Chapter-8

MONETARY POLICY

1. Money : Money is a commodity accepted by general public as a medium of economic exchange.

2. Functions of Money: Medium of Exchange (Individual goods and services are priced in terms
of money and are exchanged using money) + Measure of value (used to measure and record the
value of goods or services) + Standard for Deferred Payments (Money is used as an agreed measure
of future receipts and payments in contracts) + Store of value.
3. Forms of money
• Metallic Money : Commodity money is that type of money that possesses intrinsic value on its
own, independent of any governing Body + Pieces of metals like gold, silver, bronze, and
copper came to be used as money in both ancient as well as current times. It can be classified as
metallic money.
• Paper Money: Paper money refers to the bank notes and government notes which are used as
money.
• Plastic Money: It is used in reference to the hard plastic cards in place of actual bank notes.
They can come in many different forms such as credit cards, debit cards, etc.
• Fiat Money: Money which does not have any intrinsic value unlike commodity money + The
value of the currency, notes and coins is derived from the guarantee provided by the issuing
authority of these items.
• Fiduciary Money: It is known for its value on the confidence that it will be commonly
considered as a mode of exchange. Examples of fiduciary money are bank notes, drafts,
cheques.
• Legal Tender: They are also called legal tenders as they cannot be refused by any citizen of the
country for settlement of any kind of the transaction + Cheques drawn on savings or current
accounts, however, can be refused by anyone as a mode of payment + Hence, demand deposits
are not legal tenders.
• Cryptocurrency: It is a digital currency, which is an alternative form of payment created using
encryption algorithms. Example, Bitcoin
• Virtual currency: It is a digital representation of value only available in electronic form.
Example, awards/token in digital games
• Central bank digital currency (CBDC): These are digital tokens, similar to cryptocurrency,
issued by a central bank. They are pegged to the value of that country's fiat currency.
4. Money Supply: The total stock of money in circulation among the public at a particular point of
time is called money supply. (By public, it refers to the households, firms, local authorities,
companies etc.) + Public money does not include the money held by the government and the money
held as CRR with RBI and SLR with themselves by commercial banks.
5. Money Aggregates: Standard Measures of Money Supply
• M0 (Reserve Money or High Powered Money): Total liability of the monetary authority of
the country + Calculation =Currency in circulation + Bankers’ deposits with the RBI + ‘Other’
deposits with the RBI +

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 • M1 (Narrow Money) : Currency with the public + Deposit money of the public (Demand
deposits with the banking system + ‘Other’ deposits with the RBI).
• M2: M1 + Savings deposits with Post office savings banks.
• M3: (Broad Money) = M1+ Net Time deposits with the banking system
• M4: M3 + All deposits with post office savings banks (excluding National Savings
Certificates).
6. Money Multiplier (m): A money multiplier is an approach used to demonstrate the maximum amount of
broad money that could be created by commercial banks for a given fixed amount of base money and
reserve ratio + Higher the capital available with the banks, higher will be the money multiplier.
7. Monetary policy: It is considered as the most dynamic function of central bank (RBI) primarily
aimed at regulating size and cost of money in the economic system + It is brought out by central
bank (RBI) + It manage money and interest rates, controls inflation, savings, investment and capital
formation + RBI's Monetary policy responsibility is explicitly mandated under the Reserve Bank of
India Act, 1934 + It is announced bi-monthly (announced 6 times in a financial year).
8. Inflation Targeting: Inflation targeting is a monetary policy framework in which a country's central
bank focuses mainly on keeping inflation within a certain range (maintaining price stability while
keeping in mind the objective of growth) + Amendment in RBI Act, 1934 in 2016 to provide the
statutory basis for the implementation of Inflation Targeting + Headline CPI (Combined) is the
anchor + Target set by the government in consultation with the RBI + Target of 4% +-2% till 31
Mar. 2026 + Failure to achieve Inflation target if average inflation rate is more than the upper
tolerance level or less than the lower tolerance level for any three consecutive quarters.
9. Monetary Policy Committee: The committee will have six members. Of the six members, the
government will nominate three and other three from the RBI + Decisions will be taken by majority
vote with each member having a vote + Members of the MPC will be appointed for a period of four
years and shall not be eligible for reappointment. + The RBI Governor will chair the committee +
The governor will not enjoy a veto power to overrule the other panel members, but will have a
casting vote in case of a tie.
10. RBI Monetary policy stances
• Neutral stance: It means policy repo rate may be unchanged/increased/decreased + It is
adopted when the policy priority is equal on both inflation and growth.
• Calibrated Tightening: It means interest rates can only move upward + Central bank may not
go for a rate increase in every policy meeting, but the overall policy stance is tilted towards a
rate hike.
• Accommodative/Expansionary/Dovish stance: It means injection of more funds into the
financial system + It is aimed at expansion in lending, investment and growth + Lowering key
interest rates and enhancing market liquidity are used to implement it + It is adopted when
growth needs policy support and inflation is not immediate concern.
• Contractionary Monetary policy: It means syphoning out of fund from the financial system +
It is aims to decrease the money supply in an economy; at times also aimed to tame inflation in
long-term + Increase in key interest rates used to achieve this policy.
• Hawkish stance: It means contractionary stance aimed at checking inflation rise + It is linked
to statutory goals of inflation targeting the headline inflation.

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11. Monetary Policy tools: Quantitative and Qualitative
Parameter Quantitative Tools Qualitative Tools
1. Bank Rate
2. Statutory Liquidity Ratio (SLR)
3. Cash Reserve Ratio
1. Marginal requirements
4. Open Market Operation (OMO)
2. Regulation of consumer credit
5. Repo rate
Tools 3. Rationing of Credit
6. Reverse Repo Rate
4. Moral Suasion
7. Liquidity Adjustment Facility
5. Direct Action
8. Standing Deposit Facility (MSF)
9. Long Term Repo
10. Market Stabilisation Scheme (MSS)
Direct in nature as any changes are
Indirect in nature as any change in these
directly impacting the consumers as the
Impact tools may not transmit to the consumer
case of requirement of a down
immediately or directly.
payment.
The reach of Quantitative tools is
The reach of Qualitative tools is
general.
selective. It can affect money supply in
Reach They affect money supply in the entire
a specific sector of the economy like
economy and all sectors be it housing
automobile or agriculture.
automobile, manufacturing- everything.

12. Quantitative tools of Monetary Policy

• Cash Reserve Ratio (CRR): Banks cash deposit with RBI [% of their NDTL], no minimum
and maximum limit, mandatory for all banks, stored in bank’s vault or is sent to the RBI + It is
to be calculated with a lag of one fortnight, i.e., on the reporting Friday + Purpose: It
ensures the security of the amount; helps in keeping inflation under control + RBI does not pay
interest on deposits even if the deposits are in excess of minimum required by RBI-> Increase
cost of deposits to the banking sector + Penalty for non-maintenance-> penal interest will be
levied for that day at the rate of 3% per annum above the Bank Rate.
• Statutory Liquidity ratio (SLR): Banks deposits in G-Sec, Cash, gold, T-bills, state
development loans and other securities notified by RBI, mandated under Banking regulation act
1949 + Maximum limit: 40%+ Banks should report every alternate Friday + Mandatory for all
scheduled commercial banks, local area banks, Primary (Urban) co-operative banks (UCBs),
state co-operative banks and central co-operative banks + Banks earn returns on money parked
as SLR + The main objectives are to control the expansion of bank credit; ensures the solvency
of commercial banks.
Basis For Comparison CRR SLR
CRR is the percentage of The bank has to keep a certain
money which the bank has to percentage of their Net Time and
Meaning
keep with the Central Bank of Demand Liabilities in the form of liquid
India in the form of cash. assets as specified by RBI.
Cash Cash and other assets like gold and
Reserves in the
government securities viz. Central and
Form of
State government securities.

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 It controls excess money flow It helps in meeting out the unexpected
Effect in the economy. demand of any depositor by selling the
bonds.
Maintained RBI Bank itself
with
Regulates Liquidity in the economy Credit growth in the economy
Banks don't earn any interest on Banks can earn interest on SLR
Interest on Reserve
amount deposited in CRR
• Bank rate/Discount rate: Introduced by RBI Act, 1934. Since 2012: Bank rate % = Marginal
Standing Facility (MSF)%, rate at which RBI provides refinancing facilities to commercial
banks. In other words, when banks give loans, the RBI may refinance some of these loans given
by banks on the request of the concerned banks + Only Banks can borrow from RBI + Duration
is longer than Repo, mainly used to decide penalty.
• MSF (Marginal Standing Facility): A facility under which SCBs can borrow additional amount of
overnight (short-term) money from the RBI by dipping into their SLR portfolio up to a limit (currently
2% of their deposits) at a penal rate of interest + MSF is always fixed above the repo rate + Provides
safety valve against unanticipated liquidity shocks to the banking system.
• Repo rate: Introduced in 2000, decided by Monetary Policy + It is used for borrowing by
banks, state government, Union government, non-bank + Collateral is G-Sec, T bill but not
from SLR + Duration is short term (one day, 7 days, and a maximum of up to 21 days) + High
repo rate -> access to money is expensive for banks and lesser credit will flow into the system.
• Liquid Adjustment Facility: Consists repo rate and reverse Repo rate. Implies that by repo it
injects liquidity in banks and under reverse repo it absorbs liquidity from banks depends upon
whether banks have excess liquidity (R. Repo) or whether they are short of liquidity (Repo) +
RBI introduced it on recommendation of Narasimhan Committee on Banking Sector Reforms
(1998) + Banks are permitted to borrow only a certain percentage of its NDTL + If Bank
requires more funds, it can access through Marginal Standing Facility (MSF).
• LAF Repo rate: Rate at which RBI lends by keeping G-sec as collateral. Policy rate to control
inflation. The following are eligible to participate in repo transaction:
o Any regulated entity.
o Any listed corporate.
o Any unlisted company, which has been issued special securities by the Government of India,
using only such special securities as collateral.
o Any All India Financial Institution (FIs) viz. Exim Bank, NABARD, NHB and Small
Industries Development Bank of India (SIDBI), constituted by an Act of Parliament and
o Any other entity approved by the Reserve Bank from time to time for this purpose.
• LAF reverse Repo rate: Rate at which clients deposit their surplus funds with RBI + Collateral
used is Government secs + Reverse Repo= Repo - X. Example: RBI increases Repo rate to
control inflation and reduces it to inject liquidity in economy.
• Long-term repo operations: Funds are provided at repo rate, but for longer duration (1 year
and 3 years) of appropriate sizes for up to a total amount of Rs 1 lakh crore at the
prevailing repo rate + It helps RBI to ensure that banks reduce their marginal cost of funds-
based lending rate, without reducing policy rates.

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 • Targeted Long Term Repo operations (TLTRO): Tenure is 3 years, interest rate is linked to
Repo rate, demands Banks to invest in bonds of corporates, mutual funds and NBFC.
• Open Market Operations: It is the simultaneous sale and purchase of government securities
and treasury bills by RBI + Objective is to regulate the money supply in the economy + RBI
carries out the OMO through commercial banks and does not directly deal with the public +
Purchase of security: increases money Supply, enhances inflation, cheap money policy + Sell
of security: Reduces money Supply, controlling the inflation, dead money policy.
• Operation Twist: RBI sells shorter duration G-sec (less than 1 year) and purchases longer
duration G-sec to reduce bond yield on long term, make borrowing cheaper, make corporates to
invest in economy.
• Market Stabilization Scheme (MSS): It is intervention by the RBI in 2004 to withdraw
excess liquidity by selling government securities in the economy + These securities are owned
by the government though they are issued by the RBI + The securities issued under MSS are
purchased by financial institutions.
• Standing Deposit Facility (SDF) scheme: It is first recommended by Urjit Patel committee
report in 2014 + It is a remunerated facility that will not require the provision of collateral for
liquidity absorption.
• Quantitative easing (QE) : It refers to increasing the system's money supply. This occurs when
the Central Bank creates new money and spends it on asset purchases. These asset purchases
add new money to the system. It is one of the monetary policies in which a central bank
purchases government securities or other securities from the market in order to lower interest
rates and increase the money supply.
13. Qualitative tools of Monetary policy: They are direct and specific in nature + It include persuasion
by RBI in order to make commercial banks discourage or encourage lending done through moral
suasion.
• Moral suasion: Appealing to Banks to give credit to specific sectors. Example: RBI persuades
Banks to open branches in rural area, passing interest rate to customers + It is not a statutory
obligation + RBI may request commercial banks not to give loans for unproductive purpose
which doesn’t add to economic growth but increases inflation.
• Direct action: taking action against the erring Banks, in 2019, RBI asked Banks CEO to return
previously paid salary if engaged in scam.
• Loan to Value(LTV): Mandate LTV for home loan, auto loan, gold loan etc. Like not allowing
lending more than x% of collateral.
• Selective Credit Control: Priority Sector lending, relaxing down EMI during Corona.
• Rationing of credit: It is done by regulating the purposes for which loans are given among the
various member banks + Priority sector should be given preference in lending loans + Under it,
RBI directed banks since 1969 that they must give at least 40% of their total credit at any given
point of time to priority sectors.
14. Monetary policy transmission: It is the process by which the central bank's policy action is
transmitted in order to achieve the ultimate goals of inflation and growth + Channels of
transmission-> Interest rate, Credit, exchange rate and asset price.

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15. Bond Yield and Bond Price: Yield is the amount of return that an investor will realize on a bond. If
the investor holds the bond to maturity, he will be guaranteed to get the principal amount back plus
the interest. The bond prices and yields generally move in opposite directions. This is because, as a
bond’s price increases, its yield to maturity falls.
• Bond Yield is inversely proportional to the Bond prices and bond prices is inversely proportional
to the Interest rate. Thus, bond yield is directly proportional to the interest rate.
16. Monetary Policy Trilemma: Trilemma is a term in economic decision-making theory. However,
only one option of the trilemma is achievable at a given time, as the three options of the trilemma are
mutually exclusive. These options include:
• Setting a fixed currency exchange rate
• Allowing capital to flow freely with no fixed currency exchange rate agreement
• Independent monetary policy

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