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Economics for Everyone: Interest Rate in the Interest of the Nation

Prof. M. Guruprasad / 14:52 , Nov 19, 2012

The changes in CRR affect the amount of free cash that banks can use to lend - reducing the amount of money for lending cuts into overall liquidity, drivin..

CONTEXT 1:


SBI chairman sticks to his guns, wants debate on CRR (Cash Reserve Ratio).

 TNN | Aug 28, 2012, 11.11PM IST


CONTEXT 2:


Bernanke Meets India Central Bank Officials (October, 2012)


US Treasury Secretary Timothy Geithner and Federal Reserve chairman Ben Bernanke came on  a two-day visit to India.


CONTEXT 3:


The recent Monetary Policy (October 2012)


The Reserve Bank of India (RBI) recent monetary policy  left the key policy rate unchanged at eight per cent, defying pressure from the finance ministry to lower rates. The central bank, however, cut the cash reserve ratio (CRR), the portion of deposits banks have to maintain with it, to 4.25 per cent, freeing up Rs 17,500 crore of additional funds.


Let us try to understand the CRR debate. In this context it is important to know the following

  • Role of Monetary policy
  • The role of Reserve bank of india.
  • The CRR debate
  • The Federal Reserve system.
  • The link between inflation, interest rate and economic growth

BACKGROUND

State Bank of India (SBI) Chairman Pratip Chaudhuri has publicly joined issue with the banking regulator, the Reserve Bank of India (RBI). Chaudhuri questioned the central bank’s practice of levying a cash reserve ratio, or CRR, by which a portion of bank deposits is impounded by the central bank, thus making credit both dearer and more scarce.  


In an interview Mr Chaudhuri said ""My purpose was to start a debate on the issue. Even if it is required why should it be on banks alone? There are a number of institutions that raise funds from the public -- insurance companies, debt mutual funds and NBFCs and it should be applicable to all"" said Chaudhuri. He clarified that he did not expect an overnight ruling on the issue. Last week the SBI chairman had in a speech called for doing away with the cash reserve ratio -- the mandated portion of deposits that banks are required to maintain with RBI. Chaudhuri said that CRR does not help anyone and it is unfair to apply it only on banks. Chakrabarti had responded to this stating that if the SBI chairman was not able to do business as per RBIs regulatory environment, he has to find some other place.


CRR: Cash Reserve Ratio


All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The changes in CRR affect the amount of free cash that banks can use to lend - reducing the amount of money for lending cuts into overall liquidity, driving interest rates up, lowering inflation and sucking money out of markets. The CRR is the proportion of their deposits, which banks have to keep with the RBI. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system, which reduces demand in the economy and therefore helps curb inflation.

 
Monetary Policy

The regulation of the money supply and interest rates by a central bank, such as the Reserve Bank of India, is in order to control inflation and stabilize currency.  Monetary policy is one the ways the government can impact the economy.

By impacting the effective cost of money, the Reserve bank can affect the amount of money that is spent by consumers and businesses. It regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. The Monetary Policy aims to maintain price stability, full employment and economic growth. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements.

Indian Banking System



Role of Reserve Bank of India:


Establishment

  • The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.

  • The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated.

  • Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India.

Preamble

  • The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:
  • "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."

Main Functions


Monetary Authority:

  • Formulates, implements and monitors the monetary policy.
  • Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.
  • Regulator and supervisor of the financial system:
  • Prescribes broad parameters of banking operations within which the country's banking and financial system functions.
  • Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

Manager of Foreign Exchange

  • Manages the Foreign Exchange Management Act, 1999.

  • Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

  • Issues and exchanges or destroys currency and coins not fit for circulation.

  • Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role

  • Performs a wide range of promotional functions to support national objectives.

  • Related Functions

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.


Banker to banks: maintains banking accounts of all scheduled banks.


The above objectives are carried out through the following channels or ways of monetary management


CHANNELS OF MANAGEMENT:

  • There are four main ‘channels’, which the RBI looks at:
  • Quantum channel: money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
  • Interest rate channel.
  • Exchange rate channel (linked to the currency).
  • The above policy instruments in turn impact the  “Asset price” in the economy.  
  • In the following discussions we will discuss what are the different instruments instruments under quantum channel and interest rate channel used by the RBI for monetary management. They form the key components of the monetary policy.

INFLATION, INTEREST RATES AND THE RBI

Interest rates measure the price of borrowing money. If a business wants to borrow Rs 1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time. For example, if the bank loaned the money to the company at a 5% annual rate, the company would need to repay Rs 1,050,000 at the end of the year. From the company's perspective, the value of that Rs 1,000,000 right now is greater than the Rs 1,050,000 in a year (presumably because they have plans for the money), which is why they want to borrow it. For the bank, it is earning a 5% return on a one-year investment. Generally, there are two types of interest rates: floating and fixed.


RELEVANCE OF MONETARY AND CREDIT POLICY

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. However, with the share of credit to agriculture coming down and credit towards the industry being granted whole year around, the RBI since 1998-99 has moved in for just one policy in April-end. However a review of the policy does take place later in the year.


The monetary and credit policy is half yearly affair of the Reserve Bank of Traditionally, RBI, in this monetary and credit policy, announces structural and monetary measures to improve the functioning of the banking system and also functioning of the economy as whole. There are some key set of indicators to ensure stability in the economy. These include money supply, interest rates, inflation, amongst others. The RBI uses various tools to regulate or influence these indicators. The policy also provides a platform for the RBI to announce norms for financial entities including banks, financial institutions (FIs), non-banking financial companies (NFBCs), nidhis, primary dealers (PDs) in the money market, authorized dealers in the foreign exchange markets, which are regulated by the apex bank.


The monetary authority uses various instruments to control the supply of money. These instruments are known as instruments of credit control. These instruments can be divided into two categories; quantitative and qualitative credit control, viz, bank rate policy, open market operation and changes in statutory reserve requirements. These methods are used to control the quantum methods of credit control are also known as selective credit control methods. These include credit rationing, direct action, changes in margin requirements moral suasion etc.


The credit policy gives indication about the economy and the banking system in the country and it also provides an opportunity for the RBI to spell out on overview one the economy. The RBI now prefers to announce monetary measures as and when the situation demands.


IMPACT ON THE INDIVIDUAL:

In recent years, the policy had gained in importance due to announcements in the interest rates. A reduction in interest rates would force banks to lower their lending rates and borrowing rates. So if you want to place a deposit with a bank or take a loan, it would offer it at a lower rate of interest. On the other hand, if there were to be an increase in interest rates, banks would immediately increase their lending and borrowing rates. Since the rates of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very important to them also. Earlier, depending on the rates announced by the RBI, the interest costs of banks would immediately either increase or decrease. . Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario. This means that banks are free to decide on interest rates on term deposits and loans. Being the central bank, however, the RBI would have a say and determine direction on interest rates, as it is an important tool to control inflation. The bank rate is a tool used by RBI for this purpose as it refinances banks at this rate. In other words, the bank rate is the rate at which banks borrow from the RBI.


RBI’S CONDUCT OF MONETARY POLICY:

The RBI uses the interest rate, OMO, changes in banks' CRR and primary placements of government debt to control the money supply. OMO, primary placements and changes in the CRR are the most popular instruments used.


OPEN MARKET OPERATIONS (OMO)

Under the OMO, the RBI buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system.


Primary deals in government bonds are a method to intervene directly in markets, followed by the RBI. By directly buying new bonds from the government at lower than market rates, the RBI tries to limit the rise in interest rates that higher government borrowings would lead to.


CRR Cash Reserve Ratio

All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The changes in CRR affect the amount of free cash that banks can use to lend - reducing the amount of money for lending cuts into overall liquidity, driving interest rates up, lowering inflation and sucking money out of markets. The CRR is the proportion of their deposits, which banks have to keep with the RBI. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system, which reduces demand in the economy and therefore helps curb inflation.


Bank Rate

  • Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate.
  • Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect credit creation by banks through altering the cost of credit.
  • Prime lending rate:  The rate at which banks lend to their best customers.

Money Supply

The RBI has adopted four concepts of measuring money supply. The first one is M1, which equals the sum of currency with the public, demand deposits with the public and other deposits with the public. Simply put M1 includes all coins and notes in circulation, and personal current accounts.


The second, M2, is a measure of money, supply, including M1, plus personal deposit accounts - plus government deposits and deposits in currencies other than rupee.

The third concept M3 or the broad money concept, as it is also known, is quite popular. M3 includes net time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.


Statutory Liquidity Ratio

Banks in India are required to maintain part of their (around 25 per cent) of their demand and time liabilities in government securities and certain approved securities.


LAF (THE LIQUIDITY ADJUSTMENT FACILITY)

The LAF can be thought of as a way for the RBI to lend and borrow to banks for very short periods, typically just a day. The repo rate is the RBI's lending rate and reverse repo rate is the RBI's borrowing rate. These two rates help the RBI influence short-term interest rates in the rest of the financial system.


Repo (Repurchase) Rate:

The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. An increase in the repo rate means banks get money at a higher rate than earlier and vice versa. The repo rate in India is similar to the discount rate in the US.


Reverse Repo rate:

Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.


Relationship between Monetary Policy and Inflation.

In general it is perceived that prices rise when more money chases few goods. Thus one of the key tasks in controlling the inflation rate is to control the excessive money supply in the economy.


The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is about more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy - whether it is 1%, 10% or 100%.


Inflation is usually generated by an excess of demand over supply. To contain inflationary pressures in the economy, demand needs to grow roughly in line with output. Output grows over time at a rate which largely depends on factors which increase productivity. If demand grows faster than this, unless there is spare capacity in the economy - such as after a recession - inflation is likely to rise.


One of the underlying causes of inflation is the level of monetary demand in the economy - how much money is being spent. One can understand this by considering what happens when the prices of some products are rising.  If consumers want to buy the same amount of all goods and services as before, they will now have to spend more - because the price of one of the products they consume has risen. This will only be possible if their incomes are rising, or alternatively if consumers are prepared to spend a bigger proportion of their incomes and save less. But if total spending does not rise, then higher prices will mean consumers either will have to buy fewer goods and services. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes and spending are also rising.


ORGANISATION STRUCTURE OF RBI


CONTEXT 1:


SBI chairman sticks to his guns, wants debate on CRR(Cash Reserve Ratio).


ANALYSIS


THE CRR  DEBATE:

State Bank of India (SBI) Chairman Pratip Chaudhuri has publicly joined issue with the banking regulator, the Reserve Bank of India (RBI). Mr Chaudhuri questioned the central bank’s practice of levying a cash reserve ratio, or CRR, by which a portion of bank deposits is impounded by the central bank, thus making credit both dearer and more scarce.


AGAINST CRR

  • The debate has received support from  eminent bankers and economists due to the following reasons

  • For banks, CRR hurts: they earn nothing off it, turning the item on their balance sheets into, effectively, a non-performing asset (NPA).

  • Another view is  that liquidity can be managed through the central banks’ open market operations, and the liquidity management process through CRR can be done away with.

  • Some experts question whether CRR serves really the purpose. According to them if the purpose of CRR is to  prevent banks from becoming insolvent that can be done by SLR. The SLR requirement in inida is  around 23%, which banks can't give as collateral to raise any loan. According to some experts,  at present  around Rs 17.4 lakh crore is locked up in these two provisions (CRR,SLR) in the  banking system as a whole. So critics question whether  so much required in a system where 75% of the banking industry is still owned by the state. According to the experts, lowering of these reserve requirements theoretically would release that much funds for private entrepreneurship, bringing down the cost of funds in general.

  • The RBI had set out to achieve 3% CRR as medium-term goal, but reversed midway to use it as a tool to fight liquidity and inflation.It is also equipped with a legal provision not to pay interest rates, which many bankers call the biggest non-performing asset.More than Rs 2.5 lakh crore is with RBI without interest, while banks pay an estimated Rs 20,000-crore interest.

  • Some economist feel that  distinction can be drawn between monetary policy and managing liquidity.

Therefore, continuance of CRR, more so without any interest payout, has lost all purpose. Much of a bank’s manpower and top management time is spent maintaining CRR on a daily basis, and this is avoidable. Banks are customers to RBI, as far as maintenance of cash balances with the central bank is concerned. Their demand from the RBI is akin to a bank demanding cash margin from a borrower, and paying interest on the cash margin.Therefore, the RBI cannot justifiably refuse to pay interest on CRR balances to its customer banks when it is earning around Rs 12,000 crore surplus every year.


According to  C. Rangarajan, Chairman, Economic Advisory Council to the Prime Minister,the country needs to move towards a situation where Cash Reserve Ratio (CRR) level comes down and that it is used as an instrument of “credit control” only in extraordinary conditions According to him as “Open market operations (OMOs) became increasingly major instrument,the role of CRR, as credit control, will come down” .


FOR CRR

CRR is a time-honoured instrument in the hands of a central bank to administer and calibrate monetary policy Formulating as well as implementing monetary policy to create a conducive and stable environment for growth and development is the primary mandate of a central bank in a developing economy. In mature economies, which are already developed, the overriding aim of monetary policy is seen to be to manage inflation.

According to some experts, the arguments as put forth above for CRR merit serious consideration and concern in the present environment when uncertainty and financial volatility have been further threatening global financial markets.With rising non-performing assets of commercial banks, large public borrowings, inflation, worsening of the current account and indifferent foreign financial inflows, the Indian economy is under threat of financial turmoil. In such an atmosphere, mandatory CRR as an instrument of monetary policy cannot be abolished as it has to provide financial strength to the banking system.


Cash Reserve Ratio and Interest Rates

(Per cent per annum)


Cash Reserve Ratio relates to Scheduled Commercial Banks (excluding Regional Rural Banks). (2) Base Rate relates to five major banks since July 1, 2010. (3) Term Deposit Rate relates to five major banks for deposits of more than one year maturity. (4) Saving Deposit Rate relates to five major banks. (5) Data covers 90-95 per cent of total transactions reported by participants.Call Money Rate(Weighted Average) is volume-weighted average of daily call money rates for the week(Saturday to Friday).


Source: Reserve Bank of India


CONTEXT 2:


Bernanke Meets India Central Bank Officials (October, 2012)


US Treasury Secretary Timothy Geithner and Federal Reserve chairman Ben Bernanke came on  a two-day visit to India.


Analysis 

The visit of two of the topmost financial administrators of the US, who  held a series of meetings with top Indian policy makers in Delhi and Mumbai, comes amid a flurry of reformist moves by the UPA government over the last few weeks.


U.S. Federal Reserve Chairman Ben Bernanke, said he has discussed several key issues--including monetary and regulatory policies, banking and the state of the global economy--with officials from the country's central bank.


"India is clearly becoming a more and more important player on the world stage... it is very useful for us to exchange ideas and to build the basis for future collaboration and coordination," said Mr. Bernanke, the first serving Fed chairman to visit the Reserve Bank of India.


The Federal Reserve System

The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.


The Federal Reserve’s duties fall into four general areas:

  • Conducting the nation’s monetary policy by inf luencing the monetary and credit conditions in the economy in pursuit of maximum employ­ment, stable prices, and moderate long-term interest rates

  • Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

  • maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

  • Providing financial services to depository institutions, the U.S. gov­ernment, and foreign official institutions, including playing a major role in operating the nation’s payments system

Background

During the nineteenth century and the beginning of the twentieth cen­tury, financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy. The failure of the U.S banking system to effectively provide funding to troubled depository institutions contributed significantly to the economy’s vulner­ability to financial panics. Short-term credit is an important source of liquidity when a bank experiences unexpected and widespread withdraw­als during a financial panic. A particularly severe crisis in 1907 prompted Congress to establish the National Monetary Commission, which put forth proposals to create an institution that would help prevent and con­tain financial disruptions of this kind. After considerable debate, Congress passed the Federal Reserve Act “to  provide for the establishment of Federal reserve banks, to furnish an elastic cur­rency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” President Woodrow Wilson signed the act into law on December 23, 1913.


Soon after the creation of the Federal Reserve, it became clear that the act had broader implications for national economic and financial policy. As time has passed, further legislation has clarified and supplemented the origi­nal purposes. Key laws affecting the Federal Reserve have been the Bank­ing Act of 1935; the Employment Act of 1946; the Bank Holding Company Act of 1956 and the amendments of 1970; the International Banking Act of 1978; the Full Employment and Bal­anced Growth Act of 1978; the De­pository Institutions Deregulation and Monetary Control Act of 1980; the Financial Institutions Reform, Recov­ery, and Enforcement Act of 1989; the Federal Deposit Insurance Corpora­tion Improvement Act of 1991; and the Gramm-Leach-Bliley Act of 1999.


Congress has also adopted legislation defining the primary objectives of na­tional economic policy, including the Employment Act of 1946; the Fed­eral Reserve Reform Act of 1977; and the Full Employment and Balanced Growth Act of 1978, which is sometimes called the Humphrey-Hawkins Act, after its original sponsors. These objectives include economic growth in line with the economy’s potential to expand; a high level of employ­ment; stable prices (that is, stability in the purchasing power of the dollar); and moderate long-term interest rates.

The Federal Reserve System is considered to be an independent central bank because its decisions do not have to be ratified by the President or  anyone else in the executive branch of government. The System is, how­ever, subject to oversight by the U.S. Congress. The Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government; therefore, the description of the System as “independent within the government” is more accurate.


Structure of the System

Congress designed the structure of the Federal Reserve System to give it a broad perspective on the economy and on economic activity in all parts of the nation. It is a federal system, composed of a central, governmental agency—the Board of Governors—in Washington, D.C., and twelve re­gional Federal Reserve Banks. The Board and the Reserve Banks share responsibility for supervising and regulating certain financial institutions and activities, for providing banking services to depository institutions and the federal government, and for ensuring that consumers receive adequate information and fair treatment in their business with the banking system.


A major component of the System is the Federal Open Market Committee (FOMC), which is made up of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis. The FOMC oversees open market operations, which is the main tool used by the Federal Reserve to inf luence overall monetary and credit conditions.


The Federal Reserve implements monetary policy through its control over the federal funds rate—the rate at which depository institutions trade bal­ances at the Federal Reserve. It exercises this control by inf luencing the demand for and supply of these balances through the following means:

  • Open market operations—the purchase or sale of securities, primarily
  • U.S. Treasury securities, in the open market to inf luence the level of balances that depository institutions hold at the Federal Reserve Banks
  • Reserve requirements—requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank
  • Contractual clearing balances—an amount that a depository institu­tion agrees to hold at its Federal Reserve Bank in addition to any required reserve balance
  • Discount window lending—extensions of credit to depository in­stitutions made through the primary, secondary, or seasonal lending programs

Two other groups play roles in the functioning of the Federal Reserve Sys-tem: depository institutions, through which monetary policy operates, and advisory committees, which make recommendations to the Board of Gov­ernors and to the Reserve Banks regarding the System’s responsibilities.




Advisory Committees

The Federal Reserve Banks also use advisory committees. Of these advi­sory committees, perhaps the most important are the committees (one for each Reserve Bank) that advise the Banks on matters of agriculture, small business, and labor. Biannually, the Board solicits the views of each of these committees by mail.


The Federal Reserve System uses advisory committees in carrying out its varied responsibilities. Three of these committees advise the Board of Governors directly:


  • Federal Advisory Council. This council, which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Board’s jurisdiction. It ordinarily meets four times a year, as required by the Federal Reserve Act. These meetings are held in Washington, D.C., customarily on the first Friday of February, May, September, and December, although occasionally the meetings are set for different times to suit the convenience of either the council or the Board. Annually, each Reserve Bank chooses one person to represent its District on the Federal Advisory Committee, and members customarily serve three one-year terms and elect their own officers.

  • Consumer Advisory Council. This council, established in 1976, advises the Board on the exercise of its responsibilities under the Consumer Credit Protection Act and on other matters in the area of consumer financial services. The council’s membership represents the interests of consumers, communities, and the financial services industry. Members are appointed by the Board of Governors and serve staggered three-year terms. The council meets three times a year in Washington, D.C., and the meetings are open to the public.

  • Thrift Institutions Advisory Council. After the passage of the Deposi­tory Institutions Deregulation and Monetary Control Act of 1980, which extended to thrift institutions the Federal Reserve’s reserve requirements and access to the discount window, the Board of Gov­ernors established this council to obtain information and views on the special needs and problems of thrift institutions. Unlike the Federal Advisory Council and the Consumer Advisory Council, the Thrift Institutions Advisory Council is not a statutorily mandated body, but it performs a comparable function in providing firsthand advice from representatives of institutions that have an important relationship with the Federal Reserve. The council meets with the Board in Washing­ton, D.C., three times a year. The members are representatives from savings and loan institutions, mutual savings banks, and credit unions. Members are appointed by the Board of Governors and generally serve for two years.

The Board of Governors of the Federal Reserve System


Appointments to the Board

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman, for four-year terms.


ORGANISATION STRUCTURE OF FEDERAL RESERVE SYSTEM


CONTEXT 3:


The recent Monetary Policy (October 2012)

The Reserve Bank of India (RBI) recent monetary policy  left the key policy rate unchanged at eight per cent, defying pressure from the finance ministry to lower rates. The central bank, however, cut the cash reserve ratio (CRR), the portion of deposits banks have to maintain with it, to 4.25 per cent, freeing up Rs 17,500 crore of additional funds.


Analysis:


RECENT  POLICY HIGHLIGHTS

Some of the key highlights include

  • CRR cut by 25 bps to 4.25%, effective the fortnight beginning Nov 3, to keep liquidity comfortable and support growth
  • No change in repo rate to anchor medium-term inflation expectations
  • Bank rate stands unchanged at 9%
  • GDP growth projection for 2012-13 revised down-wards to 5.8%from 6.5% in July
  • WPI inflation projection for March 2013 raised to 7.5% from 7%indicated in July
  • Provisioning on restructured standard assets increased by 75bps

To Quote:

In his second quarter monetary policy announcement, RBI Governor D Subbarao offered a ray of hope to the ministry and a disappointed corporate India by saying there was “reasonable likelihood” of policy easing early next year. Finance Minister P Chidambaram didn’t make any effort to hide his disappointment with the central bank’s decision to hold its ground by maintaining its anti-inflationary stance. He told reporters after the policy announcement that growth was as much a challenge as containing inflation and the government would “walk alone” to face the challenge if it came to that. “Sometimes it is best to speak, sometimes it is best to remain silent. This is the time for silence,” the minister said.During his post-policy media briefing, Subbarao, however, sought to play down the face-off and said, “Both the government and RBI share concerns on growth and inflation. We are as concerned about growth as we are concerned about inflation, only our balance will be shifting.”Justifying his decision to hold rates, Subbarao said during tight liquidity conditions, a rate cut might not inspire banks to lower lending rates. “We were very conscious of the fact that a rate cut will not help if liquidity is tight. Conversely, even if we are comfortable with liquidity, it will not help if rates are high. Hence, we had to carefully calibrate between the repo rate and the cash reserve ratio,” Subbarao said.


A basic understanding of economic theory and its impact and the working of real economy would reveal that both the finance minister and the RBI governor are true from their own perspective considering the fact that  there is a complex linkage of interest rate,inflation,growth rate and unemployment.


Let us understand the Inflation growth relationship


Inflation Vs Growth

We know Inflation is: the rate at which the general level of prices for goods & services soar which means the purchasing power of the people in the  country gets affected. Generally, a country tries to maintain single digit inflation rate. To control inflation, the central bank does tighten the monetary policy e.g. increase in the interest rate. An increase in the interest rate has a side effect of curtailing the investment & employment leading to a decline in growth. The policy debate  of choice between between Inflation & Growth  is not new. According to  one school of thought, higher interest rates contain inflation & another school of thought  lower interest rates lead to better growth.


Now let us see the relationship between Interest rates, inflation  and Unemployment in an economy


Interest rates, Inflation and Unemployment


Interest rates, and Unemployment

Let us see  how it works in the real world. Companies do not keep enough money on hand to fund all the projects they want to do, so they have to borrow the money from a bank or other institution to finance it. Before the company starts, it predicts how much money it will make from the project. Then it compares this to the amount it will have to pay to borrow for the project, and if this is less than the amount they will earn, the company proceeds with the project.


Eventhough companies do  work out the time value of money when they start a project (time value of money-  that money you make in the future is worth less than money you have today). Companies will theoretically keep borrowing money and starting projects as long as they can find good returns economic sense.  Thus iif the interest rates are low, there are more available projects, more economic actuivity and so more people get hired to work on them, and more employment. 


  • In a volatile situate in like the present situation across the world where there has been a slowdown combine with soaring prices and rising interest rates the whole  process discussed above works in reverse where the cost of running projects escalates there by affecting their profits and thus recruitments and  employment prospects in the economy. Also,
  • at a high interest rate, there are fewer projects that get funded, and so fewer people are employed.

Inflation and Unemployment

Inflation is the gradual increase in the price of goods and services. When there is too much spending occurring in the economy, inflation occurs. To reduce the inflation rate, the reserve/federal bank increases the cash rate or interest rate. This allows consumers to use their money to pay off mortgages or whatever, which lowers the amount of spending happening on goods and services. So naturally, the inflation rate comes down. 


But there is another aspect  to this scenario.In the case of unemployment, if it is low, more people have more to spend, which increases inflation. Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects. When growth is low, naturally unemployment would be high, This is why government intervention is needed, to avoid problems like stagflation.


According to some experts part  of the Indian industry has been going through a painful phase of high interest rates, declining demand and insufficient availability of working capital. This along with the prevalence of inflation to a large extent impacts the industry. The industry is not able to pass on even the cost due to inflationary impact. Thus the profitability of industry is under stress. According to experts, this requires to be addressed by encouraging investments in the supply side infrastructure, rather than squeezing the investment demand with unaffordable interest rates.


There is also the long running theoretical debate that, higher interest rates can lead to unemployment. This is explained by the well known Phillips curve


Phillips curve

In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation. According to some economists,while it has been observed that there is a stable short run tradeoff between unemployment and inflation, this has not been observed in the long run.




William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow took Phillips' work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.In the 1920s an American economist Irving Fisher noted this kind of Phillips curve relationship. Eventhough many economists do not agree with the  use the Phillips curve in its original form, modified forms of the Phillips Curve that take inflationary expectations into account remain influential in the economic literature. The theory goes under several names, with some variation in its details, but all modern versions distinguish between short-run and long-run effects on unemployment.


Prof. M. Guruprasad, AICAR BUSINESS SCHOOL


SOURCE:

RESERVE BANK OF INDIA

FEDERAL RESERVE SYSTEM U.S

TIMES OF INDIA


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