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TOPICS

  • What is Monetary Policy
  • Objectives of Monetary Policy
  • Monetry policy committee
  • Monetory policy process
  • Instruments of Monetory Policy
  • Importance of Monetory Policy

WHAT IS MONETARY POLICY

Monetary policy refers to the policy of the central bank – ie Reserve Bank of India – in matters of interest rates, money supply and availability of credit.

OBJECTIVES OF MONETARY POLICY

It is designed to maintain the price stability in the economy. Other objectives of the monetary policy of India, as stated by RBI, are:

Price stability

Price stability implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability.

Controlled expansion of bank credit

One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output.

Promotion of fixed investment

The aim here is to increase the productivity of investment by restraining non essential fixed investment.

Restriction of inventories and stocks

Overfilling of stocks and products becoming outdated due to excess of stock often results in sickness of the unit. To avoid this problem, the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle money in the organisation.

Promoting efficiency

It tries to increase the efficiency in the financial system and tries to incorporate structural changes such as deregulating interest rates, easing operational constraints in the credit delivery system, introducing new money market instruments, etc.

Reducing rigidity

RBI tries to bring about flexibilities in operations which provide a considerable autonomy. It encourages more competitive environment and diversification. It maintains its control over financial system whenever and wherever necessary to maintain the discipline and prudence in operations of the financial system.

MONETORY POLICY PROCESS

The Monetary Policy Committee (MPC) determines the policy interest rate required to achieve the inflation target.

The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy and analytical work of the Reserve Bank contribute to the process of arriving at the decision on the policy repo rate.

The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through day-to-day liquidity management operations.

MONETORY POLICY COMMITTEE

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to provide for a statutory and institutionalized framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth. The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.

The Government of India, in consultation with RBI, notified the ‘Inflation Target’ in the Gazette of India dated 5 August 2016 for the period beginning from the date of publication of the notification and ending on March 31, 2021, as 4%. At the same time, lower and upper tolerance levels were notified to be 2% and 6% respectively.

The Central Government in September 2016 constituted the present MPC as under:

  • Governor of the Reserve Bank of India – Chairperson, ex officio;
  • Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex officio;
  • One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio;
  • Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member;
  • Professor Pami Dua, Director, Delhi School of Economics – Member; and
  • Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad – Member.(Members referred to at 4 to 6 above, will hold office for a period of four years or until further orders, whichever is earlier.

INSTRUMENTS OF MONETARY POLICY

The instruments of monetary policy are of two types:

1. Quantitative, general or indirect (CRR, SLR, Open Market Operations, Bank Rate, Repo Rate, Reverse Repo Rate)

2. Qualitative, selective or direct (change in the margin money, direct action, moral suasion)

These both methods affect the level of aggregate demand through the supply of money, cost of money and availability of credit. Of the two types of instruments, the first category includes bank rate variations, open market operations and changing reserve requirements (cash reserve ratio, statutory reserve ratio).

Policy instruments are meant to regulate the overall level of credit in the economy through commercial banks. The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit.

Reserve Requirement:

The Central Bank may require Deposit Money Banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money. The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public.

Open Market Operations:

The Central Bank buys or sells (on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money. Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base.

Cash reserve ratio (CRR)

Cash reserve ratio is a certain percentage of bank deposits which banks are required to keep with RBI in the form of reserves or balances. The higher the CRR with the RBI, the lower will be the liquidity in the system, and vice versa. RBI is empowered to vary CRR between 15 percent and 3 percent. Per the suggestion by the Narasimham Committee report, the CRR was reduced from 15% in 1990 to 5 percent in 200

Statutory liquidity ratio (SLR)

Every financial institution has to maintain a certain quantity of liquid assets with themselves at any point of time of their total time and demand liabilities. These assets have to be kept in non cash form such as G-secs precious metals, approved securities like bonds. The ratio of the liquid assets to time and demand liabilities is termed as the Statutory liquidity ratio. There was a reduction of SLR from 38.5% to 25% because of the suggestion by Narsimham Committee.

Bank rate policy

The bank rate, also known as the discount rate, is the rate of interest charged by the RBI for providing funds or loans to the banking system. This banking system involves commercial and co-operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other approved financial institutions. Funds are provided either through lending directly or discounting or buying money market instruments like commercial bills and treasury bills. Increase in bank rate increases the cost of borrowing by commercial banks which results in the reduction in credit volume to the banks and hence the supply of money declines. Increase in the bank rate is the symbol of tightening of RBI monetary policy. As of 9th October 2020, the bank rate is 4.25 percent

Interest Rate:

The Central Bank lends to financially sound Deposit Money Banks at a most favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP).

Direct Credit Control:

The Central Bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions.

Moral Suasion:

The Central Bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment.

Prudential Guidelines:

The Central Bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized. Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making.

Exchange Rate:

The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real exchange rate. The real exchange rate when misaligned affects the current account balance because of its impact on external competitiveness. Moral suasion and prudential guidelines are direct supervision or qualitative instruments. The others are quantitative instruments because they have numerical benchmarks.

Repo rate and reverse repo rateRepo rate

Repo rate and reverse repo rateRepo rate is the rate at which RBI lends to its clients generally against government securities. Reduction in repo rate helps the commercial banks to get money at a cheaper rate and increase in repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. The reverse repo rate is the rate at which RBI borrows money from the commercial banks. The increase in the repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation. This increase in repo rate and reverse repo rate is a symbol of tightening of the policy.

IMPORTANCE OF MONETORY POLICY

  • The growing importance of monetary policy in the management of the economy during the era of globalization in a fact.. Generally, (democratically elected governments resist to use fiscal policy to fight inflation as it requires government to take unpopular actions like reducing spending or raising taxes). The option of cutting indirect taxes is a limited one and is used rarely as it was done in 2009. Political realities favor a bigger role for monetary policy during times of inflation and deflation/disinflation (deflation is drop in prices and disinflation is drop in the rate of growth of prices).

  • Fiscal policy may be more suited to fighting unemployment as the government can step up spending to create public works and in the process jobs; while monetary policy may be more effective in fighting inflation/deflation. There is a limit to how much monetary policy can do the help the economy during a period of severe economic crisis.

  • Monetary policy has grown from simply increasing the money supply to keep up with both population growth and economic activity. It must now take into account such diverse factors as:

    • Signals to the economy by way of rate and reserve adjustment
    • exchange rates;
    • credit quality;
    • international capital flows of money on large scales;

  • With globalization and the increase in the flow of funds- highly speculative in character, monetary policy acquires unprecedented importance for the country. The following will illustrate the point further that globalization challenges monetary policy:

  • Management of the exchange is a crucial part of the monetary policy as exchange rate holds the key to many important macroeconomic goals and dictates foreign flows-inflows and outflows. It has a close bearing on money supply and inflation and interest rates. For instance, if foreign flood the country, in order to maintain its monetary stability, RBI has buy the foreign currency to save the rupee from excessive appreciation. The rupee that is printed has to be sucked out with Government securities as otherwise it will be inflationary.

  • (The Market Stabilization Bond Scheme in India was started as a sterilization attempt in 2004). Under the MSS, RBI generates government securities to sterilize excess liquidity in the market to prevent inflation). Such sterilization can be expensive as the money so sucked out costs by way of the interest paid on it. Thus, the purpose of stemming rupee appreciation leads to excess of money supply which could inflate the economy unless sterilized with the direct intervention (selling MSBs) which is a costly process. Hike in interest rates and CRR may also become necessary- it hurts growth even as it reduces inflation. The latter was seen in India in the 2006-08 period.

  • After the 2008 global financial crisis, monetary policy faces another challenge- financial stability as banks go bankrupt and other financial institutions are destabilized.Thus, monetary policy acquires enormous importance during globalization.

  • Market Stabilization Bonds  In 2004, RBI began floating Government securities and T-Bills, as a part of the Market Stabilization Scheme, to absorb excess liquidity from the market. The excess liquidity is the result of RBI buying dollars from the market. MSS is a sterilization effort of the central bank. The normally available government securities are not enough for the RBI to suck out the huge rupee supply (printed money called base money or reserve money or high powered money) that was caused for buying dollar. Therefore, the MSS was started.

 

 

Monetary policy refers to the use of monetary instruments under the control of the central bank to regulate magnitudes such as interest rates, money supply and availability of credit with a view to achieving the ultimate objective of economic policy. To read more articles on economics click here