On 8 November 2016, the Government of India announced the demonetisation of all ₹500 and

₹1,000 banknotes of the Mahatma Gandhi Series. It also announced the issuance of new ₹500
and ₹2,000 banknotes in exchange for the demonetised banknotes.[1] The government claimed
that the action would curtail the shadow economy and reduce the use of illicit and counterfeit
cash to fund illegal activity and terrorism.[2][3]

The announcement of demonetisation was followed by prolonged cash shortages in the weeks
that followed, which created significant disruption throughout the economy.[4][5][6][7][8][9] People
seeking to exchange their banknotes had to stand in lengthy queues, and several deaths were
linked to the rush to exchange cash.[10][11]

According to a 2018 report from the Reserve Bank of India, approximately 99.3% of the
demonetised banknotes, or ₹15.30 lakh crore (15.3 trillion) of the ₹15.41 lakh crore that had
been demonetised, were deposited with the banking system. The banknotes that were not
deposited were only worth ₹10,720 crore (107.2 billion),[12] leading analysts to state that the effort
had failed to remove black money from the economy.[13][14] The BSE SENSEX and NIFTY 50 stock
indices fell over 6 percent on the day after the announcement.[15] The move reduced the country's
industrial production and its GDP growth rate.[16]

Initially, the move received support from several bankers as well as from some international
commentators. The move was also criticised as poorly planned and unfair, and was met with
protests, litigation, and strikes against the government in several places across India. Debates
also took place concerning the move in both houses of the parliament.[17][18][19][20]

What is meant by Monetary Policy?

Monetary policy refers to the policy of the central bank – ie Reserve Bank
of India – in matters of interest rates, money supply and availability of
credit.

It is through the monetary policy, RBI controls inflation in the country.

RBI uses various monetary instruments like REPO rate, Reverse RERO
rate, SLR, CRR etc to achieve its purpose. (This is explained well in one of
our earlier articles – basics of economy concepts).

In short, Monetary policy refers to the use of monetary instruments under

the control of the central bank to regulate magnitudes such as interest
rates, money supply and availability of credit with a view to achieving the
ultimate objective of economic policy.

How does the Reserve Bank of India get

its mandate to conduct monetary policy?
The Reserve Bank of India (RBI) is vested with the responsibility of
conducting monetary policy. This responsibility is explicitly mandated under
the Reserve Bank of India Act, 1934.

What is the main goal of Monetary Policy

of India?
Maintain price stability.

The primary objective of monetary policy is to maintain price stability while

keeping in mind the objective of growth. Price stability is a necessary
precondition for sustainable growth.

To maintain price stability, inflation needs to be controlled. The government

of India sets an inflation target for every five years. RBI has an important
role in the consultation process regarding inflation targeting. The current
inflation targeting framework in India is flexible in nature.

Flexible Inflation Targeting Framework

(FITF)
 Flexible Inflation Targeting Framework: Now there is a flexible
inflation targeting framework in India (after the 2016 amendment to
the Reserve Bank of India (RBI) Act, 1934).
 Who sets the inflation target in India: The amended RBI Act
provides for the inflation target to be set by the Government of
India, in consultation with the Reserve Bank, once every five
years.
 Current Inflation Target: The Central Government has notified 4
percent 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 percent and the lower tolerance limit of 2 percent.
 Factors that constitute a failure to achieve the inflation target: (1)
the average inflation is more than the upper tolerance level of the
inflation target for any three consecutive quarters, OR (2) the average
inflation is less than the lower tolerance level for any three
consecutive quarters.

The Monetary Policy Framework (MPF)

While the Government of India sets the Flexible Inflation Targeting
Framework in India, it is the Reserve Bank of India (RBI) which operates
the Monetary Policy Framework of the country.

 The amended RBI Act explicitly provides the legislative mandate to

the Reserve Bank to operate the monetary policy framework of the
country.
 The framework aims at setting the policy (repo) rate based on an
assessment of the current and evolving macroeconomic situation, and
modulation of liquidity conditions to anchor money market rates
at or around the repo rate.
 Note: Repo rate changes transmit through the money market to the
entire financial system, which, in turn, influences aggregate demand –
a key determinant of inflation and growth.
 Once the repo rate is announced, the operating framework designed
by the Reserve Bank envisages liquidity management on a day-to-day
basis through appropriate actions, which aim at anchoring the
operating target – the weighted average call rate (WACR) – around
the repo rate.

Monetary Policy Committee (MPC)

Now in India, the policy interest rate required to achieve the inflation target
is decided by the Monetary Policy Committee (MPC). MPC is a six-member
committee constituted by the Central Government (Section 45ZB of the
amended RBI Act, 1934).

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 has a
second or casting vote.

The resolution adopted by the MPC is published after the conclusion of

every meeting of the MPC. Once in every six months, the Reserve Bank is
required to publish a document called the Monetary Policy Report to
explain: (1) the sources of inflation and(2) the forecast of inflation for 6-18
months ahead.

The present Monetary Policy Committee

(MPC)
The Central Government in September 2016 constituted the present MPC
as under:

1. Governor of the Reserve Bank of India – Chairperson, ex officio;

2. Deputy Governor of the Reserve Bank of India, in charge of Monetary
Policy – Member, ex officio;
3. One officer of the Reserve Bank of India to be nominated by the
Central Board – Member, ex officio;
4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) –
Member;
5. Professor Pami Dua, Director, Delhi School of Economics – Member;
and
6. Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management,
Ahmedabad – Member.(Members referred to at 4 to 6 above, will hold
office for a period of four years or until further orders, whichever is
earlier.

The Monetary Policy Process (MPP)

The Monetary Policy Committee (MPC) determines the policy interest
rate required to achieve the inflation target.

The Reserve Bank’s Monetary Policy Department (MPD) assists the

MPC in formulating the monetary policy. Views of key stakeholders in the
economy and analytical work of the Reserve Bank contribute to the process
of arriving at the decision on the policy repo rate.

The Financial Markets Operations Department (FMOD) operationalises

the monetary policy, mainly through day-to-day liquidity management
operations.

The Financial Market Committee (FMC) meets daily to review the liquidity
conditions so as to ensure that the operating target of monetary policy
(weighted average lending rate) is kept close to the policy repo rate. This
parameter is also known as the weighted average call money rate (WACR).

Monetary Policy Instruments (MPI)

There are several direct and indirect instruments that are used for
implementing monetary policy.
1. Repo Rate: The (fixed) interest rate at which the Reserve Bank
provides overnight liquidity to banks against the collateral of
government and other approved securities under the liquidity
adjustment facility (LAF).
2. Reverse Repo Rate: The (fixed) interest rate at which the Reserve
Bank absorbs liquidity, on an overnight basis, from banks against the
collateral of eligible government securities under the LAF.
3. Liquidity Adjustment Facility (LAF): The LAF consists of overnight
as well as term repo auctions. Progressively, the Reserve Bank has
increased the proportion of liquidity injected under fine-tuning variable
rate repo auctions of a range of tenors. The aim of term repo is to help
develop the inter-bank term money market, which in turn can set
market-based benchmarks for pricing of loans and deposits, and
hence improve the transmission of monetary policy. The Reserve
Bank also conducts variable interest rate reverse repo auctions, as
necessitated under the market conditions.
4. Marginal Standing Facility (MSF): A facility under which scheduled
commercial banks can borrow an 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.
5. Corridor: The MSF rate and reverse repo rate determine the corridor
for the daily movement in the weighted average call money rate.
6. Bank Rate: It 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.
7. Cash Reserve Ratio (CRR): The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such percent
of its Net demand and time liabilities (NDTL) that the Reserve Bank
may notify from time to time in the Gazette of India.
8. Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is
required to maintain in safe and liquid assets, such as unencumbered
government securities, cash and gold. Changes in SLR often influence
the availability of resources in the banking system for lending to the
private sector.
9. Open Market Operations (OMOs): These include both, outright
purchase and sale of government securities, for injection and
absorption of durable liquidity, respectively.
10. 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
the sale of short-dated government securities and treasury bills. The
cash so mobilised is held in a separate government account with the
Reserve Bank.