Monetary Policy in India: Meaning, Types, Tools & More

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Monetary Policy in India
Monetary Policy in India

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. This article of NEXT IAS aims to study in detail the Monetary Policy in India, its meaning, types, the process of formulation, major tools used therein, and other related concepts.

It is a macroeconomic policy tool used by the Central Bank to influence the money supply in the economy to achieve certain macroeconomic goals. It involves the use of monetary instruments by the central bank to regulate the availability of credit in the market to achieve the ultimate objective of economic policy.

Some of its major objectives are as follows:

  • Accelerating the growth of the economy.
  • Maintaining price stability.
  • Generating employment.
  • Stabilizing the exchange rate.

The two policies differ in various respects as can be seen below.

Fiscal PolicyMonetary Policy
DefinitionIt is a macro-economic policy used by the government to adjust its spending levels and tax rates to monitor a nation’s economyIt is a macroeconomic policy used by the Central Bank to influence money supply and interest rates.
Institutional ControlControlled by the GovernmentControlled by the Central Bank
Prime ObjectiveTo influence the economic conditionTo influence the money supply and interest rates.
Major ToolsPublic Expenditure, Taxation, Public Borrowing etcBank Rate, Cash Reserve Ratio, Statutory Liquidity Ratio etc
Monetary Policy vs Fiscal Policy

Broadly, there are two types of monetary policy – Expansionary Monetary Policy, and Contractionary Monetary Policy.

  • It is also called Accommodative Monetary Policy.
  • Its primary purpose is to increase the money supply in the economy through measures such as:
    • Decreasing interest rates – It makes it less expensive for consumers to borrow money, thus increasing the money supply in the market.
    • Lowering reserve requirements for banks – It leaves commercial banks with more money to lend to the public, thus infusing more money into the economy.
    • Purchasing government securities by central banks – The RBI buys government securities by paying cash. This means that money available in the market increases.
  • It is aimed at fueling economic growth by stimulating business activities and consumer spending and also helps to lower unemployment rates.
  • However, it may have an adverse effect of occasional hyperinflation.
  • It is used to decrease the amount of money supply in the economy through measures such as:
    • Raising interest rates – It makes it more expensive for consumers to borrow money, thus reducing the money supply in the market.
    • Increasing the reserve requirements for banks – It leaves commercial banks with less money to lend to the public, thus reducing the money supply in the economy.
    • Selling government bonds – The buyers of government securities pay cash to the RBI. This means that money available in the market decreases.
  • It is aimed at reducing inflation.

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.

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, but he could veto decisions.

  • 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.
Monetary Policy in India
  • In 2015, the RBI and the Center entered into a Monetary Policy Framework Agreement that stipulated a primary objective of ensuring price stability while keeping in mind the objective of growth.
  • Accordingly, the Reserve Bank of India Act, of 1934 was amended and the Flexible Inflation Target (FIT) was adopted in 2016 to establish a liaison between monetary policy and inflation in India.
  • The inflation target is set by the Center, in consultation with the RBI, once every 5 years.
  • For the period 2021-25, the inflation is to be kept in the range of 4 (+/-2) percent.
  • The Headline Consumer Price Inflation has been chosen as a key indicator.
  • Rising prices create uncertainties and adversely affect savings and investments. By keeping inflation in check, it aims to bring more stability, predictability, and transparency in deciding major policies.
  • To make the RBI more accountable to the government if it fails to meet the inflation targets.

Fixed inflation targets restrain the RBI from taking any tight policy stance.

  • The idea to set up MPC was mooted by an RBI-appointed Urjit Patel Committee.
  • Section 45ZB of the amended RBI Act, 1934 provides for an empowered 6-member Monetary Policy Committee (MPC).
  • Some of the major provisions with reference to the MPC are:
    • The Committee is to meet at least 4 times a year.
    • The Committee will have 6 members.
    • The members of MPC shall hold office for a period of 4 years and shall not be eligible for re-appointment.
    • The quorum for a meeting of the MPC is 4 members.
    • The RBI Governor will have a casting vote in case of a tie
  • RBI Governor – Chairperson
  • RBI Deputy Governor in charge of monetary policy,
  • One official nominated by the RBI Board,
  • 3 members are appointed by the Central Government based on the recommendations of a search cum selection committee comprised of
    • the Cabinet Secretary
    • the Secretary of the Department of Economic Affairs
    • the RBI Governor, and
    • three experts in the field of economics or banking as nominated by the Central Government.

Various instruments used by the RBI to control the money supply can be categorized into two categories:

  • Quantitative Tools – Quantitative tools of monetary policy are aimed at controlling the cost and quantity of credit.
  • Qualitative Tools – Qualitative tools of monetary policy are aimed at controlling the use and direction of credit.
    • The qualitative measures do not regulate the total amount of credit created by commercial banks. Rather, they make a distinction between good credit and bad credit and regulate only such credit which creates economic instability. Therefore, qualitative measures are known as the selective measures of credit control.
Monetary Policy Tools in India

Major instruments coming in this category are explained below:

  • Bank Rate or Discount Rate is the rate at which the RBI is ready to buy or rediscount Bills of Exchange or other Commercial Papers from the Scheduled Commercial Banks (SCBs).
  • If the RBI fixes a high Bank Rate, banks would not want to rediscount bills from the RBI as their profits will be low. This will have the effect of reducing the money supply in the market.
  • Thus, an increase in the Bank Rate results in a tightening of money supply and vice versa.

The reserve requirement or required reserve ratio is a bank regulation that sets the minimum reserves each bank must hold as a part of the deposits.

It comprises two instruments:

Cash Reserve Ratio (CRR)

  • Cash Reserve Ratio (CRR) is the minimum percentage of a bank’s total Demand and Time Liabilities (DTL) that a Scheduled Commercial Bank is obligated to deposit with the RBI in the form of cash.
  • RBI does not pay any interest on CRR deposits.
  • RBI Act does not prescribe any range (ceiling or floor) for fixing CRR. Thus, RBI has the freedom to fix the CRR at any rate depending on the macroeconomic conditions.
    • If CRR is increased: If the RBI increases the CRR, the commercial banks have to deposit more money with the RBI and are left with less money to lend to customers. Thus, the effect is reduced money supply in the economy.
    • If CRR is decreased: If the RBI decreases the CRR, the commercial banks have to deposit less money with the RBI and are left with more money to lend to customers. Thus, the effect is increased money supply in the economy.

Statutory Liquidity Ratio (SLR)

  • Statutory Liquidity Ratio (SLR) is the percentage of Net Demand and Time Liabilities (NDTL) that a Scheduled Commercial Bank (SCB) has to keep with itself, in the form of:
    • Cash, or
    • Gold, or
    • SLR Securities (such as government bonds, treasury bills, and any other instrument notified by the RBI), or
    • Any combination of the above three.
  • Unlike the CRR, SLR need not be deposited with RBI.
  • The range of SLR prescribed by the RBI is from 0 percent to 40 percent.
    • If SLR is increased: If the RBI increases the SLR, the commercial banks are left with less money to lend to customers. Thus, the effect is reduced money supply in the economy.
    • If CRR is decreased: If the RBI decreases the SLR, the commercial banks are left with more money to lend to customers. Thus, the effect is increased money supply in the economy.
  • If the bank fails to maintain the required SLR, then it is liable to pay penal interest at (Bank Rate + 3%) per annum above the bank rate, on the shortfall amount.
    • If the shortfall continues for the next succeeding day, penal interest is to be paid at (Bank Rate + 5%).
  • Liquidity Adjustment Facility (LAF) allows banks to borrow money from the RBI through repurchase agreements (repos) or to make loans to RBI through reverse repo agreements.
  • It is aimed to aid banks in adjusting the day-to-day mismatches in liquidity.
  • It comprises the following 2 sub-instruments:

Repo Rate (Re-purchase Option Rate)

Repo Rate is the rate of interest at which the RBI provides short-term loans to SCBs against approved securities.

Reverse Repo Rate

Reverse Repo Rate is the rate of interest at which the RBI borrows funds from the SCBs. In other words, it is the rate at which SCBs park their excess funds with the RBI for a short period of time.

  • This facility was introduced by the RBI in 2011 on the basis of the recommendations of the Narasimhan Committee on banking sector reforms.
  • Under this, all the SCBs having current accounts with the RBI can avail of an overnight short-term loan of up to 1% of their Net Demand and Time Liabilities (NDTL) outstanding at the end of the second preceding fortnight, against Government Securities as collateral.
  • This facility is like the penal rate at which banks can borrow money from the central bank over and above what is available to them through the LAF window.
  • MSF being a penal rate, the rate of interest under MSF is 25 basis points (0.25%) above the Repo Rate.
  • Amounts in multiples of ₹1 crore (with a minimum amount of ₹1 crore) can be accessed through MSF.

Comparison among MSF, Repo Rate and Reverse Repo Rate

MSF represents the upper band of the interest corridor, and Reverse Repo Rate is the lower band. The Repo Rate stands in the middle and acts as an anchor rate.

Monetary Policy
  • Open Market Operations (OMOs) refer to the buying and selling of government securities by RBI to regulate the short-term money supply.
  • If RBI wants to induce liquidity or more funds in the system, it will buy government securities and inject funds into the system.
  • On the other hand, if the RBI, wants to curb the amount of money in the system, it will sell government securities to the banks thereby reducing the amount of cash that banks have.
  • Market Stabilization Scheme (MSS) refers to intervention by the RBI to withdraw excess liquidity by selling government securities in the economy.
  • Under it, the RBI sells government bonds on a general basis depending upon the volume of excess liquidity in the system. Here bonds go to financial institutions and money goes back to the RBI.
    • This withdrawal of excess liquidity is called sterilization.
  • The securities issued under the MSS are, basically, government bonds and are called Market Stabilization Bonds (MSBs).
  • Since October 2013, the RBI has introduced Term Repos (of different tenors, such as 7/14/28 days), to inject liquidity over a period that is longer than overnight.
  • The aim of Term Repo is to help develop an inter-bank money market, which in turn can set market-based benchmarks for the pricing of loans and deposits, and through that improve the transmission of monetary policy.

Major instruments coming in this category are explained below

  • Margin refers to the difference between the value of securities offered for loans and the value of loans actually granted.
  • If RBI wants to control the flow of credit to a particular sector, it fixes a high margin for that sector. As a result, customers will take lesser loans for that sector.
  • Credit made available by commercial banks (installments) for the purchase of consumer durables is known as consumer credit.
  • If there is excess demand for certain consumer durables leading to their high prices, the RBI reduces consumer credit by:
    • increasing down payment, and/or
    • reducing the number of installments of repayment of such credit.
  • Moral Suasion means persuasion and request.
  • RBI makes the banks adhere to the policy and directives through persuasion or pressure in order to maintain a certain level of money supply in the economy.

The RBI takes direct action such as refusing to rediscount the bills or charging penal interest rates, etc when a commercial bank does not co-operate with the central bank in achieving its desirable objectives.

Under this, the RBI fixes a ceiling on the amount of loans that can be granted by SCBs. As a result, SCBs tighten in advancing loans to the public.

Under this, the RBI prescribes the banks to provide a specified portion of the bank lending to a few specific sectors like agriculture and allied activities, micro and small enterprises, poor people for housing, etc.

  • 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.
  • Unfavorable Banking Habits: People in India prefer to make use of cash rather than make transactions through banks. This reduces the credit creation capacity of the banks.
  • Underdeveloped Money Market: The weak money market limits the coverage as well as the efficient working of the RBI’s policy actions.
  • Existence of Black Money: 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.
  • Conflicting Objectives: Ensuring economic development requires expansionary policy measures, whereas curbing inflation requires contractionary policy measures. Striking a proper balance between these two objectives becomes difficult.
  • Limitations of Monetary Instruments: 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.
  • It refers to the process by which the Central Bank’s actions to control the money supply (such as a change in the Repo Rate) are transmitted to the final objectives of stable inflation and growth.
  • It involves the entire process starting from the change in the Policy Rate ( such as the Repo Rate) by the RBI, its response in the financial markets, and the ultimate effect on businesses and households.
  • As the Repo Rate brings changes in the market interest rate, the Repo Rate Channel is often referred to as the Interest Rate Channel of Monetary Policy Transmission.
Monetary Policy Transmission
  • Liquidity Trap is an adverse economic situation that occurs when consumers and investors prefer to hold onto their cash rather than spend or invest them, even when interest rates are low.
  • A Liquidity trap emerges when interest charges are nil or during a downturn. In such a situation, people are afraid to spend money, hence they feel safe to hold onto the cash. As a result, even expansionary policy measures fail to increase the interest rate, income, and economic growth.
Liquidity Trap
  • Quantitative Easing (QE) refers to the Central Bank’s action of purchasing securities from the open market to reduce interest rates and increase the money supply.
  • It is aimed to create new bank reserves, providing banks with more liquidity, and encouraging lending and investment.
Quantitative Easing

It refers to the process by which the RBI takes away money from the banking system to neutralize the fresh money that enters the system.

  • It is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation.
  • The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation.
  • Broadly, there are two types of Inflation Targeting:

Under Strict Inflation Targeting, the central bank is only concerned about keeping inflation as close to a given inflation target as possible, and nothing else.

Under Flexible Inflation Targeting, apart from keeping inflation within the target range, the central bank is also concerned about other things, such as the stability of interest rates, exchange rates, output, and employment.

Monetary Policy in India plays a pivotal role in stabilizing the economy and fostering a conducive environment for sustainable growth. The dynamic nature of the global economy, internal structural constraints, and the complex interplay between fiscal and monetary policies mean that constant vigilance and adaptability are required to navigate the path ahead. As India continues to develop and integrate further into the global economy, the formulation and implementation of monetary policy will remain a key area of focus for policymakers.

Who Controls Monetary Policy in India?

The RBI Act of 1934 explicitly mandates the Reserve Bank of India (RBI) with the responsibility of controlling the monetary policy for the country.

Who formulates Monetary Policy in India?

At present, monetary policy in India is formulated by the Monetary Policy Committee (MPC), which was set up by an amendment in the RBI Act of 1934 through the Finance Act of 2016.

What is the Function of Monetary Policy in India?

Its most important function is to control the supply of money in the market. Along with this, it also ensures the growth of the economy and price stability.

What is the Monetary Policy Framework Agreement?

It is an agreement signed between the RBI and the Center in 2015, the primary objective of which is to ensure price stability while accelerating economic growth.

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