. Bank rate or Discount rate is the rate which the central bank charges for loans to banks. In India, there are two rates viz repo rate and reverse-repo rate.

Repo rate is the rate at which the RBI lends money to commercial banks i.e. whenever banks have any shortage of funds they can borrow from the RBI.

 Repo rate ↓  --> Liquidity in the banking system ↑

Reverse Repo rate is the rate at which the RBI borrows money from commercial banks.

3. Open Market Operations:  Purchase and sale of government securities by the central bank. There are two type of open market operations, viz.
A. Outright -> not required to buyback the government security after maturity
B. Buyback -> securities are transaction in reverse on maturity

4. Quantitative easing: It is an unconventional monetary policy instrument. It is way of increasing directly the quantity of money into the economy by the central bank by buying financial assets from financial institutions. It is used when the conventional instrument of influencing the short term federal funds rate fails.

Monetary policy target
Monetary policy targets to influence the investment and consumption in an economy by changing the interest rates and credit availability. In demand constrained economy (recession), expansionary  monetary policy can help in creating more liquidity ↑ via following
• Cash Reserve Ratio ↓
• Bank rate ↓
• Buy government securities

Whereas in supply constrained economy (inflation), the contractionary monetary policy can help in reducing the liquidity ↓ via
• Cash Reserve Ratio ↑
• Bank rate ↑
• Sell government securities

Change in monetary policy cause the change in liquidity in the financial system and so as a result influence the investment (I) and consumption (C) in an economy. However, as described by Keynes' theory, monetary policy is an indirect method to control recession as it is not directly linked with the creation of demand, which a main cause of recession. And monetary policy may not be effective during the time of time and can fail. Similar to recession, monetary policy can also fail in inflation. In case when inflation is not due the demand-pull but due to cost-push, monetary policy can be ineffective. 
 

Monetary Policy

Example: Federal funds & rate in USA

Different countries has different way of implementing the above described instrument and the choice and implementation of them depends on the historic evolution of their financial system. For example, unlike RBI in India, which directly control the rates (by announcing repo / reverse-repo rate), Federal body in USA does not directly control the rate. They set the "target" Federal rate and then tries to achieve this by buying/selling of government securities and printing currency as required.

Notes & discussion:
1. RBI does not control inter-bank rates for transaction between banks.
2.  Loans are assets for banks and its a liability for person who is availing it.
3. Stagflation is when inflation rates are higher but there is growth rate slows down.When people expect inflation remain or to go up, they increase stocking etc which further increase the inflation and this will make the inflation worse.
4. Then (as monetary policy cannot control inflation or recession) why RBI  is doing what they are doing to control inflation? It is understood that monetary policy are ineffective as there are sectoral imbalances, there are cost-push and so on. But they still try to control inflation by monetary policy.. i.e. by controlling the CRR/repo-rate.. They do so to control the expectation of the people on inflation. Otherwise, people will assert that RBI cannot control inflation and so it will further make the inflation worst. It's all about SELLING THE RIGHT HOPES....
5. Between CRR and repo, CRR is more directly linked to liquidity. So, recent move of RBI,  reducing repo & reverse repo and not changing CRR, can be interpreted as RBI want to liquidity to not go down in the banking system (liquidity increase may be happen).