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TOPICS

  • Monetry policy committee
  • Monetory policy process
  • Instruments of Monetory Policy
  • Importance of Monetory Policy

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.

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.

INSTRUMENTS OF MONETORY POLICY

  • Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).

  • Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.

  • Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of a range of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market-based benchmarks for pricing of loans and deposits, and hence improve the transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.

  • Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow an additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.

  • Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

  • Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.

  • Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such percentage of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.

  • Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid assets, such as unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.

  • Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.

  • Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through the sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.

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