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.

Monetary policy is adopted by the monetary authority of a country that controls

either the interest rate payable on very short-term borrowing or the money
supply. The policy often targets inflation or interest rate to ensure price stability
and generate trust in the currency. The current inflation-targeting framework in
India is flexible.
The monetary policy in India is carried out under the authority of the Reserve
Bank of India.

What role does the Monetary Policy Committee play?

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance
Act, 2016, to provide for a statutory and institutionalized framework for a
Monetary Policy Committee, for maintaining price stability, while keeping in
mind the objective of growth. The Monetary Policy Committee is entrusted with
the task of fixing the benchmark policy rate (repo rate) required to contain
inflation within the specified target level.

What are the instruments of monetary policy?

Some of the following instruments are used by RBI as a part of their monetary
policies.

 Open Market Operations: An open market operation is an instrument

which involves buying/selling of securities like government bond from or
to the public and banks.  The RBI sells government securities to control
the flow of credit and buys government securities to increase credit flow.
 Cash Reserve Ratio (CRR): Cash Reserve Ratio is a specified amount
of bank deposits which banks are required to keep with the RBI in the
form of reserves or balances. The higher the CRR with the RBI, the lower
will be the liquidity in the system and vice versa. The CRR was reduced
from 15% in 1990 to 5 % in 2002. As of 31st December 2019, the CRR is
at 4%.
 Statutory Liquidity Ratio (SLR): All financial institutions have to
maintain a certain quantity of liquid assets with themselves at any point
in time of their total time and demand liabilities. This is known as
the Statutory Liquidity Ratio. The assets are kept in non-cash forms such
 as precious metals, bonds, etc. As of December 2019, SLR stands at
18.25%.
 Bank Rate Policy: Also known as the discount rate, bank rates are
interest charged by the RBI for providing funds and loans to the banking
system. An increase in bank rate increases the cost of borrowing by
commercial banks which results in the reduction in credit volume to the
banks and hence the supply of money declines. An increase in the bank
rate is the symbol of the tightening of the RBI monetary policy. As of 31
December 2019, the bank rate is 5.40%.
 Credit Ceiling: With this instrument, RBI issues prior information or
direction that loans to the commercial bank will be given up to a certain
limit. In this case, a commercial bank will be tight in advancing loans to
the public. They will allocate loans to limited sectors. A few examples of
credit ceiling are agriculture sector advances and priority sector lending.

It has two major aspects:

(a) credit expansion i.e., increase of the total volume of bank credit and

(b) credit contraction, i.e., decrease of the total volume of bank credit.

The credit control has some major objectives:

(a) Stability of internal prices

(b) Stability of the foreign exchange rates

(c) Avoidance of trade cycles

(d) Promotion of economic growth with stability

Expansionary Monetary Policy:

So long we have described the central bank’s controls from the standpoint of
combating inflation by contraction of the money supply. The controls can,
however, be used equally well to expand the supply of money.
Thus, if the government wishes to stimulate trade it can instruct the bank to
reduce the cost of borrowing by increasing the availability of loans through
releasing special deposits, and buying securities in the open market, by issuing
directives encouraging adoption of a generous lending policy and by reducing
the level of interest rates.

Money Supply, Interest Rates and Aggregate Spending:

We know that changes in the money supply are realized through changes in
loan-making by financial institutions. We also know that increases in loan-
making lead to increases in spending and, ultimately, to increases in output and
employment, or to increases in prices — if the economy is at or near full
employment. Decreases in loan-making lead to decreases in spending and
decreases in the level of economic activity. This relationship between lending,
the money supply, spending, and economic activity is summarised in Table
20.3.

Table 20.3: Relationship between Money Supply, Spending, and Economic

Activity
AD
They encourage higher levels of economic activity

They encourage a stable global economy

They promote additional transparency

They promote lower inflation rates

DISAD

They do not guarantee economic growth

They take time to begin working

They create a risk of hyperinflation

New Industrial Policy, 1991
The New Industrial Policy, 1991 had the main objective of providing facilities to market forces
and to increase efficiency.

Larger roles were provided by

 L – Liberalization (Reduction of government control)

 P – Privatization (Increasing the role & scope of the private sector)
 G – Globalisation (Integration of the Indian economy with the world economy)
Because of LPG, old domestic firms have to compete with New Domestic firms, MNC’s and
imported items

The government allowed Domestic firms to import better technology to improve efficiency and to
have access to better technology. The Foreign Direct Investment ceiling was increased from 40%
to 51% in selected sectors.

The maximum FDI limit is 100% in selected sectors like infrastructure sectors. Foreign
Investment promotion board was established. It is a single-window FDI clearance agency. The
technology transfer agreement was allowed under the automatic route.

Phased Manufacturing Programme was a condition on foreign firms to reduce imported inputs
and use domestic inputs, it was abolished in 1991.

Under the Mandatory convertibility clause, while giving loans to firms, part of the loan will/can be
converted to equity of the company if the banks want the loan in a specified time. This was also
abolished.

Industrial licensing was abolished except for 18 industries.

Monopolies and Restrictive Trade Practices Act – Under his MRTP commission was established.
MRTP Act was introduced to check monopolies. The MRTP Act was relaxed in 1991.

On the recommendation of the SVS Raghavan committee, Competition Act 2000 was passed. Its
objectives were to promote competition by creating an enabling environment.

To know more about the Competition Commission of India, check the linked article.

Review of the Public sector under this New Industrial Policy, 1991 are:

 Public sector investments (Disinvestment of Public sector)

 De-reservations –Industries reserved exclusively for the public sector were reduced
 Professionalization of Management of PSUs
 Sick PSUs to be referred to the Board for Industrial and financial restructuring (BIFR).
 The scope of MoUs was strengthened (MoU is an agreement between a PSU and
concerned ministry).