The document discusses monetary policy in India, including what it is, its goals of maintaining price stability and promoting growth, and the tools used like interest rates and required reserves. It also describes the monetary policy committee that determines the policy rate and its members.
The document discusses monetary policy in India, including what it is, its goals of maintaining price stability and promoting growth, and the tools used like interest rates and required reserves. It also describes the monetary policy committee that determines the policy rate and its members.
The document discusses monetary policy in India, including what it is, its goals of maintaining price stability and promoting growth, and the tools used like interest rates and required reserves. It also describes the monetary policy committee that determines the policy rate and its members.
The document discusses monetary policy in India, including what it is, its goals of maintaining price stability and promoting growth, and the tools used like interest rates and required reserves. It also describes the monetary policy committee that determines the policy rate and its members.
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Monetary Policy
By- Akash Kumar Thakur
Table Of Content 1. What is Monetary Policy 2. The Monetary Policy Framework 3. Understanding Monetary Policy 4. The Monetary Policy Committee 5. Goals Of Monetary Policy 6. Instruments of Monetary Policy 7. Monetary Policy Vs Fiscal Policy 8. Curbing Inflation In India-A Case Study On Monetary Policy 9. Key Take Aways 10. Bibliography What is Monetary Policy?
Monetary policy is a set of tools used by a nation's central bank
to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. In India Monetary policy helps shape a country's economic landscape by influencing key factors such as inflation, economic growth, and employment.
Through tools like interest rate adjustments and money supply
control, the Reserve Bank of India seeks to maintain price stability, ensuring that inflation remains at a sustainable level. Central banks also impact borrowing costs, consumer spending, and business investments by managing interest rates. Effective monetary policy contributes to economic stability, fostering an environment conducive to sustainable growth.
Some of its major objectives are as follows:
Accelerating the growth of the economy.
Maintaining price stability. Generating employment. Stabilizing the exchange rate. The Monetary Policy Framework
shifted towards flexible inflation targeting in 2016, with the establishment of a six-member Monetary Policy Committee (MPC). 2. Inflation Target: The Government of India set the inflation target using the Consumer Price Index (CPI combined) at 4%, with a tolerance band of ±2%, for the period from August 5, 2016, to March 31, 2021. 3. Evolution Since the Mid-1980s: The paper reviews the evolution of India's monetary policy frameworks since the mid-1980s, likely highlighting significant changes and reforms during this period. 4. Monetary Policy Transmission: It describes the monetary policy transmission process and its limitations, which may include lags and rigidities in the effectiveness of policy measures. 5. Unconventional Monetary Policy: The importance of unconventional monetary policy measures is emphasized, especially during the easing cycle, suggesting that these measures complement conventional tools. 6. MPC Voting Pattern: The paper examines the voting pattern of the MPC in India, comparing it with that of various developed and emerging economies, likely to understand decision-making dynamics. 7. Global Economic Trends: It analyzes the synchronization of policy rate cuts by MPCs of various countries during global economic slowdowns, such as in 2019 and during the COVID-19 pandemic in the early 2020s. Understanding Monetary Policy
Monetary policy is the control of the quantity of money available in
an economy and the channels by which new money is supplied. Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry and sector-specific growth rates influence monetary policy strategy.
A central bank may revise the interest rates it charges to loan money to the nation's banks. As rates rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers.
Additionally, it may buy or sell government bonds, target foreign
exchange rates, and revise the amount of cash that the banks are required to maintain as reserves.
Types of Monetary Policy
Monetary policies are seen as either expansionary or contractionary
depending on the level of growth or stagnation within the economy.
Contractionary
A contractionary policy increases interest rates and limits the
outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money.
Expansionary
During times of slowdown or a recession, an expansionary policy grows
economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. The Monetary Policy Committee RBI Act, 1934 provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette, It determines the policy repo rate required to achieve the inflation target. It is required to meet at least four times in a year. The quorum for the meeting is 4 members of the MPC. Each member has one vote, and in the event of an equality of vote the governor has a second or casting vote. Each member of the Monetary Policy Committee writes a statement specifying the reasons for voting in favor of or against the proposed resolution
The monetary Policy Committee consists of the following members:
Governor of the Reserve Bank of India—Chairperson
Deputy Governor of the Reserve Bank of India, in charge of Monetary
Policy
One officer of the Reserve Bank of India to be nominated by the
Central Board
Professor, Indira Gandhi Institute of Development Research
Professor, Indian Institute of Management, Ahmedabad
Senior Advisor, National Council of Applied Economic Research, Delhi
Goals Of Monetary Policy
Inflation Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation. Unemployment An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. Instruments Of Monetary Policy
There are several direct and indirect instruments that are used for implementing monetary policy.
Repo Rate: The interest rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) to all LAF participants against the collateral of government and other approved securities.
Standing Deposit Facility (SDF) Rate: The rate at which the Reserve Bank accepts uncollateralized deposits, on an overnight basis, from all LAF participants. The SDF is also a financial stability tool in addition to its role in liquidity management. The SDF rate is placed at 25 basis points below the policy repo rate. With introduction of SDF in April 2022, the SDF rate replaced the fixed reverse repo rate as the floor of the LAF corridor.
Marginal Standing Facility (MSF) Rate: The penal rate at which banks can borrow, on an overnight basis, from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a predefined limit (2 per cent). This provides a safety valve against unanticipated liquidity shocks to the banking system. The MSF rate is placed at 25 basis points above the policy repo rate.
Liquidity Adjustment Facility (LAF): The LAF refers to the Reserve Bank’s operations through which it injects/absorbs liquidity into/from the banking system. It consists of overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF and MSF. Apart from LAF, instruments of liquidity management include outright open market operations (OMOs), forex swaps and market stabilization scheme (MSS).
LAF Corridor: The LAF corridor has the marginal standing facility (MSF) rate as its upper bound (ceiling) and the standing deposit facility (SDF) rate as the lower bound (floor), with the policy repo rate in the middle of the corridor.
Main Liquidity Management Tool: A 14-day term repo/reverse repo auction
operation at a variable rate conducted to coincide with the cash reserve ratio (CRR) maintenance cycle is the main liquidity management tool for managing frictional liquidity requirements.
Fine Tuning Operations: The main liquidity operation is supported by fine-
tuning operations, overnight and/or longer tenor, to tide over any unanticipated liquidity changes during the reserve maintenance period. In addition, the Reserve Bank conducts, if needed, longer-term variable rate repo/reverse repo auctions of more than 14 days.
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. Following the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time.
Bank Rate: The rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. 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). The Bank Rate is published under Section 49 of the RBI Act, 1934. This rate has been aligned with the MSF rate and, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a per cent of its net demand and time liabilities (NDTL) as on the last Friday of the second preceding fortnight that the Reserve Bank may notify from time to time in the Official Gazette.
Statutory Liquidity Ratio (SLR): Every bank shall maintain in India assets, the value of which shall not be less than such percentage of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight, as the Reserve Bank may, by notification in the Official Gazette, specify from time to time and such assets shall be maintained as may be specified in such notification (typically in unencumbered government securities, cash and gold).
Open Market Operations (OMOs): These include outright purchase/sale of
government securities by the Reserve Bank for injection/absorption of durable liquidity in the banking system Monetary Policy Vs Fiscal Policy Monetary and fiscal policy are crucial components of a government's economic toolkit, each serving distinct roles in managing and stabilizing the economy.
The implementation and authority lie in different hands: monetary policy
of India is executed by the central bank, the Reserve Bank of India, using tools like interest rates and reserve requirements to control the money supply, while fiscal policy is crafted and implemented by the government, influencing the economy through decisions on taxation, government spending, and borrowing.
The time horizon for their impact differs, with India's monetary policy acting relatively quickly, whereas fiscal policy measures may have a more delayed effect.
While monetary policy primarily affects financial markets and interest
rates, fiscal policy has a broader impact on the entire economy, directly influencing government expenditures, taxation, and overall demand.
The objectives of these policies vary, with monetary policy aiming to
control inflation and promote economic growth. In contrast, fiscal policy strives to achieve full employment, economic growth, and price stability through government spending and taxation policies.
Flexibility also distinguishes them, with India's monetary policy often
considered more adaptable due to the central bank's ability to make quick adjustments. In contrast, fiscal policy changes may require legislative approval and are subject to political considerations. Curbing Inflation in India: A Case Study of Monetary Policy Measures
Introduction: Inflation has been a persistent concern for the Indian economy, affecting its growth and stability. The Reserve Bank of India (RBI), as the country's central bank, plays a crucial role in managing inflation through monetary policy tools. This case study examines how monetary policy was employed in India to curb inflation during a specific period.
Background: India has experienced various episodes of inflation over the years, driven by factors such as supply-side constraints, fiscal deficits, global commodity prices, and monetary factors. High inflation erodes purchasing power, disrupts economic planning, and adversely impacts consumers, investors, and businesses.
Case Study Period: 2013-2016
1. Tightening Monetary Policy:
a. During the period under review, the RBI pursued a tightening monetary policy stance to curb inflation. This involved raising key policy rates, such as the repo rate and reverse repo rate. b. The repo rate, the rate at which the RBI lends to commercial banks, was increased to reduce the money supply in the economy, thus restraining demand-driven inflationary pressures. c. Similarly, the reverse repo rate, the rate at which the RBI borrows from commercial banks, was raised to incentivize banks to park more funds with the central bank, thereby reducing liquidity in the banking system.
2. Liquidity Management: a. The RBI employed various liquidity management tools, including open market operations (OMOs), cash reserve ratio (CRR), and statutory liquidity ratio (SLR), to regulate liquidity conditions in the financial system. b. OMOs involved buying and selling government securities to manage liquidity levels. By selling securities, the RBI absorbed excess liquidity from the system, curbing inflationary pressures. c. Adjustments in CRR and SLR requirements influenced the amount of funds banks could lend, thereby impacting overall money supply and inflationary tendencies.
3. Communication and Forward Guidance:
a. The RBI adopted a transparent communication strategy to provide forward guidance on its monetary policy decisions. Clear communication regarding the central bank's inflation targets and policy intentions helped anchor inflation expectations. b. By providing guidance on the future direction of interest rates and liquidity management, the RBI aimed to shape market expectations and influence investor behavior, thereby supporting its inflation-fighting efforts.
Outcome: The concerted efforts of the RBI to tighten monetary policy and manage liquidity contributed to a gradual moderation in inflation during the specified period. By addressing demand-side pressures and anchoring inflation expectations, the central bank successfully curbed inflationary tendencies, thereby supporting macroeconomic stability and sustainable growth.
Conclusion: The case study illustrates how monetary policy measures, including interest rate adjustments, liquidity management, and effective communication strategies, were utilized by the RBI to curb inflation in India during the period of 2013-2016. While the effectiveness of these measures depends on various domestic and external factors, the case underscores the importance of proactive and coordinated monetary policy actions in maintaining price stability and fostering economic resilience. Key Take Aways
Monetary policy is a set of actions to control a
nation's overall money supply and achieve economic growth. Monetary policy strategies include revising interest rates and changing bank reserve requirements. Monetary policy is commonly classified as either expansionary or contractionary. The RBI commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations.
