Monetary policy refers to the set of measures adopted by the central bank of the country for monetary management for the achievement of desired objectives. In India it is done by reserve Bank of India.

The monetary functions of the RBI included control and regulation of money and credit, control of foreign exchange operations: acting as banker to the Government, banker’s bank, and lender of the last resort.

The RBI has followed the policy of controlled expansion of money supply. The same is done through monetary policy.

Monetary policy used to be announced twice in a year (in October for October to March and in April for April to September this is due’ to the busy season’s respectively of the agriculture sector. ‘But with the decline of the share of agricultural credit and Rise in that of the Industrial credit, the R.B.I. has started making an annual policy statement in April, with a Review of the same in October’. Beginning with 1999-2000 the RBI decided that the policy announcement will be an annual affair. But annual monetary policy statements were eagerly awaited leading to undue expectations, which burdened the process unnecessarily. Mindful of this RBI decided to release the whole process by following the annual policy statement in April with three quarterly reviews in July, October and January.

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.

Economic growth

The main aim of monetary policy is to achieve growth with stability. In order to achieve the above aim, 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 agricultural industry, transport, import, export etc. R.B.I. has been liberal in respect of priority sector, like small farmers, small industries and petty traders etc. It has helped in 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 increase in the volume of Investment with 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.

Methods of credit control

Quantitative or General Credit Controls

The following methods are used:

• Bank Rate:  It is the rate at which the RBI rediscounts bill of exchange or other commercial papers.  Simply put, banks rate is the rate at which the RBI extends credit to the commercial bank. No collateral is needed to borrow under bank rate. Bank rate is also called discount rate. Bank  Rate had a limited impact in the period before 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 Bank Rate has been revived. It is subject to the 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 very this ratio between 3 and 15 percent.
• Statutory Liquidity Ration (SLR):  The Statutory Liquidity Ratio specifies that a commercial bank invest a designate 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%. It is 21.5% presently.
• Open Market Operations (OMO): These involve the sale and purchase of government securities[1] by the RBI, the rationale behind this operation being 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 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 the 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 overnight basis below the stipulated SLR up to 0.75% of their respective Net Demand and Time Liabilities (NDTL) outstanding at the end of second preceding fortnight. 

Qualitative or Selective Credit Control

Though generally the RBI makes use of Quantitative tools to check the money supply in economy, the effect of such measures is often not

as desired or is delayed.                                                                            

This is so because these measures are not sector specific thereby affecting even those sectors of economy where money supply is not to be regulated.                                                                                          Also, these measures being indirect often fail to bring desired results. For ex- even if RBI increases Repo rate to curb credit supply in economy, banks might not immediately raise their lending rates and will continue cheap loans till they have reserve deposits with them.

Due to these limitations of quantitative tools, RBI also makes use of Qualitative or Selective Credit Control tools like-

LTV ratio (loan to value)/ Margin requirements- by setting LTV ratios or margin requirements RBI limits the credit limit against the value of collateral. For ex- If RBI sets LTV ratio of 70% then even with a collateral worth 100 crore one will get a loan of only 70 crore.

Selective credit control for specific fields/sectors/industries (also known as rationing of credit)- For ex- RBI asks banks to give costly loans to aviation industry or denies loan altogether to sugar industry due to existing glut in market. Alternately, there could be specified Quotas/Limits on borrowing from a particular sector.

Moral Suasion –RBI persuades banks to follow a particular monetary policy through conferences, meetings, press releases. Generally it is the Governor of RBI who uses public forums to morally persuade banks.

Therefore, in its monetary operations, the Reserve Bank uses multiple instruments to ensure that appropriate liquidity is maintained in the system so that all legitimate requirements of credit are met, consistent with the objective of price stability. Towards this end, the Bank pursues a policy of active management of liquidity through OMO including LAF, MSS and CRR, and using the policy instruments at its disposal flexibly, as and when the situation warrants.

Way Ahead

Conduct of monetary policy is complex. It has not only to be forward looking but also to grapple with uncertain future. Additional complexities arise in the case of an emerging market like India, which is transiting from a relatively closed to a progressively open economy.  In an environment of increasing capital flows, narrowing cross-border interest rate differentials and surplus liquidity conditions, exchange rate movement tends to have linkages with interest rate movements. The challenge of a monetary authority is to balance the various choices into a coherent whole and to formulate a policy as an art of the possible.

RBI adopts Inflation Targeting

Until 2014, in its monetary policy framework, RBI focused on multiple indicators like Growth, Inflation, Employment, and Exchange Rate.

But, the Urjit Patel Committee on Monetary Policy highlighted certain drawbacks of such an approach. The multiple indicators approach has no nominal anchors and defined targets which can be objectively measured and the policy framing authority held accountable.

Also, often the different targets are in contradiction to each other. For ex- to boost growth RBI might lower bank rates. But this could lead to rise in inflation.

 Another condition could be the one involving exchange rate. To boost exports RBI might lower the exchange rate, but it will lead to inflationary pressures due to costly imports.

Therefore, the multiple indicator approach to Monetary Policy has certain drawbacks and needs to be reformed.

The Urjit Patel Committee, going by international standards, recommends that the RBI should focus only on Inflation Targeting as the objective of the Monetary Policy. Persistent high inflation lowers the demand thereby affecting production and hence growth in the economy. High inflation also lowers the real interest rates thereby lowering financial savings and hence reducing investible capital in economy which leads to poor growth.  

 High inflation by lowering real interest rates pushes public preference towards physical savings like gold. This leads to increased CAD which in turn leads to weaker rupee and inflation due to costly imports (crude mainly as it affects all other commodities).

Therefore targeting inflation will automatically check other indicators like growth, exchange rate etc.

Inflation Targeting framework-

• RBI to choose CPI (combined) as the nominal anchor.
• Inflation target should be of 4% with a band of ±2%.

In case of failure to achieve the targets the RBI as to give a public statement detailing the reasons for failure along with framework for future corrections and a time limit to achieve the desired targets.

But this approach has certain drawbacks the most evident of which is that inflation in India in recent years has been led by food and fuel and there is little that monetary policy can do to check these.

For this there should be close cooperation and coordination between government and RBI so that the inflation targets are achieved easily. On its part the government must focus on certain issues like –

• Moderate wage growth in MNREGA so as to check demand side pulls on inflation.
• Rationalize the MSP so that there is no supply side inflation in food.
• Lower Fiscal Deficit because high Fiscal deficit leads to either deficit financing or borrowing both of which are not good for economy. (Poor fiscal health leads to poor ratings by international organizations which leads to poor FDI/FII/ECB inflows and weakens the rupee causing further inflation).

MONETARY POLICY COMMITTEE

Until 2014, RBI has been the sole authority on matters pertaining to Monetary Policy. But recently, the government expressed its desire to be a part of the monetary policy formulation and review exercise. Even in the past several committees like Tarapore committee, FSLRC, Urjit Patel committee have recommended for constitution of a Monetary Policy Committee comprising of representatives from both RBI as well as Government of India. Several countries (like England) have such committees.

Generally the Central Banks across the world are independent authorities on Monetary Policy. This is so because, governments in order to fulfil the Populist agendas during their term might modify the monetary policy so as to attain these short term objectives but causing harm in the long run. For ex- to boost growth during their term, the Government might lower the interest rates and increase the money supply in economy. But in the long run it might lead to inflationary pressures.

Therefore it is the central banks which decide upon the monetary policy in most major economies.

But recently there has been a growing voice that the government should be a part of the monetary policy. This is so because the government has some election agendas, some planned development targets and welfare objectives to fulfil for which it needs to effect certain changes in the monetary policy framework.

Also, now since the RBI has adopted Inflation Targeting as the central objective of Monetary Policy, the role of government has become imperative because inflation in India is mostly led by Food and Fuel and cannot be dealt by monetary policy alone and needs government action (like moderating wage growth rate, rationalising MSPs etc.).

Therefore there is being proposed 5-membered Monetary Policy Committee (3 members nominated by RBI and 2 by Union government).

To ensure its independent functioning the discussions and the decisions of the committee must be put in public domain.