Monetary Policy in India

Contents
✓ Introduction
✓ Functions of Central Bank
✓ Monetary Policy
✓ Objectives of Monetary policy
✓ Instruments
✓ How it works?
✓ Who conducts it?

✓ Monetary policy committee (MPC)

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Functions of Central Bank
1. Issuing notes
• Notes issued by the central bank enjoy public confidence.
• There is uniformity in the monetary system.
• The central bank can estimate the requirement of cash and it can increase or decrease the supply
of notes.
• The central bank can also control the credit created by commercial banks through controlling
the issue of notes.

2. Acting as the banker of the government

3. Acting as the banker of commercial and other banks
4. Preserving the gold and foreign exchange reserve of the country
5. Acting as the controller of credit
6. Publishing important economic statistics on the economy
7. Lender of last resort - providing liquidity to financial institutions in times of crisis.

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Monetary Policy

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Objective of the Monetary policy

Price stability while keeping in mind the objective of growth.

original Preamble from the Reserve Bank of India Act 1934

“it is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes and keeping of
reserves with a view to securing monetary stability in India and generally, to operate the currency and
credit system of the country to its advantage”.

Aggregate demand – a key determinant of inflation and growth

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Price stability

• Inflation

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What it is?

• Inflation is a sustained rise in overall price levels.

• Persistent increase in the general price level

• Too much money chasing too few goods

-Coulbourn

• A state in which the value of money is falling

- Crowther
Causes of Inflation
Demand-Pull Inflation
Inflation that is initiated by an increase in aggregate demand. It occurs when the
demand for goods or services is higher when compared to the production capacity.
The difference between demand and supply (shortage) result in price appreciation.
Cost-push inflation, or supply-side
Inflation caused by an increase in costs. Increase in prices of the inputs (labour, raw
materials, etc.) increases the price of the product.
Expectations (Built-in Inflation)
Expectation of future inflations results in Built-in Inflation. A rise in prices results in
higher wages to afford the increased cost of living. Therefore, high wages result in
increased cost of production, which in turn has an impact on product pricing. The
circle hence continues.
Money Supply
An increase in the money supply can lead to an increase in the aggregate price level.
 Instruments of Monetary Policy

Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity (funds) to banks
against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
Rate at which commercial banks borrow money by selling their securities to the RBI to maintain their liquidity.

Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis,
from banks against the collateral of eligible government securities under the LAF. The interest earned by
commercial banks for keeping their excess funds with RBI.

Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other
commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate
has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes
alongside policy repo rate changes.

The main interest rate set by a nation’s central bank. This is the rate of interest charged to commercial banks if they
must borrow from the central bank when short of liquidity. Market interest rates often take their cue from changes
in the Base Interest Rate.

Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank
as a share of such percentage of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from
time to time in the Gazette of India. percentage of commercial bank's net demand and time liability that commercial
banks have to maintain with the RBI at all times.
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 Instruments of Monetary Policy

Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid assets,
such as unencumbered government securities, cash and gold. Changes in SLR often influence the availability of
resources in the banking system for lending to the private sector.

Open Market Operations (OMOs): These include both, outright purchase and sale of government securities,
for injection and absorption of durable liquidity, respectively.

Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. The aim of
term repo is to help develop the inter-bank term money market, which in turn can set market-based benchmarks for
pricing of loans and deposits, and hence improve the transmission of monetary policy.

Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow an additional
amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio
up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the
banking system.

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 Instruments of Monetary Policy

Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004.
Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through the sale of
short-dated government securities and treasury bills. The cash so mobilised is held in a separate government
account with the Reserve Bank.

Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted
average call money rate.

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 Repo vs Reverse Repo

• Repo transactions are used by RBI to inject liquidity

• Reverse repo is the opposite of a repo transaction which is used by RBI to absorb
liquidity

• Reverse repo rate is currently 3.35%

• If banks run out of government bonds to use for repo loans (but they have to meet
SLR) they can borrow at the marginal standing facility (MSF) charged at ‘bank
rate’ –currently 6.75% (repo rate + 25 bps)

• Under MSF, SLR can fall below the requirement by 2%

• Banks can borrow up to 1% of deposits under repo channel

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Classification of credit or money supply control measures or instruments

• Quantitative measures of credit control

• Qualitative measures of credit control

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Qualitative measures:
The quantitative measures of credit control are :

• Bank Rate Policy: The bank rate is the Official interest rate at which RBI rediscounts the approved
bills held by commercial banks. For controlling the credit, inflation and money supply, RBI will
increase the Bank Rate.

• Open Market Operations: OMO The Open market Operations refer to direct sales and purchase of
securities and bills in the money market by Reserve bank of India.
• When the RBI feels that there is excess liquidity (inflation) in the market, it sells securities, thereby
sucking out the rupee liquidity.

• Cash Reserve Ratio: Cash reserve ratio refers to that portion of total deposits in commercial Bank
which it has to keep with RBI as cash reserves.

• Statutory Liquidity Ratio: It refers to that portion of deposits with the banks which it has to keep
with itself as liquid assets(Gold, approved govt. securities etc.) .

• If RBI wishes to discourage credit it would increase CRR & SLR.

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 Qualitative measures:
• Unlike quantitative tools which have a direct effect on the entire economy’s money supply, qualitative tools are selective tools that have
an effect on the money supply of a specific sector of the economy.

• Qualitative credit is used by the RBI for selective purposes. Some of them are

• Credit Rationing: Under credit rationing, RBI fixes a ceiling (maximum limit) on loans and advances of various categories, which the
commercial banks cannot exceed.
• This controls the amount of credit for certain sectors and ensures that all sectors get adequate credit. This is required for inclusive growth
of all sectors of the economy.

• Margin requirements: Margin is the amount that has to be contributed by the borrower for availing any loan. The full amount of the loan
is not given; rather the borrower has to contribute some sum as margin. If the margin is high, then off-take of the loan is low and vice-
versa.

• Consumer Credit Regulation: This refers to issuing rules regarding down payments and maximum maturities of installment credit for
purchase of goods.

• Guidelines: RBI issues oral, written statements, appeals, guidelines, warnings etc. to the banks.

• Moral Suasion: RBI uses persuasion and request, giving suggestions and advice to commercial banks to undertake certain actions in the
economic interests of the country. The advice is morally binding, but not mandatory for the banks.

• Direct Action: This step is taken by the RBI against banks that don’t fulfill conditions and requirements. RBI may refuse to rediscount their
papers or may give excess credits or charge a penal rate of interest over and above the Bank rate, for credit demanded beyond a limit.
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Factors considered during monetary policy decision making

• Rate of growth of real GDP and the estimated size of the output gap
• Forecasts for price inflation
• Rate of growth of wages and other business costs
• Movements in a country’s exchange rate
• Rate of growth of asset prices such as house prices
• Movements in consumer and business confidence
• External factors such as global energy prices and inflation in other
countries
• Financial market conditions including the rate of growth of credit /
money

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 Instruments of Monetary Policy

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 Instruments of Monetary Policy

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 Once again

Monetary policy refers to the use of monetary instruments under the control
of the central bank to regulate magnitudes such as interest rates, money
supply and availability of credit with a view to achieving the ultimate
objective of economic policy.

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✓ Introduction
✓ Monetary Policy
✓ Objectives of Monetary policy
✓ Instruments

✓ How MP works?
✓ Who conducts it?

✓ Monetary policy committee (MPC)

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Monetary Policy Transmission Channels

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Monetary Policy Transmission Channels ↓Policy Rate

Closed Economy
↓ SR - ↓ LT –
Interest Rate ↑ Investment ↑ AD
interest rate interest rate
Asset Price ↑ Asset Price ↑ Net Wealth ↑ Consumption
↑ AD
↑ Tobin q ↑ Investment
Price
Expectation Better future Y ↑ Consumption ↑ Investment ↑ AD level/Out
put
Credit Asymmetric Information in financial market - External Finance Premium (EFP)

Lending ↑ Reserves ↑ Loans ↑ Investment ↑ AD

↑Net worth & ↓ EFP &

Balance sheet ↑ Collateral value ↑ Loans
cash flow Moral Hazard
Risk taking Search for Yield
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Monetary Policy Transmission Channels ↓Policy Rate

Open Economy

Exchange Rate
Channel

Flexible
Capital outflow Depreciation ↑Net Export ↑ AD
Exchange Rate
Price
level
/Out
put
Fixed
Exchange Rate
Capital outflow Depreciation ↑Interest rate ↓ AD

Forex
Market
Intervention

Money Supply↓
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Who sets the inflation target in India?
The amended RBI Act provides for the inflation target to be set by the Government of India, in consultation
with the Reserve Bank, once every five years.

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✓ Introduction
✓ Monetary Policy
✓ Objectives of Monetary policy
✓ Instruments
✓ How it works?
✓ Who conducts it?

✓ Monetary policy committee (MPC)

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 The Monetary Policy Process

The Monetary Policy Process

1. Governor of the Reserve Bank of India —Chairperson, ex officio; Shaktikanta Das
2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy—Member, ex officio; Dr. Michael Debabrata Patra
3. One officer of the Reserve Bank of India to be nominated by the Central Board—Member, ex officio; Dr. Rajiv Ranjan
4. Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research —Member;
5. Prof. Jayanth R. Varma, Professor, Indian Institute of Management, Ahmedabad—Member; and
6. Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi— Member.

(Members referred to at 4 to 6 above, will hold office for a period of four years or until further orders, whichever is earlier.)

Open and Transparent Monetary Policy Making

Source

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 Thank You

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