Monetary Policy

Introduction to Monetary Policy

• Definition: Monetary Policy refers to the measures undertaken by the Central Bank (Reserve Bank of India - RBI) to influence the availability, cost, and use of money and credit in the economy. It is essentially about managing the money supply and interest rates.
• Authority: The RBI is the sole authority responsible for formulating and implementing monetary policy in India.
• Primary Objective: As per the RBI Act, 1934, the primary objective of monetary policy in India is to maintain price stability while keeping in mind the objective of growth. This is enshrined in the Monetary Policy Framework Agreement signed between the Government of India and the RBI in 2015.
• Other Objectives: Besides price stability and growth, monetary policy also aims for:
  • Maintaining an adequate flow of credit to productive sectors to support economic growth.
  • Ensuring stability of the exchange rate.
  • Promoting financial stability.
  • Fostering employment generation (indirectly, by stimulating growth).

Types of Monetary Policy

• Expansionary Monetary Policy (Easy/Cheap Money Policy):
  • Objective: To increase the money supply in the economy.
  • When applied: During periods of economic slowdown, recession, or high unemployment.
  • Measures: Involves reducing interest rates (e.g., Repo Rate), lowering CRR/SLR, or conducting open market purchases of government securities.
  • Effect: Makes credit cheaper and more accessible, encouraging investment, consumption, and thereby boosting economic activity.
  • Risk: Can lead to inflationary pressures if implemented excessively or for too long.
• Contractionary Monetary Policy (Tight/Dear Money Policy):
  • Objective: To decrease the money supply in the economy.
  • When applied: Primarily to control inflation (rising prices).
  • Measures: Involves increasing interest rates, raising CRR/SLR, or conducting open market sales of government securities.
  • Effect: Makes credit more expensive and less accessible, discouraging borrowing, consumption, and investment, thereby cooling down the economy and curbing inflation.
  • Risk: Can slow down economic growth and potentially lead to unemployment if overdone.

Instruments of Monetary Policy

Monetary policy instruments are broadly categorized into Quantitative (General) and Qualitative (Selective) methods.

I. Quantitative Instruments (Affect Overall Money Supply)

• Statutory Liquidity Ratio (SLR):
  • Definition: The proportion of total deposits that commercial banks are mandated to maintain with themselves in liquid assets (cash, gold, approved securities like Government Securities) at the end of every business day.
  • Purpose: Ensures solvency and liquidity of banks, acts as a control on credit expansion.
  • Current Status: RBI has the power to raise this ratio up to 40%. It is currently 18% (as of latest policy updates, subject to change).
  • Impact: Higher SLR reduces the funds available for lending, thus tightening credit. Lower SLR increases lending capacity.
• Cash Reserve Ratio (CRR):
  • Definition: The percentage of a bank's Net Demand and Time Liabilities (NDTL) that it must keep as reserves with the RBI.
  • Purpose: Primarily a tool for liquidity management and inflation control. CRR deposits do not earn any interest.
  • Current Status: The minimum and maximum limits (3% and 20%) were removed by an amendment to the RBI Act in 2006, giving RBI full flexibility. It is currently 4.5% (as of latest policy updates, subject to change).
  • Impact: An increase in CRR reduces the lendable funds of banks, thereby controlling inflation. A decrease in CRR increases lendable funds, stimulating economic activity.
• Bank Rate:
  • Definition: The interest rate at which RBI provides long-term loans to commercial banks. It is also the rate at which RBI discounts bills of exchange.
  • Purpose: Acts as a penal rate for banks that fail to meet their SLR and CRR requirements. It is also a signal of RBI's monetary policy stance.
  • Impact: A higher bank rate makes borrowing by banks more expensive, which in turn leads to higher lending rates for customers, thus discouraging credit.
  • Note: Bank Rate is generally aligned with the MSF rate.
• Repo Rate (Repurchase Rate):
  • Definition: The interest rate at which commercial banks borrow money from the RBI for short-term needs (overnight to 7-14 days) by selling government securities with an agreement to repurchase them at a pre-determined price.
  • Purpose: Primary policy rate used by RBI to control liquidity and inflation.
  • Impact: An increase in the repo rate makes borrowing more expensive for banks, leading to higher lending rates for consumers and businesses, curbing inflation. A decrease makes borrowing cheaper, stimulating growth.
• Reverse Repo Rate (Reverse Repurchase Rate):
  • Definition: The interest rate at which the RBI borrows money from commercial banks for short periods. Banks lend their surplus funds to RBI.
  • Purpose: Absorbs excess liquidity from the banking system.
  • Impact: An increase in reverse repo rate encourages banks to park more funds with RBI, reducing money supply in the economy.
• Marginal Standing Facility (MSF):
  • Definition: A window for commercial banks to borrow overnight funds from RBI in emergency situations when interbank liquidity dries up. Banks can borrow by dipping into their SLR portfolio.
  • Purpose: Provides a safety valve against unanticipated liquidity shocks.
  • Rate: The MSF rate is typically kept higher than the repo rate, acting as an upper bound for the overnight interbank rate.
• Open Market Operations (OMOs):
  • Definition: The buying and selling of government securities (and other approved instruments) by the RBI in the open market.
  • Purpose: To inject or absorb liquidity from the banking system.
  • Impact: When RBI buys securities, it injects money into the system (expansionary). When it sells securities, it absorbs money (contractionary).
• Liquidity Adjustment Facility (LAF):
  • Definition: A collective term for the RBI's operations (primarily repo and reverse repo) that influence the short-term liquidity in the market.
  • Purpose: To manage liquidity on a day-to-day basis and maintain the policy rate (repo rate) within a narrow corridor.

II. Qualitative Instruments (Selective Credit Control Methods)

• These instruments aim to control the flow of credit to specific sectors or for particular purposes, rather than the overall volume.
• Moral Suasion: Persuading commercial banks to follow the Central Bank's policy through advice, appeals, or informal pressure.
• Rationing of Credit: Limiting the amount of credit available to specific sectors, usually during times of credit shortage.
• Regulation of Consumer Credit: Controls on down payments, loan tenure, etc., for consumer goods to manage demand.
• Direct Action: Punitive action taken by RBI against banks that do not comply with its directives (e.g., refusing to discount bills, imposing penalties).
• Margin Requirements: Specifying the margin (the difference between the loan amount and the market value of the security offered for the loan) for different types of advances. Higher margin means less credit against the same security.

Monetary Policy Committee (MPC)

• Establishment: The MPC was constituted in 2016, following an amendment to the RBI Act, 1934, based on the recommendations of the Urjit Patel Committee.
• Purpose: To bring transparency and accountability to monetary policy decisions and move towards a committee-based approach, replacing the earlier system where the RBI Governor primarily made the decisions.
• Mandate: To fix the benchmark policy interest rate (Repo Rate) to achieve the inflation target set by the Government of India. The current inflation target is 4% with a band of +/- 2% (i.e., 2% to 6%).
• Composition: The MPC comprises six members:
  • The RBI Governor (ex-officio Chairperson).
  • The Deputy Governor of RBI in charge of monetary policy (ex-officio member).
  • One officer of the RBI nominated by the Central Board of the RBI (ex-officio member).
  • Three members appointed by the Central Government, who are experts in economics, banking, finance, or monetary policy. These members hold office for a period of four years and are not eligible for re-appointment.
• Decision Making: Decisions are taken by majority vote. In case of a tie, the RBI Governor has a casting vote.
• Accountability: If the RBI fails to meet the inflation target for three consecutive quarters, it is deemed to have failed in its mandate and must explain the reasons to the Government, along with remedial actions.

Financial Stability and Development Council (FSDC)

• Establishment: The FSDC is an apex-level body established by the Government of India in 2010. It is a non-statutory body, set up by an executive order.
• Background: Formed to strengthen and institutionalize the mechanism for maintaining financial stability, enhancing inter-regulatory coordination, and promoting financial sector development. It replaced the informal High-Level Coordination Committee on Financial Markets (HLCCFM).
• Chairperson: The Union Finance Minister.
• Members:
  • Heads of financial sector regulatory authorities (e.g., RBI Governor, Chairpersons of SEBI, IRDAI, PFRDA, FMC (now merged with SEBI)).
  • Finance Secretary.
  • Secretary, Department of Economic Affairs.
  • Secretary, Department of Financial Services.
  • Chief Economic Adviser to the Government of India.
• Objectives/Functions:
  • To maintain financial stability.
  • To enhance inter-regulatory coordination and resolve inter-regulatory disputes.
  • To promote financial sector development.
  • To foster financial literacy and financial inclusion.
  • To monitor macro-prudential supervision of the economy.
  • To assess the functioning of the financial sector.