Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
Objectives of Monetary Policies are:-
- Accelerated growth of the economy
- Balancing saving and investments
- Exchange rate stabilization
- Price stability
- Employment generation
Monetary Policy could be expansionary or contractionary; Expansionary policy would increase the total money supply in the economy while contractionary policy would decrease the money supply in the economy.
RBI issues the Bi-Monthly monetary policy statement. The tools available with RBI to achieve the targets of monetary policy are:-
- Bank rates
- Reserve Ratios
- Open Market Operations
- Intervention in forex market
- Moral suasion
Repo Rate- Repo rate is the rate at which the central bank of a country (RBI in case of India) lends money to commercial banks in the event of any shortfall of funds. In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.
Reverse Repo Rate is the rate at which RBI borrows money from the commercial banks.An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.
Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy.
CRR specifications give greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves. This is called fractional reserve banking.
Statutory liquidity ratio (SLR) is the Indian government term for reserve requirement that the commercial banks in India require to maintain in the form of gold, government approved securities before providing credit to the customers.its the ratio of liquid assets to net demand and time liabilities.Apart from Cash Reserve Ratio (CRR), banks have to maintain a stipulated proportion of their net demand and time liabilities in the form of liquid assets like cash, gold and unencumbered securities. Treasury bills, dated securities issued under market borrowing programme and market stabilisation schemes (MSS), etc also form part of the SLR. Banks have to report to the RBI every alternate Friday their SLR maintenance, and pay penalties for failing to maintain SLR as mandated.
Role of RBI
| Pre-reform | Post-reform | |
| Developmental Role: the developmental role has increased in view of the changing structure of the economy with a focus on SMEs and financial inclusion | Priority Sector Lending: Introduced from 1974 with public sector banks. Extended to all commercial banks by 1992 | In the revised guidelines for PSL the thrust is on ensuring adequate flow of bank credit to those sectors that impact large segments of the population and weaker sections, and to the sectors which are employment intensive such as agriculture and small enterprises |
| Lead Bank Scheme | Special Agricultural Credit Plan introduced. | |
| Kisan Credit Card scheme (1998-99) | ||
| Focus on credit flow to micro, small and medium enterprises development | ||
| Financial Inclusion | ||
| Monetary Policy: the role of RBI has changed from regulating credit and money flow directly to using market mechanisms for achieving policy targets. MP framework has changed to promote financial deregulations and market development. Role as a facilitator rather than as principal actor. | M3 as an intermediary target | Multiple Indicator Approach |
| Regulation of foreign exchange | Management of foreign exchange | |
| Direct credit control | Open Market Operations, MSS, LAF | |
| Rupee convertability highly managed | Full current ac convertability and some capital account convertability | |
| Banker to the government | Monetary policy was linked to the fiscal policy due to automatic monetisation of the deficit | Delinking of monetary policy from the fiscal policy. From 2006, under FRBM, RBI ceased to participate in the primary market auctions of the central government’s securities. |
| As regulator of financial sector: As regulator of the financial sector, RBI has faced the challenge of regulating the increasing financial sector in India. Credit flows have increased. RBI had to make sure that financial institutions are regulated in a way to protect the consumers while not impeding economic growth. | Reduction in SLR | |
| Custodian of FOREX reserves | Forex reserves have increased drastically. Need to manage it adequately and avoid inflationary impact | |
| Inflation | Direct instruments were used | Multiple indicators |
| Financial Stability | Closed economy | Increased FDI and FII has made financial stability one of the policy objectives. |
| Money Market | Narsimhan Committee (1998) recommended reforms in the money market
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