Evolution of Monetary Policy of India

The RBI’s monetary policy has emerged as a very important policy tool in managing
macroeconomic variables especially economic growth and price stability. The policy has
evolved overtime w.r.t its framework and operating procedure. In 1985, on the
recommendations of chakravarty committee, the RBI adopted “monetary targeting with
feedback”. In 1970s and 1980s inflation reached to very high because of increased Ms
(Money supply) an outcome of large amount of credit provided to government from RBI.
With a regulated interest structure monetary aggregates (Ms) became the target variable to
maintain price stability. In this framework Broad money (M3) and reserve money (M0) were
used as two targets and CRR, SLR and bank rate were used as policy instruments to achieve
the targets and stabilize the economy.

With the advent of economic reforms, freeing interest rate and exchange rate, a broad based
financial market developed and it became possible to shift the focus from exclusive reliance
on monetary aggregates for conducting MP to a set of indicators like interest rates, price,
bank credit growth, foreign exchange rate and balance of payments indicators etc. Thus RBI
adopted “Multiple Indicator Approach” (MIA) in 1989-99. In early 1990s, OMOs and in the
MIA framework Liquidity Adjustment Facility (LAF) emerged as the major tool in monetary
policy operating procedure. Since June 2000, RBI started using the Liquidity Adjustment
Facility (LAF) to inject/ withdraw liquidity on a day-to-day basis consistent with overnight
call money rate. Desired policy induced changes in call money rate is expected to be
transmitted to the financial markets influencing medium and long term interest rates.

After that, guided by the recommendations of Patel Committee (RBI 2014), Inflation
targeting became the latest monetary policy framework since 2014-15. In the current MP
operating procedure also LAF plays a critical role. The overnight fixed repo rate under LAF
plays the role of single policy rate and sets the path for call money rate. The repo rate is
designed to be bound by a systematic corridor with the fixed reverse repo as the floor and
Marginal standing Facility Rate (MSFR) as the ceiling.

The present framework has undergone a significant transformation since 2014-15. The GoI
signed an agreement with RBI in February 2015 and RBI adopted a new framework of
‘flexible inflation targeting’. With amendment of RBI Act 1934, with effect from 27 June
2016, the RBI formally joined the club of inflation targeters. In this new framework the
explicit inflation target is set at 4% in terms of consumer price index (CPI) with a tolerance
band of ±2% during August 2016-March 2021 and formally constituted a six member
Monetary Policy Committee (MPC) taking decisions on the policy rate.

Thus 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. Repo rate changes transmit through the money market to the entire the 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.
In the current policy framework the basic premises of liquidity management operations are
stated as:

1. Short term liquidity management to address seasonal and frictional needs and
2. Management of durable liquidity to facilitate meeting the objective of growth with
price stability unde-r a broad monetary policy stance.

Thus, how effectively MP influences economic growth and price stability rests on the
strength of transmission of monetary policy impulses from short run interest rates like money
market rates to medium term interest rates like bank lending rates and costs of borrowing in
the capital market.

Source: ‘RBI’s Interest Rate Policy and Durable Liquidity Question’ by C. Rangarajan and
Amresh Samantarya, Economic and Political Weekly, June 3, 2017, Vol LIINo. 22

Monetary Policy Committee

Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-member
monetary policy committee (MPC) to be constituted by the Central Government by
notification in the Official Gazette. The 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 for arriving at
the decision on the policy repo rate.