Monetary Policy

 

Monetary Policy

 

Introduction

  • Monetary Policy in India is the lifeblood of India’s economy. As a critical economic management tool, it helps the RBI and the Government to control the supply of money, manage inflation, and achieve economic stability.
  • It is the Central Bank’s policy for managing the proper amount of money supply and demand in the economy. The primary purpose of monetary policy is to maintain price stability while seeking growth.
  • The Reserve Bank of India (RBI) has the authority to issue monetary policy at any time, based on the state of the economy. RBI uses a variety of measures to attain the desired level of credit and monetary policy.

 

 

What is Monetary Policy?

  • It refers to the actions taken by a central bank, such as the Reserve Bank of India (RBI), to regulate the supply and demand of money and credit in the economy.
  • The goal of monetary policy is to achieve price stability, economic growth, and financial stability.
  • The monetary policy instruments used by RBI are Repo and Reverse repo. The repo rate is the rate at which the RBI lends money to commercial banks. On the other hand, the Reverse repo rate is the rate at which the RBI borrows money from commercial banks within the country.

 

Types of Monetary Policy

Expansionary Policy:An expansionary policy boosts economic activity during slowdowns or recessions.

  • Expansionary policy works by increasing the total money supply in the economy.
  • The money supply in the economy is increased by lowering the general interest rates on loans and other forms of debt.
  • When there are low interest rates, people tend to save less, and consumer spending and borrowing increase. Thus, it is used to stimulate economic growth.

 

Contractionary Policy:It decreases the total supply of money in the economy by increasing the interest rates.

  • It is used to reduce prices caused by an excess money supply.

 

The key tools used in the contractionary monetary policy include:

  • Raising interest rates: By increasing key interest rates, the central bank makes borrowing more expensive, discouraging spending and investment and reducing inflationary pressures.
  • Open market operations: The central bank can sell government securities to the market, thereby reducing the money supply and increasing interest rates.
  • Reserve requirement increases: The central bank can raise the reserve requirement, forcing banks to hold more reserves against customer deposits. This reduces the amount of money available for lending and restricts credit growth.
  • Sterilization operations: When the central bank intervenes in foreign exchange markets to prevent excessive currency depreciation or appreciation, it may engage in sterilization operations. These operations help offset the impact of foreign exchange interventions on the money supply.

 

 

What are the Instruments of Monetary Policy?

  • Liquidity Adjustment Facility (LAF): It allows banks to borrow money through repurchase agreements (repos) or to make loans to the RBI through reverse repo agreements.
  • Repo Rate: The repo rate is the rate at which the RBI lends money to banks to meet their short-term funding needs.
  • Reverse Repo Rate: The interest rate at which the Reserve Bank absorbs liquidity from banks against the collateral of eligible government securities under the LAF.
  • Statutory Liquidity Ratio (SLR): It is the minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold or other securities.
  • Marginal Standing Facility (MSF) Rate: It is the penal rate at which banks can borrow, on an overnight basis, from the RBI by dipping into their SLR portfolio.
  • Bank Rate: The Bank Rate acts as the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio).
  • Cash Reserve Ratio (CRR): It is a percentage of total deposits that the banks have to maintain as liquid cash with the RBI.
  • Open Market Operations (OMOs): These include outright purchase/sale of government securities by the RBI for injection/absorption of durable liquidity in the banking system.

 

Importance of Monetary Policy Instruments

  • Tools for monetary policy are significant because they have a direct impact on how we live our lives.
  • Utilizing monetary policy tools effectively would aid in combating inflation, lowering unemployment rates, and fostering economic growth.
  • The price of practically everything would soar if the Fed rashly decided to decrease the discount rate and flood the market with money.
  • The ability to make purchases would be reduced as a result.
  • The aggregate demand curve is significantly impacted by monetary policy tools.
  • This is because monetary policy directly affects the interest rate in the economy, which in turn determines how much money is spent on consumption and investment.

 

Significance of Monetary Policy

  • It plays an important role in maintaining price stability and ensuring economic growth.
  • By maintaining price stability, it helps manage inflation.
  • It shapes variables like Consumption, Savings, Investment, and capital formation.
  • An increase in the money supply helps to stimulate the business sector, which also helps to create more jobs.
  • By controlling the money supply in the market, it helps balance Currency Exchange Rates.

 

Limitations of Monetary Policy in India

  •  People in India prefer to make use of cash rather than make transactions through banks. This reduces the credit creation capacity of the banks.
  • The weak money market limits the coverage as well as the efficient working of the RBI’s policy actions.
  • Black money is not recorded since the borrowers and lenders keep their transactions secret. Consequently, the supply and demand of the money also do not remain as desired.
  •  Ensuring economic development requires expansionary policy measures, whereas curbing inflation requires contractionary policy measures. Striking a proper balance between these two objectives becomes difficult.
  • There are several kinds of interest rates in India. Influencing them all appropriately becomes very difficult as most of the monetary policy instruments available in India have some or other kinds of limitations.

 

Monetary Policy in India

  • In India, the monetary policy of the Reserve Bank of India aims to control the amount of money in circulation in order to meet the requirements of various economic sectors and quicken the rate of economic expansion.
  • Historically, in India, monetary policy was announced twice a year, once during the slack season (April-September) and once during the busy season (October-March), in accordance with agricultural cycles.
  • However, because monetary policy has become more dynamic, the Reserve Bank of India decided to issue a bi-monthly Monetary Policy.
  • Statements—once every two months—beginning in 2014, as recommended by the Urjit Patel Committee.
  • In India, the Reserve Bank of India Act of 1934 explicitly mandates the Reserve Bank of India (RBI) with the responsibility of formulating the monetary policy for the country. The process of monetary policy formulation in India underwent a paradigm shift in the year 2016 as explained below.

Pre-2016

Prior to the year 2016, the Governor of RBI was singularly responsible for the formulation of monetary policy in India. Although the Governor was advised by a Technical Committee, he could veto decisions.

 

Post-2016

The Finance Act of 2016 amended the RBI Act of 1934 to set up a Monetary Policy Committee (MPC).

At present, monetary policy in India is formulated by this committee.

 

 

What is the Monetary Policy Committee?

  • It is constituted under Section 45ZB of the amended RBI Act, 1934.
  • It comprises six members, empowered by the Central Government through an official notification in the Gazette.
  • The first MPC came into existence on 29th September 2016. The current composition, as of 5th October 2020, includes the
    • Governor of the RBI (ex officio Chairperson),
    • Deputy Governor of the RBI in charge of Monetary Policy (ex officio member),
    • One officer nominated by the Central Board of RBI (ex officio member),
    • And three external members.

Function:

The primary function of the MPC is to determine the policy repo rate necessary to achieve the inflation target set by the government.

 

Meeting:

  • The MPC is mandated to convene at least four times annually to deliberate on monetary policy decisions. The meetings are important for assessing economic indicators and devising appropriate strategies to maintain price stability and economic growth.

Voting Power:

  • Each member of the MPC holds equal voting power, with one vote per member.
  • In the event of a tie, the Governor exercises a second or casting vote to resolve the deadlock.

Statement Writing:

  • Every MPC member is required to draft a statement detailing the rationale behind their vote, whether in favor of or against the proposed resolution.
  • This transparency ensures that the decision-making process is well-documented and based on informed analysis.

 

Key outcomes of MPC 2024

  • MPC decided to keep the policy repo rate unchanged at 6.50%.
  • Repo rate is the rate at which the Reserve Bank of India lends money to commercial banks in the event of any shortfall of funds.
  • The standing deposit facility (SDF) rate remains at 6.25%, while the marginal standing facility (MSF) rate and the bank rate stand at 6.75%.
  • The SDF is a liquidity window through which the RBI will give banks an option to park excess liquidity with it.

 

Food prices drive inflation

The headline inflation, after remaining steady at 4.8% during April and May, had increased to 5.1% in June.

 

GDP forecast

  • Real GDP growth for 2024-25 has been projected at 7.2%, with the first quarter (Q1) projection at 7.1%; Q2 at 7.2%; Q3 at 7.3%; and Q4 at 7.2%.
  • Real GDP growth for the first quarter of 2025-26 is projected at 7.2%.

 

Conclusion

  • The monetary policy of the RBI plays a pivotal role in steering India’s economy by regulating the money supply, interest rates, and credit availability.
  • Through a combination of tools and strategies, the RBI aims to maintain price stability, support economic growth, and ensure financial stability.
  • Effective monetary policy decisions are critical for achieving these objectives and fostering a conducive environment for sustainable development and prosperity.