What is Monetary Policy?

Monetary policy refers to a regulatory policy made by the central bank aiming at controlling the supply of money in the market to achieve desired objectives.

• Regulatory policy – binding
• controlling the supply of money  - Monetary management
• desired objectives- Inflation vs Growth

The RBI has followed the policy of controlled monetary expansion.

• Monetary functions of the RBI
• control and regulation of money and credit,
• control of foreign exchange operations
• acting as banker to the Government
• banker’s bank 
• lender of the last resort

Types of monetary policy

• Dear and Cheap money policy
• Expansionary and contractionary policy
• Easy and tight money policies

Objectives Of Monetary Policy

The preamble to the Reserve Bank of India Act, 1934 sets out the objectives of the Bank as “to regulate the issue of Bank notes and the 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”. Although there is no explicit mandate for price stability, as is the current trend in many countries, the objectives of monetary policy in India have evolved as those of maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. In essence, monetary policy aims to maintain a judicious balance between price stability and economic growth. The primary objective includes

Economic Growth

The main aim of monetary policy is to achieve growth with stability. In order to achieve the above aim, the Reserve Bank of India has played a significant role in the expansion of credit. It has followed a liberal policy to expand credit in the country to meet the financial need of the agricultural industry, transport, import, export, etc. R.B.I. has been liberal in respect of priority sectors, like small farmers, small industries and petty traders, etc. It has helped in the development of public sectors by giving discriminatory support to govt. securities. After Independence Monetary policy not only encouraged Investment for economic development but also increased the Rate of Interest to encourage saving.

Controlling Inflation

Price stability is to be maintained by the process of credit control keeping in view the production resources of the country. In a developing country like India problem of investment persists, due to constant increases in the volume of Investment with an increase in income and output, inflationary pressures are unavoidable.

To maintain the level of economic growth and price stability RBI make use of all those methods of credit control to strike a balance between inflation and investment rate.

Other aims

1. Reducing the impact of business cycles (slumps and booms) by manipulation of credit and Interest policy.
2. Stability of external value: Fluctuation in exchange rate of a currency affects foreign trade & Investment. It is therefore important that the rate of exchange is maintained without violent fluctuations.

Objectives - Generalized Approach

The main objectives of the recent monetary policy of RBI are as follows:

Controlling imports and exports 

Monetary policy helps industries to get a loan at a reduced interest rate, which means they can substitute imports with export-oriented units and, in turn, increase exports.

Promotion of savings and investments

A monetary policy can impact the savings and investments of the people. A higher rate of interest will result in greater investments and savings, thereby maintaining a healthy cash flow within the economy.

Managing business cycles

There are two main stages of a business cycle – boom and depression. The monetary policy is one of the most efficient financial tools that can help to control the boom and depression period of business cycles by managing credit distribution and supply of money in the economy.

Employment generation

A monetary policy can lead to reduced interest rates, which means small and medium enterprises (SMEs) can easily secure a loan for business expansion. This means more employment generation.

Development of infrastructure

The monetary policy by RBI allows concessional funding for the development of infrastructure within the country.

Developing and managing the banking sector

The central bank is responsible for managing the entire banking industry. RBI also instructs other banks using the monetary policy to establish rural branches for agricultural development wherever required. Additionally, the government has also set up cooperative and regional rural banks to help farmers receive the financial aid they require in no time.

Credit Controls – Monetary policy tools

Quantitative tools

Bank Rate

It is the rate at which the RBI rediscounts bills of exchange or other commercial papers.  Simply put, the banks rate is the rate at which the RBI extends credit to the commercial bank. No collateral is needed to borrow under the bank rate. The bank rate is also called the discount rate. Bank  Rate had a limited impact in the period before the economic reforms of (1991) when RBI determined the interest rate structure. However, with the delegating of this power to the commercial banks (except interest rate in priority sectors) the importance of the Bank Rate has been revived. It is subject to frequent variations, as the RBI uses changes in bank rate to regulate fluctuations in domestic inflation.

?Cash Reserve Ratio (CRR)

RBI Act 1934 stipulates that a commercial bank is required to keep in cash a portion of its demand and time liabilities with the RBI: this is known as Cash Reserve Ratio.  The RBI can vary this ratio between 3 and 15 percent.

Statutory Liquidity Ration (SLR)

The Statutory Liquidity Ratio specifies that a commercial bank invests a designated minimum proportion of its Net Demand and Time Liability (NDTL) in liquid assets, such as cash, gold, and unencumbered approved securities.  This is in addition to the cash reserve ratio. The SLR cannot be raised beyond 40%. In order to overcome this Narasimhan Committee recommended that SLR should be brought down to 25%.

Open Market Operations (OMO)

These involve the sale and purchase of government securities by the RBI, the rationale behind this operation being the stabilization of liquidity in the market. Sales have always been greater than the purchase. In the current monetary policy framework, with growing inter-linkages in the financial market, reliance on direct instruments has been reduced and liquidity management in the system is carried out through OMO in the form of outright purchases/sales of government securities under the Market Stabilization Scheme (MSS) and daily reverse repo and repo operations under Liquidity Adjustment Facility (LAF). The LAF has enabled the Reserve Bank to modulate short-term liquidity under varied financial market conditions, including large capital inflows from abroad. In addition, it has enabled the Reserve Bank to set a corridor for short-term interest rates consistent with the policy objectives.

Marginal standing facility

MSF rate is the rate at which only scheduled commercial banks borrow funds overnight from the Reserve Bank of India (RBI) against their excess SLR-based holdings. This came into effect in May 2011. Additionally, they can also avail funds on an overnight basis below the stipulated SLR up to 0.75% of their respective Net Demand and Time Liabilities (NDTL) outstanding at the end of the second preceding fortnight. 

Qualitative tools

These tools affect the money supply of a specific sector of the economy.

Margin requirements

The RBI mentions a certain margin against collateral. When the RBI raises the margin requirements, customers will be able to borrow less and vice-versa.

Selective credit control

Through this method, RBI avoids lending to speculative businesses or selective industries through discriminatory rates of interest or other means

Moral suasion

With the help of this tool, the central bank persuades other banks to keep money in government securities and not in any other sector.

Critical Rates (Dec. 2022)

• Repo Rate is the rate at which money is lent by the Reserve Bank of India to commercial bank under LAF on the other hand MSF is a rate at which RBI lends money only to scheduled banks. MSF banks are allowed to use the securities that come under the Statutory Liquidity Ratio in the process of reserve requirements.
• Marginal Standing Facility rate: Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short.
• Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements (reverse repo rate – 3.35%)  availing loans from RBI.

About Repo rate

• A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities.
• In the case of a repo, a dealer sells government securities to investors, and buys them back at a slightly higher price.
• They are also a common tool of central bank open market operations.
• For the party selling the security and agreeing to repurchase it in the future, it is a repo.
• for the party on the other end of the transaction, buying the security and agreeing to sell in the future, it is a reverse repurchase agreement.

Market Stabilization Scheme (MSS)

• Market Stabilization scheme or the MSS is the instrument used by the Reserve Bank of India(RBI) in times of excess liquidity.
• The scheme was brought into operation in the year 2004 to control the surge of US dollars in the Indian market.
• The RBI uses this technique to repair the excess liquidity prevailing in the market due to the issuance of securities on Government’s behalf like Treasury bills or Dated securities.
• The fund that the RBI raises under the MSS scheme is kept in a separate account from the Government account and is not used by the RBI to fund regular expenditures.
• This separate account is called the MSS account. To manage the excess liquidity, the RBI issues securities under the MSS, which are called the MSS Bonds or the Market Stabilization Bonds (MSBs).
• The various financial institutions further purchase these bonds in the country, and the funds earned by the selling of these bonds is Reserve Bank of India.

RBI Monetary Policy (Dec 2022)

RBI Monetary Policy Highlights Key highlights of RBI monetary policy as announced on December 2022 are:

Key Points

• RBI has maintained the CPI forecast for FY 2023 at 6.7%. The real FY 2023 GDP forecast lowered to 6.8% from 7%.
• Inflation is expected to be above 4% in the next 12 months.
• Standing Deposit Facility Rate, Marginal Standing Facility Rate also increased by 35 basis points each to 6% and 6.5%.
• India's retail inflation fell to a three-month low of 6.77% in October, down from 7.41% in September. However, remains the RBI"s tolerance band for the 10th consecutive row.?

Trends in Monetary Policy

• 1947 – Early 70s – Developmental
• 1970s – 1991 – Stabilization of prices
• 1991 onwards – Developmental
• 1991

1. CRR-15%
2. SLR – 35%

• 2006

1. CRR-5%
2. SLR – 25%

• 2020

1. CRR-3%
2. SLR – 18.5%

• 2022

1. CRR - 4.5%
2. SLR - 18%

Monetary Reforms

• Deregulation of Interest rate structure
• reduction in the CRR and SLR requirements
• More reliance on OMOs
• Government instruments have also become increasingly market-based
• Autonomy to RBI with respect to Govt lending.
• Inflation targeting (2015 onwards)