Discussion below was kept at the basic level as per the need of the examination. Monetary policy is part of ESI as well as Finance paper of the phase 2 of RBI Grade B Generalist examination.
It refers to the actions undertaken by a nation’s central bank to control money supply to achieve macroeconomic goals that promote sustainable economic growth. Monetary policy increases liquidity to create economic growth. It reduces liquidity to prevent inflation.
It involves the use of monetary instruments under the control of the central bank to influence variables, such as interest rates, money supply and availability of credit, with a view to achieving the objectives of the policy.
- In India, The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy (mandated under the Reserve Bank of India Act, 1934).
- Pursuant to the amendment to RBI Act, 1934, in May 2016, the primary objective of monetary policy is to maintaining price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
Evolution of Monetary Policy Framework in India:
- Monetary Targeting Framework : Under this framework, broad money became the intermediate target while reserve money was one of the main operating instruments for achieving control on broad money growth. Accordingly, monetary (M3) projection was made consistent with the expected real GDP growth and a tolerable level of inflation. This framework was in operation during mid-1980s to 1997-98. Analysis of the money growth outcomes during the monetary targeting regime indicates that targets were rarely met. The biggest impediment to monetary targeting was lack of control over RBI’s credit to the central government, which accounted for the bulk of reserve money creation.
- Multiple Indicator Approach: The RBI adopted a ‘multiple indicator approach’ in April 1998 with a greater emphasis on rate channels for monetary policy formulation relative to quantity instruments. Under this approach, a number of quantity variables such as money, credit, output, trade, capital flows and fiscal position as well as rate variables such as rates of return in different markets, inflation rate and exchange rate were analysed for drawing monetary policy perspectives. Use of a large panel of indicators was not providing a clearly defined nominal anchor for monetary policy. It also left policy analysts unclear about what the RBI looks at while taking policy decisions. Since 2007 several high level Committees in India have highlighted that the RBI must consider switching over to inflation targeting. (Dr. Urjit R. Patel, 2014).
- Flexible Inflation Targeting: Against this backdrop, the RBI constituted an Expert Committee to Revise and Strengthen Monetary Policy Framework on September 12, 2013 to recommend what needed to be done to revise and strengthen the current monetary policy framework with a view to, inter alia, making it transparent and predictable. In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework. The Expert Committee (Dr. Urjit R. Patel, 2014) submitted its report in Jan 2014. The salient recommendations of the Committee were :
- Consumer Price Index (CPI) to be the nominal anchor The nominal anchor/target to be set at 4 per cent with a band of +/- 2 per cent.
- The Monetary Policy decision making be vested in a Monetary Policy Committee (MPC). Before the amendment to the RBI Act, 1934, the policy rate was decided by the RBI Governor MPC being accountable for failure to establish and achieve the nominal anchor. The failure defined as the inability to achieve the target of 4 per cent (+/- 2 per cent) for 3 successive quarters. Such failure requires MPC to issue a public statement
- The inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly, in August 2016, the Central Government has notified in the Official Gazette, 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
- Under the amended RBI Act, the MPC is required to meet at least four times in a year. The quorum for the meeting of the MPC is four members.
- Each member of the MPC has one vote, and in the event of an equality of votes, the Governor of the RBI has a second or casting vote.
- The resolution adopted by the MPC is published after conclusion of every meeting of the MPC in accordance with the provisions of Chapter III F of the amended Reserve Bank of India Act, 1934. On the 14th day, the minutes of the proceedings of the MPC meeting are published which include (a) the resolution adopted by the MPC; (b) the vote of each member on the resolution, ascribed to such member; and (c) the statement of each member on the resolution adopted.
- Once in every six months, the Reserve Bank is required to publish a document called the Monetary Policy Report to explain (a) the sources of inflation; and (b) the forecast of inflation for 6-18 months ahead.
- The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation.
Monetary Policy Committee
The MPC determines the policy interest rate required to achieve the inflation target. The committee comprises six members – three officials of the Reserve Bank of India and three external members nominated by the Government of India. The Governor of Reserve Bank of India is the chairperson ex officio of the committee. Decisions are taken by majority with the Governor having the casting vote in case of a tie.
The twenty fourth meeting of the Monetary Policy Committee (MPC), constituted under section 45ZB of the Reserve Bank of India Act, 1934, was held from August 4 to 6, 2020. The meeting was attended by the following six members :
- Dr. Michael Debabrata Patra, Deputy Governor in charge of monetary policy Chairman
- Shri Shaktikanta Das, Governor.
- Dr. Chetan Ghate, Professor, Indian Statistical Institute
- Dr. Pami Dua, former Director, Delhi School of Economics
- Dr. Ravindra H. Dholakia, former Professor, Indian Institute of Management, Ahemedabad
- Dr. Mridul K. Saggar, Executive Director (the officer of the Reserve Bank nominated by the Central Board under Section 45ZB(2)(c) of the Reserve Bank of India Act, 1934)
Members referred from 4 to 6 above, will hold office for a period of four years from the date of appointment while the other three members are official. All the central government nominees are not eligible to be re-appointed.
Instruments of Monetary Policy
The instruments of monetary policy are of two types:
- Quantitative, general or indirect
- Qualitative, selective or direct
Quantitative tools include Cash Reserve Ratio (CRR), Statutory Liquid Ratio (SLR), Repo rate, Reverse Repo rate, Marginal Standing Facility, Bank Rate and Open Market Operations.
Qualitative tools include Loan to Value (LTV) ratio (margin requirement), Priority Sector Lending (credit rationing), Moral Suasion and Direct Action.
The Cash Reserve Ratio in India is decided by RBI’s Monetary Policy Committee in the periodic Monetary and Credit Policy. The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL). Banks do not get any interest on the money that is with the RBI under the CRR requirements. The bank cannot use this money for investment or lending.
The Cash Reserve Ratio acts as one of the reference rates when determining the base rate. Base rate means the minimum lending rate below which a bank is not allowed to lend funds.
Apart from this, there are two main objectives of the Cash Reserve Ratio:
- Cash Reserve Ratio ensures that a part of the bank’s deposit is with the Central Bank and is hence, secure.
- Another objective of CRR is to keep inflation under control. During high inflation in the economy, RBI raises the CRR to lower the bank’s loanable funds.
Current CRR = 3% of NDTL
NDTL = Demand and time liabilities (deposits) with public and other banks – deposits with other banks (liabilities)
Statutory Liquidity Ratio – Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. This is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restricts the bank’s leverage position to pump more money into the economy.
Current SLR= 18%
It is the rate at which the
RBI lends money to the banks for a short term. When the repo rate
increases, borrowing from RBI becomes more expensive. If RBI wants to make it
more expensive for the banks to borrow money, it increases the repo rate
similarly, if it wants to make it cheaper for banks to borrow money it reduces
the repo rate. Current repo rate is 4%
Reverse Repo rate
It is the short term borrowing rate at which RBI borrows
money from banks. The Reserve bank uses this tool when it feels there is
too much money floating in the banking system. An increase in the reverse
repo rate means that the banks will get a higher rate of interest from RBI.
As a result, banks prefer to lend their money to RBI. Current reverse repo rate- 3.35%
Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse Repo rate signifies the rate at which the central bank absorbs liquidity from the banks.
MSF – Marginal Standing facility
A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system. MSF rate is higher then Repo rate. Current MSF Rate: 4.25%
The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
Call money is the overnight funds that are lent by one bank to another bank and call money rate is the rate at which this is done. The Weighted Average Call Rate (WACR) is the operating target of monetary policy.
is the rate at which the Reserve Bank is ready to buy or rediscount bills of
exchange or other commercial papers. The Bank Rate is published under
Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned
to the MSF rate and, therefore, changes automatically as and when the MSF
rate changes alongside policy repo rate changes.
Current bank rate is 4.25%
LAF- Liquidity Adjustment Facility
Liquidity Adjustment Facility was introduced for the first time from June 2000 onwards. LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF helps banks to quickly borrow money in case of any emergency or for adjusting in their SLR/CRR requirements. LAF consists of repo and reverse repo operations. It refers to the difference between the two key rates viz. repo rate and reverse repo rate.
Open Market Operations (OMOs)
These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.
Market Stabilisation Scheme (MSS)
This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.
Whenever the central bank has to induce inflation, it can lower CRR, SLR, repo rate, reverse repo rate, MSF, bank rate, and buy government securities.
Whenever the central bank has to reduce inflation, it can increase CRR, SLR, repo rate, reverse repo rate, MSF, bank rate, and sell government securities.