Monetary policy is a policy formulated by the central bank, i.e., RBI (Reserve Bank of India) and relates to the monetary matters of the country. The policy involves measures taken for regulating the money supply, availability and cost of credit in the economy. The policy also oversees distribution of credit among users as well as borrowing and lending rates of interest. In a developing country like India, it is significant in the promotion of economic growth.
The various instruments of monetary policy include variations in bank rates, other interest rates, selective credit controls, supply of currency, variations in reserve requirements and open market operations.
|Reverse repo rate||6.25%|
|Marginal Standing facility rate||6.75%|
Objectives of Monetary Policy
While the main objective of monetary policy is economic growth as well as price and exchange rate stability, there are other aspects that it can help with as well.
- Promotion of saving and investment: Since the monetary policy controls the rate of interest and inflation within the country, it can impact the savings and investment of the people. A higher rate of interest translates to a greater chance of investment and savings, thereby, maintaining a healthy cash flow within the economy.
- Controlling the imports and exports: By helping industries secure a loan at a reduced rate of interest, monetary policy helps export-oriented units to substitute imports and increase exports. This, in turn, helps improve the condition of the balance of payments.
- Managing business cycles: The two main stages of a business cycle are boom and depression. Monetary policy is the greatest tool using which boom and depression of business cycles can be controlled by managing the credit to control the supply of money. The inflation in the market can be controlled by reducing the supply of money. On the other hand, when the money supply increases, the demand in the economy will also witness a rise.
- Regulation of aggregate demand: Since monetary policy can control the demand in an economy, it can be used by monetary authorities to maintain a balance between demand and supply of goods and services. When credit is expanded and the rate of interest is reduced, it allows more people to secure loans for the purchase of goods and services. This leads to the rise in demand. On the other hand, when the authorities wish to reduce demand, they can reduce credit and raise the interest rates.
- Generation of employment: As monetary policy can reduce the interest rate, small and medium enterprises (SMEs) can easily secure a loan for business expansion. This can lead to greater employment opportunities.
- Helping with the development of infrastructure: The monetary policy allows concessional funding for the development of infrastructure within the country.
- Allocating more credit for the priority segments: Under the monetary policy, additional funds are allocated at lower rates of interest for the development of the priority sectors such as small-scale industries, agriculture, underdeveloped sections of the society, etc.
- Managing and developing the banking sector: The entire banking industry is managed by the Reserve Bank of India (RBI). While RBI aims to make banking facilities available far and wide across the nation, it also instructs other banks using the monetary policy to establish rural branches wherever necessary for agricultural development. Additionally, the government has also set up regional rural banks and cooperative banks to help farmers receive the financial aid they require in no time.
Flexible Inflation Targeting Framework (FITF)
The Flexible Inflation Targeting Framework (FITF) was introduced in India post the amendment of the Reserve Bank of India (RBI) Act, 1934 in 2016. In accordance with the RBI Act, the Government of India sets the inflation target every 5 years after consultation with the RBI. While the inflation target for the period between 5 August 2016 and 31 March 2021 has been determined to be 4% of the Consumer Price Index (CPI), the Central Government has announced that the upper tolerance limit for the same will be 6% and the lower tolerance limit can be 2% for the same.
In this framework, there are chances of not achieving the inflation target fixed for a particular amount of time. This can happen when:
- The average inflation is greater than the upper tolerance level of the inflation target as predetermined by the Central Government for 3 quarters in a row.
- The average inflation is less than the lower tolerance level of the target inflation fixed by the Central Government beforehand for 3 consecutive quarters.
Monetary Policy Tools
To control inflation, the Reserve Bank of India needs to decrease the supply of money or increase cost of fund in order to keep the demand of goods and services in control.
Quantitative tools –
The tools applied by the policy that impact money supply in the entire economy, including sectors such as manufacturing, agriculture, automobile, housing, etc.
Banks are required to keep aside a set percentage of cash reserves or RBI approved assets. Reserve ratio is of two types:
Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the RBI. The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR.
Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid assets such as gold or RBI approved securities such as government securities. Banks are allowed to earn interest on these securities, however it is very low.
Open Market Operations (OMO):
In order to control money supply, RBI buys and sells government securities in the open market. These operations conducted by the Central Bank in the open market are referred to as Open Market Operations.
When RBI sells government securities, the liquidity is sucked from the market, and the exact opposite happens when RBI buys securities. The latter is done to control inflation. The objective of OMOs are to keep a check on temporary liquidity mismatches in the market, owing to foreign capital flow.
Unlike quantitative tools which have a direct effect on the entire economy’s money supply, qualitative tools are selective tools that have an effect in the money supply of a specific sector of the economy.
- Margin requirements – RBI prescribes a certain margin against collateral, which in turn impacts the borrowing habit of customers. When the margin requirements are raised by the RBI, customers will be able to borrow less.
- Moral suasion – By way of persuasion, RBI convinces banks to keep money in government securities, rather than certain sectors.
- Selective credit control – Controlling credit by not lending to selective industries or speculative businesses.
Market Stabilisation Scheme (MSS) -
- Bank rate – The interest rate at which RBI lends long term funds to banks is referred to as the bank rate. However, presently RBI does not entirely control money supply via the bank rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant tools to establish control over money supply.
Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed SLR or CRR.
- Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity and money supply. The following types of LAF are:
- Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-term basis against a repurchase agreement. Under this policy, banks are required to provide government securities as collateral and later buy them back after a pre-defined time.
- Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in order to keep additional funds in RBI. It is linked to repo rate in the following way:
Reverse Repo Rate = Repo Rate – 1
- Marginal Standing Facility (MSF) Rate: MSF Rate is the penal rate at which the Central Bank lends money to banks, over the rate available under the rep policy. Banks availing MSF Rate can use a maximum of 1% of SLR securities.
MSF Rate = Repo Rate + 1
Monetary Policy Transmission
Borrowers fail to fully benefit from RBI’s repo rate cut due to the following reasons:
- Banks are not affected by RBI rate cuts as the Central Bank is not their primary money supplier.
- Deposits already made are fixed at the rates when taken and cannot be reduced; the rate cuts will only reflect in the new deposit rates.
- PPF, Post Office accounts and other small saving instruments are available at high administered interest rates and in case of reduction of bank deposit rates, customers have the choice to move to those funds.
- Banks do not prefer to lower their rates as high lending rates keeps their profit margins up.
- India does not have a well-developed corporate bond market, therefore corporate customers have little choice but to reach out to banks for borrowing.
Steps to improve monetary transmission:
Both the government and RBI has taken and plans to take some steps in order to accelerate the transmission of monetary policy.
- Government intends to bring down the interest rates on small saving accounts. If the small saving rates are linked to the bank rate, this could serve as a permanent solution.
- In order to improve monetary transmission, RBI wants banks to change the calculation methodology of base rate to marginal cost of funds from average cost of funds.
Despite banks raising the lending rates immediately after RBI’s rate cuts, the Central Bank is unable to control inflation due to the following reasons:
- Financial deficit in the higher government.
- Issues at the supply side, such as crude oil prices, issues in agri marketing, etc.
- Lack of financial inclusion as borrowers still depend on moneylenders, who are not under RBI’s control.
- Non-monetised economy in certain rural areas.
Dear Money Policy or Contractionary Monetary Policy:
Dear money policy is a policy when money become more expensive with the rise of interest rate. Due to this, the supply of money also decreases in the economy, therefore it is also referred to as the contractionary monetary policy.
This policy leads to a drop in business expansions owing to a high cost of credit, as well as a fall in business expansion. This in turn affects employment as it brings down growth rates. Therefore, interest rate cuts such as SLR and CRR are preferred by the government and the corporates.
A policy set by the finance ministry that deals with matters related to government expenditure and revenues, is referred to as the fiscal policy. Revenue matter include matters such as raising of loans, tax policies, service charge, non-tax matters such as divestment, etc. While expenditure matters include salaries, pensions, subsidies, funds used for creating capital assets like bridges, roads, etc.
Demand Pull Inflation:
This is a state when people have excess money to buy goods in the market. RBI practises easier control on this as it can lead to a fall in money supply in the economy, which in turn would mean a drop in prices.
Supply Side Inflation:
Inflation in the economy owing to constraints in the supply side of goods in the market. This cannot be controlled by RBI as it does not control prices of commodities. The government plays an important role in this case through fiscal policy.
RBI has been following a neutral policy stance for some time now. This means that with inflation being at an all time low of 4.0%, and the growth projections of the Indian economy being at a constant 7.30%, the RBI will try not to destabilize the delicate balance, by either infusing or removing too much funds from the markets.
To this end, the Central Bank has increased the repo rate and reverse repo rate on 1 August 2018 by 25 basis points taking them to 6.50% and 6.25%, respectively. It has also increased the Bank Rate and MSF Rate to 6.75% each. This ensures that the government’s requirement for more liquidity for industry growth is fulfilled, without the risk of increase in inflation being too high.