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MONETARY POLICY

MONETARY POLICY

It refers to the set of measures adopted by the Central Bank (RBI in case of India) for monetary management and to achieve other macro-economic goals. Some of the macro-economic goals that monetary policy seeks to achieve are:

  • Maximum feasible output
  • High rate of growth
  • Fuller employment of resources
  • Price stability
  • Greater equality in the distribution of income and wealth; and
  • Healthy balance in the balance of payments

The instruments used by RBI to achieve the above goals are as follows:

Open Market Operations (OMOs)

  • OMOs refer to the purchase and sale of government securities by the RBI from/to the public and banks on its own account.
  • Every Open Market purchase by the RBI increases money supply in the economy as it increases currency with the public. There opposite effect of an open market sale by RBI.

Variations in Reserve Requirement or Cash Reserve Ratio (CRR)

  • All commercial banks have certain amount of cash reserves with the RBI. These reserves can be of two types- (a) required reserves and (b) excess reserves. Banks keep excess reserves voluntarily to meet their currency drains.
  • Required reserves are cash balances which a bank is required statutorily to hold with the RBI. The ratio of required reserves to net demand and time liabilities of banks is called Cash Reserve Ratio (CRR).
  • The RBF is empowered to fix CRR anywhere below 15%. It is this authority of RBI to vary the CRR which makes CRR a tool of monetary control.
  • When CRR is revised upward, banks are required to hold larger reserves with RBI, which decreases cash with banks and in turn decreases money supply.

Bank Rate Policy

  • Formally, the bank rate is the rate at which the RBI should be prepared to buy or rediscount eligible bills of exchange or other commercial paper.
  • In practice, it is the rate at which RBI lends to other commercial banks. According to its proponents, an increase in the bank rate by raising the cost of borrowed reserves discourages bank borrowings from the Central Bank.
  • This has adverse effect on the level of money supply. However, it has been found that bank rate is not very efficient instrument because it may not have any significant effect on the interest-rate differential between the bank rate and the lending rate that they apply to loan seekers.
  • Thus, an increase in bank rate may not discourage the banks from borrowing because they may also in turn charge higher interest rates from borrowers.

Statutory Liquidity Ratio (SLR)

  • Apart from the cash reserve requirement, the banks are also required statutorily to maintain a prescribed minimum of their daily total demand and time liabilities in the form of designated liquid assets.
  • These liquid assets consist of (a) excess reserves; (b) government and other securities; and (c) current account balances with the other banks.
  • SLR can be used as an instrument of monetary control in two ways; one is by affecting the borrowings of the government from the RBI; the other is by affecting the freedom of banks to sell government securities or borrow against them from the RBI.
  • As most of SLR requirement is met through government securities, the government, in the past, has been using SLR as a means to mobilize low cost resources.
  • This abuse of SLR led to distortion in the interest rate and credit supply in the pre-reform period. Narasimhan Committee, in 1991, recommended that the SLR should be brought down from 35-40% to 25%.

Moral Suasion

  • It is a combination of persuasion and pressures which a Central Bank is always in a position to use on banks in general and errant banks in particular.
  • This is exercised through discussions, letters, speeches, and hints thrown to banks.

Selective Credit Controls (SCCs)

  • All the instruments discussed till now were primarily related to quantitative aspect of Credit Control. The regulation of Credit for specific purposes is termed as selective or qualitative credit control.
  • Unlike other credit control instruments which focus on volume and cost of credit, SCCs operate on the distribution of credit.
  • SCCs can be used in a positive way through measures used to encourage greater channeling of credit into particular sectors, as is being done in India in favour of designated priority sectors.
  • On the negative side, measures are taken to restrict the flow of credit to particular sectors or activities.

Repo and Reverse Repo

  • Repo (Repurchase Option) and Reverse Repo are instruments used by RBI in day-to-day liquidity management under the Liquidity Adjustment Facility (LAF).
  • Repo rate is the rate at which RBI lends to the commercial banks and Reverse Repo is the rate at which RBI borrows from commercial banks.
  • A hike in Repo rate tends to make borrowing costly for banks, thus reducing credit and money supply in the economy and vice versa for a fall in Repo rate.
  • Repo rate is generally resorted to in order to fine tune the liquidity position in short run without resorting to major policy changes like changes in CRR, Bank Rate, etc.

Trends in Inflation during 2013-14

WPI Inflation

  • Through 2013-14, inflation in India has remained high, and above the RBI’s comfort zone, as reflected in the tight monetary policy stance. Headline WPI Inflation, which reflects price of tradeable, has moderated in 2013-14 to 5.98%.
  • This is due to weak post crisis global demand and lower international commodity prices, as well as a sharp seasonal correction in vegetable prices.

Core inflation

  • Inflation in non-food manufactured (NFM) commodities, i.e. core inflation remained benign at around 2.5-3.5% throughout the year on account of lower international prices and growth slowdown.
  • Inflation in NFM inched up partly on account of wearing off of base effect and inflationary pressure within the chemicals, machinery and textile groups.

CPI Inflation

  • There have been 3 consumer price indices, before the Central Statistics Office launched the new CPI series in January 2011, each for a specific class of consumers.
  • The CPI for industrial workers (CPIIW), which is primarily used for wage indexation, however, has been the CPI index preferred by many economists. CPI Inflation remained close to double digits for a large part of the year.
  • The CPI-NS (combined) inflation in the last three years has come from food. The drivers of CPI-NS food inflation were similar to those for the WPI, with vegetables, cereals, and protein items together contributing more than 80%.
  • The Central Statistics Office in the Ministry of Statistics and Programme Implementation started a new series of CPI in January 2011.  MONETARY POLICY
  • The new series has a wide geographical spread and covers 310 towns and 1181 villages. With a weighting scheme derived from the Consumer Expenditure Survey Data (2004-05), the new series has an all India character.
  • Since the series is fairly new, inflation numbers are available only for 12 months so far. Broad food and non-food weights of the new CPI series more or less match those on CPI-IW.
  • Though the points of inflection are common, the new series shows higher overall food inflation than the CPI-IW.

Possible causes for persistence of higher inflation in India

  • Inflation in protein foods, particularly eggs, meat and fish, and in fruits & vegetables has persisted because of changes in dietary habits and supply constraints.
  • Long time series data from National Accounts on private final consumption expenditure (PFCE) indicate a structural shift in per capita consumption.
  • The share of food consumption in total consumption has declined over time, from an average of 51.34 per cent during 1950- 60 to an average of 27.17 per cent during 2007- 2012. The share of protein foods within overall food expenditure increased from 26.28 per cent during 1950-60 to 33.71 per cent during 2007-2012.
  • Decline in expenditure on food relative to that in other commodities and services as expected has been associated with rising income levels.
  • Average annual growth of per capita expenditure during 1950-2011 was 2.40 per cent for non-food group.
  • Within non­food commodities and services, average annual growth was 5.53 per cent, 3.97 per cent, 3.60 per cent and 3.42 per cent for transport and communication; recreation and education; medical and health care; and miscellaneous goods and services, respectively.
  • Growth in expenditure for these sub sectors significantly exceeded the growth in expenditure on food.
  • Significant increase in rural wages has also contributed to inflation. Rural wages in nominal terms went up by an average of over 18 per cent from 2008-09. Inflation adjusted rural wages also went up by 7.5 per cent during this period. MONETARY POLICY
  • A continuous increase in Minimum Support Price (MSP) has raised the floor prices and also contributed to the rise in input prices.
  • A higher MSP also leads to higher procurement and hence reduces the open market availability of food grains, particularly of wheat. This causes excess demand in the market pushing prices further.
  • Volatility in the prices of vegetables is another cause of inflation. Apart from a demand and supply mismatch, inefficient intermediation and the loss in the value of vegetables at different stages of their movement from farm to mouth have contributed to an increase in prices, high volatility, and significant dispersion across locations.
  • All these could be reduced considerably with improvements in the supply chain. The existence of a large number of intermediaries between the farmer and the consumers and time delays due to their activities leads to intermediation costs and value losses.
  • Organised marketing and greater private sector participation is critical for improving this state of affairs but it requires reforming the APMC legislation.
  • The Inter Ministerial Group on Inflation (IMG) had suggested exempting perishables from the purview of APMC Act, providing farmers the freedom to make direct sales to aggregators and processors, introducing electronic auction platforms for all mandis and replacing licenses of the APMC market with open registration backed by bank guarantees.  MONETARY POLICY
  • Electronic display of prices for short duration vegetable crops could reduce the asymmetry in information flow and provide appropriate marketing signals to producers.
  • High inflation in animal products has partly been due to the regional concentration of production centres, rising input costs which raised the floor price and lower productivity.
  • While in some cases, there has been an increase in availability, typically it has been at a higher cost. Further, due to limited organized marketing (even in case of milk it is around 15 per cent of total milk produced) back end infrastructure such as a seamless cold chain has not been established, reducing quality and increasing wastage.

Inflation in residential buildings is captured by Residex, calculated by the National Housing Bank since 2007 covering 20 cities.

While in case of Hyderabad, Jaipur and Bangalore, there has been a decline in prices In July-September 2012 compared to the prices in 2007, Pune, Bhopal and Chennai have witnessed an increase of over 100 per cent in residential prices.

Increase in prices in the other three metro cities, that is, Delhi, Mumbai and Calcutta, have also been in the range of 75 per cent to 100 per cent.  MONETARY POLICY

 

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Indian Economy

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