MONETARY POLICY

By Akshita Sharma

It is a macroeconomic policy laid down by the central bank of a country. It involves the management of cash supply and interest rates. It refers to the actions undertaken by a nation’s central bank to regulate funds to realize macroeconomic goals that promote the sustainable economic process.

Monetary policy refers to policies of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the act.

Let’s take an example
Suppose there is price instability in the market of a country then the investment would reduce which, in turn, would lead to reduced growth and reduced GDP of that country.
Now, what causes price instability? The answer is the flow of cash in the market or money supply in the market. So to manage this instability we need to use monetary policy and now the question is why this will help? The answer is because then we will be able to manage cash inflow and outflow in the market. This will create price stability in the market and hence good growth and high GDP will be there in the economy.

EXPANSIONARY MONETARY POLICY

When the economy of a country is faced with a high unemployment rate during a slowdown or a recession, the monetary authority of that country can opt for an expansionary policy aimed toward increasing economic process and expanding economic activity. This type of monetary policy aims at increasing money supply in the economy by reducing interest rates, purchasing government securities by the central bank and decreasing the reserve requirement for banks.

Expansionary policy can increase the availability of cheap credit sources in the market which will enhance consumer spending. Also, private investment would boost up leading to the lower unemployment rate. Its overall goal is to boost economic growth.

CONTRACTIONARY MONETARY POLICY

The contractionary monetary policy is adopted by the central bank when the government wants to control inflation in the economy. This policy helps to reduce money supply in the economy by increasing interest rates, selling government securities and increasing reserve requirements for banks. It aims to bring down inflation.
However, it can also lead to slow economic growth and increased unemployment but it is necessary to control excess inflation in the economy by adopting this policy.

The primary objectives of the monetary policy of a country are:
* Price stability
* Inflation control
* Maximum level of Employment
* Economic Growth

It is RBI’s responsibility to manage monetary policy in India under RBI Act 1934. In May 2016, RBI act 1934 was amended to provide a statutory basis for the implementation of FLEXIBLE INFLATION TARGETING FRAMEWORK. In this framework, inflation targets are set by the government of India in consultation with RBI for 5 years. The RBI has to ensure that the inflation level remains within the given targets. However, a relaxation (flexibility) of a certain percentage is given by the government to RBI and hence RBI has to keep the inflation rate between a certain range. Before this amendment, the inflation was managed in India without any targets.
Presently, the inflation target set by the union government is 4% with the flexibility of ± 2% for the period from August 5, 2016, to March 31, 2021. This means RBI has to maintain the inflation rate between the range of 2% to 6%.
So, the government of India sets the flexible inflation targeting framework in consultation with RBI.
RBI operates and manages the monetary policy framework.
Monetary policy is drafted by the monetary policy committee.
Monetary policy is drafted once in a year and reviewed bi-monthly, i.e, every 60 days.

What happens when RBI fails to satisfy the inflation target?

When the RBI fails to meet the inflation target, it will send a report to the central government stating reasons and the remedial actions that will be taken to control the inflation. A breach of the tolerance level for 3 consecutive quarters will constitute a failure of monetary policy.
The central government notified the subsequent as factors that constitute a failure to realize the inflation target:
(a) The average inflation is more than the upper tolerance level (presently 6%) of the inflation target for any three consecutive quarters,
or
(b) The average inflation is less than the lower tolerance level (presently 2%) of the inflation target for any three consecutive quarters

FLEXIBLE INFLATION TARGETING FRAMEWORK (FITF)

Flexible inflation targeting is a monetary policy strategy used by Central Bank to maintain the price level within a certain range.
Through an agreement signed between the RBI and, therefore, the government as of February 20, 2015, RBI decided to adopt FITF because of the modern monetary policy framework. In May 2016, the RBI Act, 1934 was amended to supply a statutory basis for the implementation of the FITF. The amended RBI Act provides for the inflation target to be set by the govt of India, in consultation with the Federal Reserve Bank, once every five years.

MONETARY POLICY FRAMEWORK

• The amended RBI Act provides the legislative mandate to the Reserve Bank of India to manage the monetary policy framework of the country.
• The framework aims at fixing the policy (repo) rate based on an evaluation of the current and emerging macroeconomic situation, and transition of liquidity conditions to set money market rates at or around the repo rate. Repo rate changes impart through the money market to the whole financial system, which influences aggregate demand of the economy which is a basic determinant of inflation and growth.
• Once the repo rate is disclosed, the operating framework designed by the RBI anticipates liquidity management on daily basis through appropriate actions, which aims at securing the operating target — the weighted average call rate (WACR) — round the repo rate.

MONETARY POLICY COMMITTEE

• Monetary policy in India is drafted by the monetary policy committee. The policy interest rates to achieve inflation target are decided by the monetary policy committee.
• It is a 6 member committee constituted by the central government under section 45ZB of amended RBI act.
• Of the six members, three members are nominated by the government for a tenure of 4 years. These members shall not be reappointed and also their tenure shall not be increased.
• The other three members would be from RBI with the governor being ex-officio chairperson, deputy governor of RBI and officer of RBI.
• MPC is required to meet at least 4 times a year.
• Each member of MPC has one vote and in case of a tie, the governor will have a casting vote.
• On the 14th day after the MPC meeting, the minutes of the proceeding of MPC is to be published with all details to the public on the RBI website.

Composition of Current Monetary Policy Committee:

The present members of the Monetary Policy Committee are :

1. Shaktikanta Das (Governor of RBI) — chairperson, ex officio
2. Michael Patra (Deputy Governor of RBI) — In charge of Monetary Policy
3. Janak raj (Executive Director of RBI) — In charge of Monetary Policy
4. Shri Chetan Ghate (Professor, Indian Statistical Institute) — Member
5. Professor Pami Dua (Director, Delhi School of Economics) — member
6. Dr Ravindra H. Dholakia (Professor, Indian Institute of Management, Ahmadabad) — Member

MONETARY POLICY PROCESS

• MPC determines the policy interest rate required to achieve the inflation target.
• RBI’s monetary policy department assists the MPC in formulating monetary policy.
• Financial market operations department implements the monetary policy in the market.
• Financial Market Committee meets daily to review liquidity conditions to ensure that target of monetary policy is achieved.

MONETARY POLICY INSTRUMENTS

QUANTITATIVE INSTRUMENTS

The quantitative instruments of monetary policy help to regulate the total quantity of credit. These instruments focus on the overall money supply and affect the economy as a whole. These are :

Cash Reserve Ratio (CRR)

it is the specified minimum percentage of a bank’s total deposits that a scheduled commercial bank is required to maintain with RBI in cash form on an average daily basis.
Presently the CRR is 3% according to RBI’s 7th monetary policy review.

Statutory Liquidity Ratio (SLR)

It is the specified minimum percentage of a bank’s total deposits that a scheduled commercial bank is required to maintain with it in liquid form such as cash, gold, government securities etc. the banks are required to keep this reserve requirement with them before offering credit to customers.
Presently the SLR is 18%.

Bank Rate

It is the rate at which RBI lends long term loans to domestic banks. Also, It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers.
Here, long term loans mean loans of more than 90 days.
Presently the bank rate is 4.25%

Repo Rate

It is the interest rate at which the RBI lends money to commercial banks in case of shortage of funds against the collateral of government and other approved securities. It includes short term loans of less than 90 days. The bank pays the loan and repurchases its securities kept as collateral with RBI.
The loans of short term by RBI to commercial banks include overnight lending facility, term repo facility and long term repo operations (newly introduced due to COVID-19 as a monetary measure).
Presently, it is 4%.

Reverse Repo Rate

It is the rate of interest at which the banks receive when they deposit their surplus funds with RBI on a short term basis against the collateral of approved government securities. Presently, it is 3.35%.

Marginal Standing Facility

It is a facility in which scheduled commercial banks can borrow additional amount of overnight money from the RBI by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This helps in providing a safety valve against unforeseen liquidity shocks to the banking system.
The rate of MSF is more than the repo rate in India. Presently the MSF rate is 4.25%.

Open Market Operations

These include buying and selling of government securities, for injection and absorption of durable liquidity, respectively. In the case of inflation, it sells the government securities and in the case of deflation, it purchases the government securities. This sale and purchase is done through RBI’s E-kuber platform.

MARKET STABILIZATION SCHEME

It was introduced in April 2004 by RBI. It is used to absorb excess liquidity in the market through the sale of government securities and treasury bills. The proceeds from the sale are held in separate government account of RBI and are not transferred to the government because then the government can spend this money in the economy which would increase liquidity.

QUALITATIVE INSTRUMENTS

These instruments focus on selected sectors of the economy. The instruments are :

Moral Suasion

Moral suasion is a strategy used by reserve bank to influence and pressure, banks and other economic agents into adhering to its policy and guidelines

Margin Requirement

The margin requirement is the difference between the value of security and the loan amount sanctioned against these securities. To reduce the money supply the central bank raises the margin requirements. This will reduce the amount available from pledging the securities.

Direct Action

The direct action is taken by the RBI when some commercial banks do not coordinate with the central bank in controlling the credit. Thus, the central bank takes direct action against such banks by following ways:
It may change rates over the bank rate.
It may refuse to provide rediscounting facilities to banks which are not following its directions.
It may refuse to give loans to such banks

Regulation of Consumer Credit

this method is followed during inflation to control the excess expenditure of the consumers. Generally, the hire purchase facilities or instalment methods are reduced to curb the expenditure on consumption. whereas, during a depression period, more credit facilities are allowed so that consumer may spend more and more money to pull the economy out of depression.

Originally published at https://www.studentsofeconomics.com.