RBI & Its Monetary Policies

RBI & Its

Monetary
Policies

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 RBI & Its Monetary Policies

Table of Contents

NO. Particulars

1. Introduction of RBI
2. Monetary policy
3. Monetary policy objectives
4. Monetary policy functions
5. Operations of Monetary policy
 Quantitative credit control
 Selective or qualitative methods
6. Operating procedures of Monetary policy
 Liquidity adjustment facility (LAF)
 Market stabilization scheme
7. Monetary policy tools
8. Recent changes in Monetary policy
9. Evaluation of Monetary policy
10. First quarter review of monetary policy (2010-11)
11. Mid quarter review of monetary policy (2010-11)
12. limitations
13. Conclusion
14. Bibliography

INTRODUCTION OF RBI

The central bank of the country is the Reserve Bank of India (RBI). It was
established in April 1935 with a share capital of Rs. 5 crores on the basis of the
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 RBI & Its Monetary Policies

recommendations of the Hilton Young Commission Reserve Bank of India was

nationalized in the year 1949. The general superintendence and direction of the
Bank is entrusted to Central Board of Directors of 20 members, the Governor and
four Deputy Governors, one Government official from the Ministry of Finance, ten
nominated Directors by the Government to give representation to important
elements in the economic life of the country, and four nominated Directors by the
Central Government to represent the four local Boards with the headquarters at
Mumbai, Kolkata, Chennai and New Delhi. Local Boards consist of five members
each Central Government appointed for a term of four years to represent territorial
and economic interests and the interests of co-operative and indigenous banks.

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act,
1934 (II of 1934) provides the statutory basis of the functioning of the Bank.

Objectives and Reasons for the Establishment of R.B.I:

The main objectives for establishment of RBI as the Central Bank of India
Were as follows:
 To manage the monetary and credit system of the country
 To stabilizes internal and external value of rupee.
 For balanced and systematic development of banking in the country.
 For the development of organized money market in the country.
 For proper arrangement of agriculture finance.
 For proper arrangement of industrial finance
 For proper management of public debts.To establish monetary
relations with other countries of the world andinternational financial
institutions.
 For centralization of cash reserves of commercial banks.

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 To maintain balance between the demand and supply of currency.

According to the Reserve Bank of India Act, the aim of RBI is, “to
regulate the issue of bank notes and keeping of reserve with a view to secure
system of the country to its advantage.”

Monetary Policy

India is the management of a nation's money supply to achieve economic

goals by a central bank or currency board. Monetary policy objectives can include

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control of inflation, control of exchange rates, or even simply economic stability.

Monetary policy is contrasted with fiscal policy, which aims to achieve economic
goals through taxation and government expenditure. The Federal Reserve, or Fed,
handles monetary policy in the United States. The Fed controls the money supply
through open market operations, and also sets interest rates between banks and
reserve requirements. Tight monetary policy, also called contractionary monetary
policy, tends to curb inflation by contracting the money supply. Easy monetary
policy, also called expansionary monetary policy, tends to encourage growth by
expanding the money supply.

These factors include - money supply, interest rates and the inflation. In
banking and economic terms money supply is referred to as M3 - which indicates
the level (stock) of legal currency in the economy.

Besides, the RBI also announces norms for the banking and financial sector
and the institutions which are governed by it. These would be banks, financial
institutions, non-banking financial institutions, Nidhis and primary dealers (money
markets) and dealers in the foreign exchange (forex) market.

When is the Monetary Policy announced?

Historically, the Monetary Policy is announced twice a year - a slack season

policy (April-September) and a busy season policy (October-March) in accordance
with agricultural cycles. These cycles also coincide with the halves of the financial
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 RBI & Its Monetary Policies

year. Initially, the Reserve Bank of India announced all its monetary measures
twice a year in the Monetary and Credit Policy. The Monetary Policy has become
dynamic in nature as RBI reserves its right to alter it from time to time, depending
on the state of the economy

Monetary regulations

The main function of the Reserve Bank of India, as of all the central banks, is to
formulate and administer monetary policy. Monetary policy refers to the use of
instruments with the purview of the central bank to influence the level of aggregate
demand for goods and services. Monetary policy is the twin objective of price and
growth. As part of the monetary policy, money supply is sought to be influenced
because it will have effect on output and prices. With the economic and the
financial liberalisation and deregulation measures initiated since early 1990s, the
framework of the monetary policy formulation and implementation has been
undergoing significant changes, indirect tools gaining prominence over direct
instruments along with a series of steps for the development and integrity of
financial markets. The Reserve Bank of India thus seeks to influence the level of
money through a continuation of measures that include interest rates as well as
open market operations and other measures that alter the Bank reserves

Monetary policy objectives

In India, the main objective of monetary policy is ‘growth with stability. But
of late, financial stability is also becoming an important objective in view of the

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increasing openness of the Indian economy. Besides, the RBI also uses its power to
direct credit flows to the priority sector to meet certain social objectives.
The following are the main objective of RBI’s monetary policy:-

1) Growth with stability :-

the main objective s of monetary policy in India are (a) price
stability and (b) provisions of adequate credit to productive sectors of the
economy to support aggregate demand and ensure high GDP growth. These
objectives can be together termed as ‘growth with stability’. Traditionally,
RBI’s monetary policy was focused on controlling inflation through
contraction of money supply and credit. But this resulted in poor growth
performance of the economy. Therefore, RBI has now adopted the policy of
‘growth with stability’ or ‘controlled expansion’ of credit. this means, the
monetary policy will be such that sufficient credit will be made available for
the growing needs of different sectors of the economy, and at the same time,
inflation will be controlled within a certain limit.

2) Financial stability:-
Financial stability means the ability of the economy to absorb shocks
and maintain confidence in the financial system. Threats to financial stability
can come internal and external shocks, e.g. collapse of major banks or a
sudden rise in international oil price. Such shocks can destabilize the
country’s financial system and cause volatile and unpredictable changes in
the economy. The Indian economy is now open to external influences and
can be affected by such shocks. Therefore, greater emphasis is being given
to RBI’s role in maintaining confidence in the financial system through

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proper regulations and controls, without sacrificing the objective of growth.

Accordingly, RBI is focusing on regulation, supervision and development of
the financial system.

3) Promotion of financial inclusion:-

Financial inclusion is the process by which financial services and
timely and adequate credit at affordable cost are provided to the weaker
sections and low income groups. Since nationalization of commercial banks
in 1969, RBI has been promoting priority sector lending by banks. Priority
sector includes agriculture, export and the small scale enterprises and the
weaker section of the population. Of late, it has been observed that financial
inclusion has not been achieved in case of many sections of society.
Therefore, RBI< along with NABARD, is focusing on microfinance through
the promotion of self help groups and other institutions. These efforts of RBI
are expected to reduce income inequality.

4) Employment generation :-
Monetary policy promotes growth and therefore indirectly
promotes employment generation. Selective measures of credit control
indirectly help in employment generation. By allocating cheap credit to
agriculture and small scale industries, the RBI seeks to generate
employment.al though maintaining price stability is considered the most
important objective of monetary policy, recent experiences in conducting
monetary policy has called for an imperative need for strategic adjustment so
as to enable the policy to respond effectively to market disturbances and

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external sector development, particularly in the context of Indian economy

getting integrated with global financial market.

Monetary policy functions

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 RBI & Its Monetary Policies

Monetary policy functions form the core of central banking functions and
constitute the key functions of almost all the central banks. Of these functions,
currency management and maintenance of external value of currency were the
predominant concerns of central banks in the early years of central banking .the
explicit concern for price stability is of relatively later origin.

1) Currency issue and management :

Currency management is one of the most Important traditional

functions of the central banks in most countries. Until the evolution of
central banks, private banks issued their own currency and there were often
numerous currencies with varying degrees of acceptability. The task of
currency issue was entrusted to the central bank so as to bring uniformity in
note issue across the country and facilitate exchange. Central bank s have
continued to perform this functions for number of years. Currency issue was
nationalized in almost all the countries. This function grew in scope and the
present task of currency management includes functions such as estimating
the demand for currency, currency design, printing, shortage, distribution
and disposal of unit notes.

The monopoly power to issue currency is delegated to a central

bank in full or sometimes in part. The practice regarding the currency issue
is governed more by convention than by any particular theory. It is well
known that the basic concept of currency evolved in order to facilitate
exchange. The primitive currency note was in reality a promissory note to
pay back to its bearer the original precious metals. With greater acceptability
of these promissory notes, these began to move across the country and the
banks that began to issue the promissory notes soon learnt that they could

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issue more receipts than the gold reserves. Even after the emergence of
central banks, the concerned governments continued to decide asset backing
for issue of coins and notes. The asset backing took various forms including
gold coins, bullion, foreign exchange reserves and foreign securities.

2) Maintaining internal value of the currency

Instituting a medium of exchange is one of the oldest functions

assigned to central banks. Arising from the core function is the monetary
policy function of keeping inflation low in order to maintain the value of the
medium of exchange over time. This function is still very relevant to modern
central banks as can be seen from the widespread adoption of inflation
targeting framework.

Domestic policy objectives have been centered on price stability goals

for years and even today have remained the main pre-occupation of central
banks. There have been often a conflict between functions of central bank;
for instance, maintaining the value of currency conflicted with its functions
of being a banker to the government, especially in developing country.
These central banks have to manage a very level of public debts and often
used inflation tax that undermined their price stability objective.

There is increasing realizing that printing more money does not help
in raising growth rates. In fact, a stable price level has become a pre-
requisite of growth and trade. Accordingly, the maintenance of price
stability through the conduct of monetary policy has become the prime
objective of central bank. In a market economy, the central may have the
option of using market-based instruments for conduct of monetary policy. It

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may choose intermediate targets such as interest rates, exchange rates and
monetary aggregates.

3) Maintaining external value of the currency

Central banks in many economies consider exchange rate

management as a crucial function. Exchange rate management was the core
concern of the traditional central banks even in the 17 th century. During the
gold standards, the exchange rate was determined more or less automatically
by the mechanism of specie flow. It ensured that the value of the currency
rose with an increase in gold reserves and decreased with a decrease in the
reserves.

The role of central bank in managing the exchange rate cannot be

underplayed. The rationale underlying the management of the exchange rate
by the central bank has varied over time. There are various patterns to the
management of the exchange rate. Some central banks keep exchange rates
depressed while others target it a particular point or within a range.

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Operations of monetary policy

Instruments

The RBI has multiple instruments at its command such as repo and reverse
repo rates, cash reserve ratio (CRR), statutory liquidity ratio, open market
operations, including the market stabilization schemes (MSS) and the liquidity
adjustment facility (LAF), special market operations, and sector- specific liquidity
facilities. In addition, the RBI also uses other operational tools to modulate flow of
credit to certain sectors consistent with financial stability. The availability of
multiple instruments and flexible use of these instruments in the implementation of
monetary policy has enabled the RBI to modulate the liquidity and interest rate
conditions admit uncertain global macroeconomics conditions.

The important function of RBI is to control money and credit in the country. The
instruments of monetary policy operated by the RBI may be classified into two
categories

(i) Quantitative measures which affect the total money supply and credit
(ii) Qualitative or the selective measures which affect the allocation of bank
credit among competing uses and users

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Quantitative credit control

1) Bank rate: -
As the lender of the last resort, the RBI helps the commercial banks in
temporary need of cash when other sources of raising cash are exhausted.
The RBI provides credit to banks by rediscounting eligible bills of exchange
and by making advances against eligible securities such as government
securities. The lending rate for these advances by the RBI is called the
BANK RATE which is a traditional weapon to control money supply. An
increase in the bank rate would discourage commercial banks to borrow
from the RBI and a corresponding increase in the lending rate of commercial
banks to general public would decrease public borrowings from the bank.

2) Reserve requirements: -
Reserve requirements are used by RBI to control the credit creation
capacity of banks. Every commercial bank needs to maintain a certain
proportion of its assets in the form of reserves dash reserve ratio (CRR) and
statutory liquidity ratio (SLR) are the two reserve requirements imposed by
the RBI. When the TBI changes the reserve requirements, its influences that
capacity of banks to lend and create credit. During inflation the reserve
requirements are raised and during recession they are lowered.

a) CASH RESERVE RATIO (CRR):-

Scheduled banks in India are required to hold cash reserves,
called cash reserve ratio (CRR), with the RBI. Increase/decrease in CRR is
used by the RBI as an instrument of monetary control, particularly to

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mop up excess increase in the supply of money this power was given to
RBI in 1956.

b) STATUTORY LIQUIDITY RATIO:

Apart from the CRR, the banks in India are also subject to
statutory liquidity requirement. Under this requirement, commercial
banks along with other financial institutions are required under law to
invest prescribed minimum proportions of their total assets/liabilities in
government securities and other approved securities. The underlying
philosophy of this provision is to allocate total bank credit between the
government and the rest of the economy. The assurance of a certain
minimum share of bank credit to the government affects the borrowings
of the government from the RBI and hence serves as a tool of
quantitative monetary control.
The SLR provisions have created a captive market for government
securities which increases automatically with the growth in the liabilities of
the banks. Moreover, it has kept the cost of the debt to the government
low in view of the generally low rate of interest on government securities.

3) OPEN MARKET OPERATIONS: -

The RBI can enter the money market for the purpose or sale of
government securities on its own account. Every open market purchase of
the RBI increase primary money by equal amount while every sale
decreases it. As regards their advantages, open market operations are
highly flexible. Easily reversible in time, their effect on money supply is

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immediate, and they do not carry announcement effect as in the case of

changes in the bank rate.
Open market operations, consider very effective in developed
countries, are not of much importance in India in view of captive nature of
the market for government bonds. For example, the treasure bill market is
limited largely to the RBI itself and scheduled commercial banks which are
required under law to invest minimum proportion of their total liabilities in
government securities. The private dealers In government securities are
few and far between.

4) Repo And Reverse Repo Rates:

The bank rate as a credit control policy instrument is losing its
importance in recent years. At present, the repo and the reverse repo rates
are becoming important in determining interest rate trends. Repo (sale and
repurchase agreement) is a swap deal involving the immediate sale of
securities and simultaneous purchase of those securities at a future date, at
a predetermined price. Such swap deals take place between the RBI on one
hand, and banks and other financial institutions, on the other. The repo
rate helps commercial banks, to acquire funds from the RBI by selling
securities and at the same time agreeing to repurchase them at a later
date. Reverse repo rate that banks get from RBI for parking their short term
excess funds with the RBI. The RBI has introduced overnigh repos as well as
longer-term up to 14 day period. Repo and reverse repo operations are
used by RBI in its liquidity adjustment facility which is used to manage day-
to-day liquidity position in the market.

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b) selective or qualitative methods

The RBI has the power to direct banks to meet their obligation through
selective methods of credit control. These methods affect particular sections of
the economy as the influence distribution and direction of credit. The following
are some of the selective methods followed by RBI:-

1) Margin requirements: -
A loan is sanctioned against a collateral security. Margin is that
proportion of value of the security against which loan is not given higher
the margin, lesser will be the loan sanctioned in India, bank loans are often
used for speculative and unproductive purposes. To prevent this, the RBI
has relied on the method of minimum requirements.

2) Discriminatory rates of interest:-

Under this method, different rates of interest are charged for
different use of credit. RBI has relied on this method to direct resources to
priority sector, export promotion and prevent speculative use of bank
finance. This method has been used along with margin requirements in to
prevent hoarding essential agricultural commodities.
3) Ceiling on credit:- Under this scheme, the RBI imposes limits on the amount
of credit to different sectors.
4) Direct action:- RBI may use strict disciplinary actions against banks that fail
to follow its directives. These may be in the form of cancellation of
licenses , refusal of rediscounting facility and imposition of penalty. These
methods are very harsh and are therefore rarely carried out by RBI.
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MORAL SUASION:- though moral suasion (discussions, suggestions and advise),

the RBI can influence the investment and credit policies of the commercial banks.
For example, it can ask the commercial banks to invest a larger proportion, than
required, of their assets in government securities. Similarly, it canadvice them
regarding the allocation of credit to the private sector.

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Operating Procedures of Monetary Policy

The conduct of contemporary monetary policy in the Indian economy is based
on a carefully strategy. The strategy aims to balance the linkage between monetary
policy, credit policy and the regulatory regime in a dynamics environment of
structural transformation.

Monetary policy now simultaneous pursues the objectives of price stability,

provision of appropriate credit for growth and increasingly, financial stability.
While there are complementarities between the objectives, especially in the long
run, it cannot be denied that there are certain tradeoffs, especially in the short-run.
The RBI has always had to address the monetary policy dilemma of providing
adequate credit to the government and the commercial sector, without fuelling
inflationary pressure. With the deregulation of the interest rates, as added
dimensions is to balance the interest cost of public debt with the price of the
commercial credit.

In the late 1990s, in view of ongoing financial openness and increasing

evidence of changes in underlying transmission mechanism with interest rates and
exchange rates gaining in importance vis-à-vis quantity variables, it was felt that
monetary policy exclusively based on the demand function for money could lack
precision. The Reserve Bank, therefore, formally adopted a multiple indicator
approach in April 1998 whereby interest rates or rates of return in different
financial markets along with data on currency, credit, trade, capital flows, fiscal
position, inflation, exchange rate, etc., are juxtaposed with the output data for
drawing policy perspectives. Such a shift was gradual and a logical outcome of
measures taken over the reform period since the early 1990s. The switchover to a
multiple indicator approach provided necessary flexibility to respond to changes in

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domestic and international economic environment and financial market conditions

more effectively.
The operating procedures of monetary policy in India have undergone a
significant shift. In particularly, short-term interest rates have emerged as
instruments to signal the stance of monetary policy. In order to stabilize short-term
interest rates, the RBI now modulates market liquidity to steer monetary conditions
to the desired trajectory this is achieved by the mix of policy instruments including
changes in the reserve requirements an standing facilities and open market
operations which affect the quantum of marginal liquidity and changes in the
policy rates, such as bank rate and reverse repo/repo rates, which impact the price
of liquidity.

Now two new initiatives are – one structural and the other on policy review and
communication.

(i) Liquidity adjustment facility(LAF):-

LAF, introduced in June 2000, allows the RBI to manage market
liquidity on a daily basis and also transmit interest rate signals to the
market. The LAF, initially recommended by the committee on
banking sector reforms, was introduced in the stages in consonance
with the level of market development and technological advances in
payment and settlement systems. The first challenge was to combine
the various sources of liquidity available from the RBI into a single
comprehensive window, with a common price. An interim liquidity
adjustment facility (ILAF), introduced in April 1999 as a mechanism
for liquidity management through a repo operation, export credit
refinance facilities and collateralized lending facilities support by

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open market operations at set rates of interest, was upgraded into a

full- fledge LAF. Most of the alternative provision of primary
liquidity has been gradually phased out and even though export credit
refinance is still available, it is linked to the repo rate since March
2004. Accordingly, the LAF has now emerged as the principal
operating instrument of monetary policy.
The LAF has emerged as an effective instrument for maintaining
orderly conditions in the financial markets in the face of sudden
capital outflows to ward off the possibility of speculative attacks in
the foreign exchange market. By funding the Government through
private placements and mopping up the liquidity by aggressive reverse
repo operation at attractive rates, the LAF helps to minimize the
impact of market volatility on the cost of public debt. The LAF
accords the Reserve Bank the operational flexibility to alter the
liquidity in the system (by rejecting bids) as well as adjusting the
structure of interest rates.

(ii) Market stabilization scheme:

Pursuant to the recommendations of the Internal Working Group on
LAF as well as the Internal Working Group on Instruments for
Sterilisation, a market Stabilisation Scheme (MSS) was introduced in
April 2004. The issurance of securities under the MSS enables the
Reserve Bank to improve liquidity management in the system\, to
maintain stability in the foreign exchange market and to conduct
monetary policy in accordance with the stated objectives.
The Indian experience underscores the need for constant innovation in
terms of instruments and operating procedures for effective monetary
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management. Apart from introduction of innovative instrument such as

the MSS, the policy framework has evolved in response to the changing
environment. Illustratively, the interest rates in the LAF auctions were
initially allowed to emerge from the bids, with the RBI holding
occasional fixed rate auctions to transmit interest rate signals. As market
players began to bid at the prices signalled by the RBI, the de jure
market-determined LAF rates began to turn into de facto fixed rates. It is
in this context that the Reserve Bank switched to a fixed auction format
in March 2004. Second, while the reverse repo rate, acted as the floor, the
practice of supplying liquidity at multiple rates, e.g., the and the repo
rate, implied that there was no unique ceiling. It is in this context that the
RBI has increasingly been resorting to pricing its liquidity at the repo
rate, in recent years. Apart from Ways and Means Advances (WMA)
which are still at the Bank Rate, all other forms of liquidity support are at
the repo rate.

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Monetary policy tools

 Monetary base
Monetary policy can be implemented by changing the size of the
monetary base. This directly changes the total amount of money circulating
in the economy. A central bank can use open market operations to change
the monetary base. The central bank would buy/sell bonds in exchange for
hard currency. When the central bank disburses/collects this hard currency
payment, it alters the amount of currency in the economy, thus altering the
monetary base.
 Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary
policy can be implemented by changing the proportion of total assets that
banks must hold in reserve with the central bank. Banks only maintain a
small portion of their assets as cash available for immediate withdrawal; the
rest is invested in illiquid assets like mortgages and loans. By changing the
proportion of total assets to be held as liquid cash, the Federal Reserve
changes the availability of loanable funds. This acts as a change in the
money supply. Central banks typically do not change the reserve
requirements often because it creates very volatile changes in the money
supply due to the lending multiplier.
 Discount window lending
Many central banks or finance ministries have the authority to lend
funds to financial institutions within their country. By calling in existing
loans or extending new loans, the monetary authority can directly change the
size of the money supply.

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 Interest rates
The contraction of the monetary supply can be achieved indirectly by
increasing the nominal interest rates. Monetary authorities in different
nations have differing levels of control of economy-wide interest rates. In
the United States, the Federal Reserve can set the discount rate, as well as
achieve the desired Federal funds rate by open market operations. This rate
has significant effect on other market interest rates, but there is no perfect
relationship. In the United States open market operations are a relatively
small part of the total volume in the bond market. One cannot set
independent targets for both the monetary base and the interest rate because
they are both modified by a single tool — open market operations; one must
choose which one to control.
In other nations, the monetary authority may be able to mandate specific
interest rates on loans, savings accounts or other financial assets. By raising
the interest rate(s) under its control, a monetary authority can contract the
money supply, because higher interest rates encourage savings and
discourage borrowing. Both of these effects reduce the size of the money
supply.
 Currency board
A currency board is a monetary arrangement that pegs the monetary base
of one country to another, the anchor nation. As such, it essentially operates
as a hard fixed exchange rate, whereby local currency in circulation is
backed by foreign currency from the anchor nation at a fixed rate. Thus, to
grow the local monetary base an equivalent amount of foreign currency must
be held in reserves with the currency board. This limits the possibility for the

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local monetary authority to inflate or pursue other objectives. The principal

rationales behind a currency board are three-fold:

1. To import monetary credibility of the anchor nation;

2. To maintain a fixed exchange rate with the anchor nation;
3. To establish credibility with the exchange rate (the currency board
arrangement is the hardest form of fixed exchange rates outside of
dollarization).

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 RBI & Its Monetary Policies

Recent changes in RBI’S monetary policy

RBI’s monetary management has undergone some major changes since 1991.
Before 1991, the RBI’s monetary policy was closely linked with the financing of
fiscal deficit. Now, the focus is more on promoting economic growth and
maintaining price stability.

1) Multiple indicator approach:

In 1980s and up to 1990s, the RBI used the ‘monetary targeting
approach’ to its monetary policy. Monetary targeting refers to a monetary
policy strategy aimed at maintaining price stability by focusing on the
changes in growth of money supply (M3). It was believed that a continuous
rise in money supply caused inflation. After reforms in 1991, this approach
became difficult to follow. Financial liberalization brought more innovative
financial products. Earlier, RBI could monitor money supply as banks were
the only financial intermediaries. As non-banking sources of finance grew,
monitoring money supply and controlling inflation became difficult. Hence,
RBI adopted the Multiple Indicators Approach in which it looks at a
variety of economic indicators and monitors their impact on inflation
and economic growth. This approach was formally adopted in April 1998.
As a part of this approach, variables such as money, credit, output, trade,
capital flows and fiscal position, as well as rates of return in different
markets, inflation rate and exchange rate, are analyzed.

2) Expectation as a channel of monetary transmission:

Monetary policy transmission refers to the channel through which a
change in monetary policy affects the economy. Traditionally, four key
channels of monetary policy transmission are identified, interest rate, credit
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availability, asset prices and exchange rate channels. The interest rate
channel is the most dominant has an immediate impact on interest rate and
through it on prices, demand, consumption and growth. In the recent
period, a fifth channel, expectations, has also emerged. Future
expectations about asset prices, general price and income level influence the
four traditional channels and is therefore, taken into consideration by RBI in
evaluating monetary policy transmission.

3) Introduction of liquidity adjustment facility (LAF):

LAF is a tool used in monetary policy that allows banks to borrow
money through repurchase agreements. LAF was introduced by RBI during
June 2000, in phases. The funds under LAF are used by the banks to meet
their day-to-day mismatches in liquidity. Under the scheme, reverse repo
auctions (for absorption of liquidity) and repo auctions (for injection of
liquidity) are conducted. LAF has emerged as the most important factor in
RBI’s short term monetary management.

4) Selective methods being phased out:

With greater market orientation of monetary policy and rapid
progress taking place in the financial markets, the selective methods of
credit control are being slowly phased out. The quantitative methods are
becoming more and more significant.

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5) Delinking monetary policy from budget deficit:

In 1994, an agreement has been reached between the central
government and the RBI to phase out the use of ad hoc treasury bills. These
bills were being used by the government to borrow form to finance fiscal
deficit. With the phasing out the bills, RBI would no longer lend to the
government to meet fiscal deficit.

6) Deregulation of administered interest rate system:

The lending rates of banks used to be determined by the RBI earlier.
Since 1990s this system has been changed and the lending rates are no
longer regulated by the RBI but are determined by commercial banks on the
basis of market forces.

7) Reduction in reserve requirements:

CRR and SLR have been progressively lowered during the post-
reform period. This has done as a part of financial sector reforms on the
recommendations of the narasimham committee report. As a result, more
bank funds have been released for lending purpose. This promoted growth
of the economy and improved profitability of banks.

8) Provision of micro finance:

The RBI has introduced the scheme of micro finance for the rural
poor by linking the banking system with Self Help Groups.RBI, along with
NABARD, has been promoting various other microfinance institutions.

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9) External sector:
The monetary policy is now oriented towards the process of
globalization of India’s financial markets. It has become sensitive to
changes in the rest of the world as India is increasingly attracting large
amount of foreign capital. RBI uses sterilization and LAF to absorb the
excess liquidity that comes in with huge inflow of foreign capital. This is
done to provide stability in the financial markets.

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Evaluation of monetary policy

Achievements:
1) Financial stability:
RBI has been successful in maintaining financial stability during the
global financial crisis because of its controls, regulation and supervision
mechanism. It has also been able to maintain macroeconomic stability to a large
extent during the global crisis period.

2) Short term liquidity management:

The RBI has succeeded in managing short term liquidity in order to
maintain stability in interest rate and exchange rate. It has developed various
methods to do this through LAF, OMO and MSS. In spite of large inflows of
foreign capital, the RBI has managed its sterilization operations very well.

3) Adaptability:
RBI has adapted its monetary policy approach with changing times. It has
developed new methods of credit control and has shifted from monetary
targeting to multiple indicator approach. This has made the monetary system in
India flexible, helping it to move with the times.

4) Financial inclusion:
RBI, along with Narbada, has made a great impact in the growth of
microfinance. It has supported the Self Help Group model and promoted other
microfinance institution. However, there is a lot more that needs to be done in
this area

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5) Promotion of Growth:
RBI has used its instruments effectively to maintain the growth of the
economy even during the current phase of global slowdown. India at present
has the second highest rate of GDP growth after china. Monetary policy has
played a major role in this.

Limitations:

1. Existence of unorganized money market:

Despite all that has been achieved by the banking sector through
branch expansion, a large unorganized sector continues to exist, especially in
the rural areas. RBI’s monetary policy does not affect the functioning of this
sector. It is comprised of indigenous bankers, money lenders, agents etc.
who continue to provide credit to a large number of people at high rate of
interest.
2. Weak channels of monetary transmissions:
Recently, RBI has admitted that the traditional channels of monetary
transmission, interest rate, credit availability, asset prices and exchange rate
channels are weak. That is, the RBI’s monetary policy dose not get properly
transmitted to the economy through these channels, this is because of
underdeveloped securities market, unorganized money market and
speculative assets markets.
3. Unable to control inflation:
India experienced high of inflation in the 1960s, 1970s and 1980s due
to rapid growth in money supply and shortages in the availability of goods.
To control inflation , RBI raised bank rate, CRR and SLR to very high
levels. This proved to be ineffective as money supply continued to rise due
to deficit financing and shortages continued to exist to excessive government

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control. The monetary policy followed by RBI the restricted growth of the
economy. Only after 1990s this situation has changed and today CRR, SLR
and bank rate are lower and inflation too is under control. Currently India is
facing high rate of food inflation. Since it is largely due to supply side
factors, RBI’s monetary policy is not very effective in controlling such
inflation.
4. Existence of black money:
Due to high rate of taxation in the past, India has had high incidence of
tax evasion. This has generated huge amount of black money. Black
economy gives rise to inflation and speculative activities. The impact of
such money cannot be controlled by RBI’s monetary policy.
5. Preference for cash transactions:
A large part of the country is still non-monetizes and transaction are
preferred to be done in cash rather than through the banking system. Such
cash transactions do not come under the purview of the RBI’s monetary
policy. However, with rapid growth of the economy, preference for cash
transactions is also reducing.
6. Phasing out of Selective Methods:
It is being argued that the RBI should revive the use of selective
measures of credit control to directly attack sector specific inflation, since
the general methods are ineffective in case of such inflation. Methods like
credit rationing and discriminatory interest rates can be used in this case.

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First Quarter Review of Monetary Policy 2010-11

The Reserve Bank released the First Quarter Review of Monetary Policy for
2010-11 at a meeting of the chief executives of major banks. Given below are
comments made by Dr. D. Subbarao, Governor of the Reserve Bank of India.

1) The important decisions contained in the review were to raise the repo
rate from 5.5 per cent to 5.75 per cent and the reverse repo rate from 4
per cent to 4.50 per cent.  This asymmetric raise in rates narrows the
LAF corridor from 150 basis points to 125 basis points.

Balance of Policy Stance

2)  The dominant concern that has shaped the monetary policy stance in this
review is high inflation. Even as food price inflation and, more generally,
consumer price inflation, have shown some moderation, they are still in
double digits. Non-food inflation has risen, and demand side pressures are
clearly evident. With growth taking firm hold, the balance of policy stance
has to shift decisively to containing inflation and anchoring inflationary
expectations.

Global Outlook

3)   Since our last policy review in April, the macroeconomic environment

has changed significantly. In the aftermath of the Greek sovereign debt
crisis and other visible soft spots in Europe and the US, there is renewed
uncertainty about the sustainability of the recovery. In contrast, EMEs are
witnessing strong growth, driven by rising domestic demand, restocking of
inventories and, thus far, recovering global trade. The relatively rapid

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recovery in EMEs has also been accompanied by higher inflation. Overall,

though, there is widespread expectation of a slowdown of the global
economy in the second half of 2010.
Indian Economy
Growth
4) The macroeconomic developments in India are contrarian to the global
trend. We have recovered faster, but our inflation rate has also been higher.
The recovery process has consolidated and become more broad-based
since April 2010. A big ‘known unknown’ in April 2010 was the outlook
on monsoon. That has since become a ‘known known’ in the sense that
rainfall so far has been better than during last year, and the crop-wise area
sown and the distribution of rainfall offer scope for cautious optimism on
the agricultural front.
5)   Better farm sector prospects should lead to a pick-up in rural demand.
This should give further momentum to the performance of the industrial
sector which has been growing firmly. The strength of the recovery is also
reflected in the sales and profitability growth of the corporate sector with
more investment intentions being translated into action across a range of
sectors. While domestic drivers of growth are robust, any slowdown in the
global recovery will affect all EMEs, including India.
6)  Taking into account the above factors, the projection for real GDP
growth for 2010-11 is revised to 8.5 per cent, up from our April policy
projection of 8.0 per cent with an upside bias. This upward revision is
primarily based on better industrial production and its favourable impact
on the services sector while giving due consideration to the global
scenario.

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Inflation

7)  The developments on the inflation front are, however, worrisome. Let me

explain. WPI inflation has been in double digits since February 2010.
Primary food articles inflation, despite some moderation, continues to be in
double digits. Between November 2009 and June 2010, non-food inflation
rose from zero to 10.6 per cent and non-food manufactured inflation from
zero to 7.3 per cent. Significantly, non-food items contributed over 70 per
cent to WPI inflation in June 2010, suggesting that inflation is now very
much generalised. Inflation in terms of all four consumer price indices
remains in double digits notwithstanding some decline in recent months.
8)   Going forward, the outlook on inflation will be shaped by: (i) the
monsoon performance for the remaining period; (ii) movements in global
energy and commodity prices, which have been showing distinct signs of
softening over the past few weeks; and (iii) potential build-up in demand-
side pressures with the strengthening of domestic growth drivers.
9)   Taking into account the emerging domestic and external scenario, the
baseline projection for WPI inflation for March 2011 has been raised to
6.0 per cent from our April policy projection of 5.5 per cent.

Monetary Aggregates

10) It is expected that even with the higher growth projection, monetary
aggregates will evolve along the projected trajectory indicated in the April
policy statement. Accordingly, for policy purposes, we have retained the
earlier projections of money supply (M3) at 17 per cent and of non-food
bank credit growth at 20 per cent.

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Risk Factors

11) Let me indicate some important risks to the growth and inflation
outlook.
 The first risk factor is that if the global recovery falters, the
performance of EMEs is likely to be adversely affected, and a
widespread slowdown in global trade will have an impact on the
Indian manufacturing and service sectors too.
 The second risk factor is that an uncertain global situation will 
significantly reduce the flow of capital into EMEs. Such a slowdown
in capital inflows will constrain domestic investment which is critical
to achieving and sustaining high growth rates. This could potentially
be a problem in India too since our rapid recovery has resulted in a
widening of the current account deficit.
 It must be recognized though that the risk of capital flows runs both
ways. It is quite possible that EMEs, including India, will receive
more flows than they need because of accommodative monetary
policies of advanced country central banks for an extended period.
Large capital inflows above the absorptive capacity of our economy
will pose a challenge for monetary and exchange rate management,
and also have implications for asset prices. In this scenario, a
widening current account deficit will help absorb a larger proportion
of the inflows.

 The third risk factor is on the inflation front.  Softening of inflation in

the months ahead is contingent on moderation of food prices which

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in turn will depend on a balanced spatial andtemporal distribution of

rainfall in the remaining period of this monsoon season.
 While on risk factors, we must note one important upside.  If global
growth does not pick up, commodity and energy prices will remain
subdued.  Furthermore, unutilised global capacity in several sectors
will soften the prices of imports and put downward pressure on
import substitutes.

Monetary Policy Stance

12. The Reserve Bank began the reversal of its expansionary monetary policy in
October 2009 and has calibrated the exit to India’s specific growth-inflation
dynamics. Today’s policy action in particular has been informed by three major
considerations:

 domestic economic recovery is firmly in place and is strengthening;

 there is a need to contain the demand-side inflationary pressures
which are clearly evident; and
 despite the increase in the policy rates by 75 basis points
cumulatively, it is imperative that we continue in the direction of
normalising our policy instruments to a level consistent with the
evolving growth and inflation scenario, while taking care not to
disrupt the recovery.
13) Our monetary policy actions are expected to:
 Moderate inflation by reining in demand pressures and inflationary
expectations.
 Maintain financial conditions conducive to sustaining growth.

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 Generate liquidity conditions consistent with more effective

transmission of policy actions.
 Restrict the volatility of short-term rates to a narrower corridor.

Operating Procedures of Monetary Policy

14)   The two new initiatives are – one structural and the other on policy review
and communication.

15)  The Reserve Bank’s LAF operates in such a manner that as systemic liquidity
alternates between surplus and deficit, even at the margin, the overnight call
money rate alternates between the reverse repo rate and the repo rate. As the
systemic liquidity transits from a uni-directional surplus mode to a bi-directional
mode, it will have implications for the effectiveness of monetary transmission. In
the context of the changing liquidity dynamics, the operation of the LAF needs to
be studied.  Accordingly, it is proposed to set up a Working Group to review the
current operating procedure of monetary policy of the Reserve Bank, including the
LAF.

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Mid-Quarter Review of Monetary Policy 2010-11

1)   The second new initiative relates to a more frequent policy review. While our
scheduled policy announcements are quarterly, in recent years, there have been
several occasions, including March and July 2010, when we had to take off-cycle
monetary policy actions. One significant advantage of the quarterly schedule is that
it allows us to bring the full range of inputs into the decision-making process.
Nevertheless, in a rapidly evolving macroeconomic situation, we need to combine
the rigour and comprehensiveness of the quarterly process with the responsiveness
and flexibility of more frequent reviews.

2) Accordingly, the Reserve Bank will now undertake mid-quarter reviews

roughly at the interval of about one and half months after each quarterly review. As
per schedule, mid-quarter reviews will be in June, September, December and
March.  They will be by way of a press release and will communicate our
assessment of economic conditions more frequently, and will provide a rationale
for either policy action or maintenance of the status quo. However, the Reserve
Bank will have the flexibility, as always, to take swift and pre-emptive policy
action, as and when warranted by the evolving macroeconomic developments.

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Limitations

 As the study of specific area is restricted, and time allotted is much limed for
making project. If time permits then there would be a wide scope of study on
specified topic.
 Study/ project on a specific topic have page constraints. The information which
is provided is not enough for in-depth study of the topic.
 Lack of experience of using because the systems which are electronically
settled are not developed is used generally in every bank or banks. If there is
experience of using payment system, there would be different explanation for
their working mechanism.
 Due to lack of practical knowledge or work experience it is different to compare
topic with international scenario.

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Conclusion

RBI has powers to supervise and control commercial and co-operative banks
with a view to developing an adequate and a sound banking system in the country.
The RBI has powers to issue licenses to new banks and branches, prescribe
minimum requirements regarding paid up capital and reserve, maintenance of cash
and other reserves and inspect the working of banks in India and abroad. The RBI
has also powers to conduct ad-hoc investigations from time to time into
complaints, irregularities and frauds in banks. The functions of RBI include issue
of currency notes, banker to the government, banker’s banks, and exchange control
authority audit control and agriculture finance. The monetary policy of RBI is
regulatory policy whereby the central bank maintains its control over the supply of
money for the realization of general economic goals.

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Bibliography

Books

 Monetary, banking and financial development in India -Nitin basin.

 RBI functions and working - shri m Jesudasan.
 RBI volume 3.
 Business economics.

Net

www.google.com

www.scribd.com

www.wikipedia.org

www.brupt.com

www.rbi.com

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