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Monetary Policy

Monetary Policy

INTRODUCTION

  • Monetary policy is the policy related to money supply in the economy. In India, the Reserve Bank of India (RBI; Central Bank) manages money supply.
  • While managing money supply, the RBI keeps primarily two factors in mind: (1) inflation and (2) economic growth.
  • Inflation is undesirable, whereas economic growth is desirable. Decrease in inflation is desirable, whereas decrease in economic growth is not desirable. It is seen that usually both inflation and economic growth move in the same direction.

Relation between Inflation and Economic Growth

  • With increase in money supply, people demand more products because they have more funds in hand. Greater demand for products leads to inflation. At the same time, on account of increase in money supply, people invest more money, leading to higher economic growth.
  • To conclude, in times of increase in money supply, inflation rate as well as economic growth increases. (One is undesirable, and the other is desirable). On the contrary, if there is decrease in money supply, the rate of inflation as well as the growth rate reduces.

Working of Monetary Policy

  • When inflation rates are high in the economy, the main focus of the RBI is to target inflation and, thus, the growth objective is sidelined. Inflation targeting is given priority over economic growth because inflation affects both rich and poor, whereas economic growth mainly benefits the rich.
  • To counter inflation, demand needs to be reduced, so the RBI reduces the money supply in the economy by making credit dearer (costlier). Thus, in times of high inflation, the RBI adopts dear money policy.
  • On the contrary, when inflation rate is low or moderate, the main focus of the RBI is on increasing growth in the economy. Therefore, the RBI increases money supply by making credit cheaper. Thus, in times of low or moderate inflation, the RBI adopts cheap money policy.

TOOLS TO EXERCISE MONETARY POLICY | Monetary Policy

The RBI uses quantitative as well as qualitative measures to control the flow of credit (money supply) in the economy. Quantitative or general measures influence the total volume of credit, while qualitative measures are used to influence availability of credit among various type of borrowers.

Quantitative Measures

Some of the quantitative measures are as follows:

  1. Reserve ratios: Reserve ratios are calculated over total deposits received by a commercial bank. Reserve ratios are of two types:
  • Cash reserve ratio (CRR): It is the percentage of total deposits a commercial bank is required to maintain with the RBI. According to the Banking Regulation Act, CRR cannot exceed 15% and cannot be less than 3%. The present rate of CRR (1 January 2017) as prescribed by the RBI is 4%.
    • CRR serves two purposes. The amount deposited with the RBI as CRR acts as an assurance to the depositors that their money will be returned. Moreover, CRR can be used to manage money supply in the economy and thus inflation.
    • In case the RBI increases CRR, the funds available with commercial banks reduce. The commercial banks further reduce the credit in the economy, thereby reducing the money supply. Reduction in money supply further leads to fall in prices. In case the RBI decreases CRR, the money supply in the economy increases leading to rise in prices.
    • CRR is used to adjust money supply over a long time period (more than a year). The RBI makes changes in CRR when it expects inflation levels to persist over a longer time period.
  • Statutory liquidity ratio (SLR): It refers to the percentage of total deposits that a commercial bank is required to maintain with itself in the form of liquid assets.
    • Liquid assets are those assets that can be converted into cash within 3 months without any significant risk involved. The term liquid assets include gold, government securities, etc.
    • According to the Banking Regulation Act, SLR cannot be higher than 40% and cannot be lower than 15%. The present rate of SLR is 20.75%.
    • Like CRR, SLR serves two purposes. The amount kept in the form of liquid assets can meet even the sudden high demand for return of money by depositors. Moreover, SLR can also be used to manage money supply in the economy and thus inflation.
    • If the RBI increases SLR, the funds available with commercial banks for lending operations reduce. The commercial banks further reduce the credit in the economy and thereby money supply reduces, leading to fall in prices.
    • If the RBI decreases SLR, the money supply in the economy increases, leading to rise in prices.
    • SLR is also used to adjust money supply over a long time period (more than a year). The RBI makes changes in SLR when it expects inflation levels to persist over a longer time period.
    • SLR serves another important purpose. It serves as a financing mechanism to government because to meet SLR requirements, banks are required to invest in government securities.
  1. Interest rate changes: Interest rate changes can be used to adjust the money supply in the following ways:
  • Bank rate: It refers to the official interest rate at which the RBI provides loans to the banking system, which includes commercial/cooperative banks, development banks, etc. Such loans are given out either by direct lending or by rediscounting (buying back) the bills of commercial banks. Thus, bank rate is also known as discount rate. Bank rate is used as a signal by the RBI to communicate interest rate levels to commercial banks. Thus, it is also considered benchmark interest rate of the economy. Bank rate at present (1 January 2017) is 6.75%.
    • Significance of bank rate: Bank rate is the interest rate charged by the RBI for long-term lending. It serves as a benchmark rate or only as an indicative rate. Commercial banks do not prefer to borrow money from the RBI for long term and rather prefer low interest deposits from common people.
    • However, bank rate reflects the policy of RBI. When the RBI increases the bank rate, the cost of borrowing rises. Consequently, demand for credit also reduces, leading to reduction in money supply. Thus, increase in bank rate reflects tightening of monetary policy by the RBI.
  • Repo rate: Under repo or repurchase agreement, the RBI lends money to commercial banks and commercial banks give government bonds to the RBI with an agreement to purchase them back. In other words, repo rate or repurchase rate is the rate at which the RBI lends money to banks for a short time period.
    • Objective of repo: Commercial banks borrow from the RBI by means of repo. Thus, repo is used to inject liquidity (money supply) in the system. If the RBI wants to reduce money supply, it increases the repo rate. Similarly, if it wants to increase money supply, it reduces the repo rate.
  • Reverse repo rate: Under the reserve repo or reverse repurchase agreement, commercial banks park their excess funds at fixed rate with the RBI and the RBI gives government bonds to commercial banks with an agreement to purchase them back. The reverse repo rate, or reverse repurchase rate, is the rate at which commercial banks lend money to the RBI for a short time period.
    • Objective of reverse repo: Commercial banks park excess funds with the RBI by means of reverse repo. Thus, reverse repo is used to suck liquidity (money supply) from the system. If the RBI wants to reduce money supply, it increases the reverse repo rate. Similarly, if it wants to increase money supply, it reduces the reverse repo rate.
    • If the RBI increases the reverse repo rate, banks have more incentive to park their money with the RBI and vice versa. The repo rate is always higher than the reverse repo rate. That is, the rate at which the RBI lends money to commercial banks is always higher than the rate at which the RBI borrows from commercial banks. As on 30 June 2017, the repo and reverse repo rates were 6.25% and 6%, respectively.
    • Unlike the bank rate, the repo and reverse repo rates are frequently used by commercial banks to adjust short-term deficit and surplus of funds, respectively.
  • Difference between bank rate and repo rate: Bank rate and repo rate seem to be similar because in both, the RBI lends to the banks. However, repo rate is a short-term measure. It is used to adjust temporary increase or decrease in money supply. On the other hand, bank rate is a long-term measure and is governed by the long-term monetary policies of the RBI.

Liquidity Adjustment Facility (LAF)  | Monetary Policy 

  • LAF is a monetary tool that allows the banks to borrow money through repurchase agreements. It is used to aid banks in adjusting the day-to-day mismatches in liquidity. It consists of repo and reverse repo operations.
  • Marginal standing facility: The marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter bank liquidity dries up completely.
  • Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate. The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Under MSF, banks can borrow funds up to 1% of their net demand and time liabilities (NDTL).
  1. Open market operations: Open market operations are conducted by the RBI by way of sale or purchase of government securities to adjust money supply. The central bank sells government securities to suck out liquidity from the system and buys back government securities to infuse liquidity into the system.
  • These operations are often conducted on a day-to-day basis in a manner that balances inflation while helping banks continue to lend.
  • Why is it important? Liquidity management is essential so that banks and their borrowers do not face cash crunch. The RBI buys government securities if it thinks liquidity needs a boost and sells them if it wants to mop up excess money.
  • Open market operations by the RBI also help the borrowing programme of the government because the sale of government securities generates funds for the government.

What Is Sterilization?

  • Sterilization refers to the process by which the RBI takes away money from the banking system to neutralize the fresh money that enters the system.
  • Suppose the RBI decides to buy US dollars from the market. Now the money held by the RBI does not form part of the banking system. So if the RBI releases rupees in the market to buy dollars, the money supply in the banking system increases. This can lead to inflation.
  • It will reduce (sterilize) liquidity by selling the government bonds that it holds. Thus, sterilization is possible only to the extent that the RBI holds government bonds in its portfolio.
  • This process of selling government bonds to reduce liquidity is part of its open market operations.
  1. Currency printing: Currency printing is undertaken by the RBI based on the availability of goods and services in the economy and the corresponding requirement of cash to purchase available goods and services. While printing currency, the RBI also considers popularity of plastic money among people, tendency of people to hoard cash, available cash in the economy, etc.
  • One-rupee note is printed by the Ministry of Finance and contains signature of the secretary to the Ministry of Finance. Rest of the currency is printed under the supervision of the RBI and contains signature of the RBI governor.
  • Implications of printing more currency: When more currency is printed, people start demanding more commodities, but the supply of commodities does not increase in a short period. Consequently, the prices of commodities increase and the value of currency reduces. This situation may lead to extraordinary price rise of commodities.

Qualitative Measures

Qualitative measures are also called instrument of selective credit control. Selective credit control refers to influence in division of credit among various types of borrowers. Some of them are as follows:

  • Margin requirement: This refers to the difference between the securities offered and the amount borrowed from the banks. In case the RBI mandates banks to demand higher margin requirements, the amount of credit given on security reduces.
  • Consumer credit regulation: This refers to the issuing of rules regarding down payments and maximum time period of instalment credit for purchase of goods.
  • Guidelines: The RBI issues oral, written statements, appeals, guidelines, and warnings to the banks. For instance, the RBI requests commercial banks to pass the benefits of decrease in interest rates to the final consumers.
  • Rationing of credit: The RBI controls the credit allocated by commercial banks to various sectors. For instance, the RBI mandates banks to issue 40% of their credit to the priority sector. Priority sector refers to those sectors of the economy that may not get timely and adequate credit in the absence of this special dispensation but are important for overall growth of economy. Priority sector lending is an important role given by the RBI to the banks for providing a specified portion of the bank lending to a few specific sectors such as agriculture and allied activities, micro and small enterprises, poor people for housing, students for education, social infrastructure, renewable energy, export credit and other low-income groups and weaker sections.
  • Moral suasion: A moral suasion is a persuasion tactic used by the RBI to influence and pressure, but not force, banks in adhering to policy. Tactics used are closed door meetings with bank directors, increased severity of inspections, appeals to community spirit, or vague threats.
  • Direct action: This step is taken by the RBI against the banks that do not fulfil conditions and requirements. The RBI may refuse to rediscount their papers or charge a penal rate of interest over and above the bank rate, for credit demanded beyond a limit.

MARGINAL COST OF FUNDS BASED LENDING RATE VERSUS BASE RATE

Marginal Cost of Funds Based Lending Rate

  • The RBI has brought a new methodology of setting the lending rate by commercial banks under the name Marginal Cost of Funds based Lending Rate (MCLR). It has modified the existing base rate system since April 2016 onwards.
  • The new methodology requires banks to charge interest rates based on the additional cost or marginal cost incurred by banks to obtain the funds. This means that the interest rate given by a bank for deposits and the repo rate (for obtaining funds from the RBI) are the decisive factors in the calculation of MCLR.

Why the MCLR reform?

  • At present, banks are slightly slow to change their interest rate in accordance with the interest rate change by the RBI. Commercial banks significantly depend on the RBI’s repo to get short-term funds. But they are reluctant to reduce their individual lending rates and deposit rates with periodic reduction in repo rate.
  • Whenever the RBI is changing the repo rate, it verbally compels the banks to make changes in their lending rate. The purpose of changing the repo rate is realized only if the banks change their individual lending and deposit rates.

Base Rate

  • The base rate is the minimum interest rate of a bank below which it cannot lend, except in the cases allowed by the RBI. The base rate system was introduced with effect from 1 July 2010. The base rate includes all those elements of the lending rates that are common across all the categories of borrowers. Banks may choose any benchmark to arrive at the base rate for a specific tenor that may be disclosed transparently.
  • Base rate is decided in order to enhance transparency in the credit market and ensure that banks pass on the lower cost of funds to their customers. Loan pricing is done by adding base rate and a suitable spread depending on the credit risk premium.

Monetary Policy Committee

  • The Monetary Policy Committee (MPC) has the responsibility to take decisions on monetary policy matters to meet inflation target as decided between the central government and the RBI.
  • Composition
    • The six-member committee comprises three members from the RBI, including the governor, who will be the ex-officio chairperson, a deputy governor and one officer of the central bank. The other three members will be appointed by the centre on the recommendations of a search-cum-selection committee to be headed by the Cabinet Secretary. These three members of the MPC will be experts in the field of economics or banking or finance or monetary policy and will be appointed for a period of 4 years and shall not be eligible for re-appointment.
  • Decision Making by MPC
    • The committee meets four times a year. MPC decisions are taken on a majority basis and the chairman of the committee will have casting vote only (and not veto power).
  • Implications of Setting up MPC
    • Earlier, decisions on monetary policy were taken solely by the RBI. With the establishment of the MPC, the central government has equal say in deciding on monetary policy matters.
    • Inflation Targets
    • In August 2016, the government notified an inflation target of 4% for the next 5 years, which the MPC of the RBI has to achieve through its interest rate policy. The government has provided a margin of plus or minus 2% in the retail inflation target, fixing the upper tolerance level at 6% till 2021.

RESERVE BANK OF INDIA   | Monetary Policy 

  • The RBI is India’s central bank, which commenced its operations on 1 April 1935 during the British Rule in accordance with the provisions of the Reserve Bank of India Act, 1934.
  • The RBI is an independent apex monetary authority that also regulates banks and provides important financial services such as storage of foreign exchange reserves, availability of credit, accept deposits from government and banks. Specifically, the RBI performs the following important functions:

Eight Major Functions of the Reserve Bank of India

  • Issue of bank notes: The RBI has the sole right to issue currency notes except one-rupee notes, which are issued by the Ministry of Finance.
  • This function of the RBI has a number of advantages: (i) it brings uniformity in issue of notes; (ii) it makes possible effective state supervision; (iii) it is easier to control and regulate credit in accordance with the requirements in the economy
  • Banker to the government: As banker to the government, the RBI manages the banking needs of the government. It has to maintain and operate the government’s deposit accounts. It collects receipts of the funds and makes payments on behalf of the government. It represents the Government of India as the member of the IMF and the World Bank.
  • Custodian of cash reserves of commercial banks: The commercial banks hold deposits in the Reserve Bank, and the latter has the custody of the cash reserves of the commercial banks.
  • Custodian of country’s foreign currency reserves: The Reserve Bank has the custody of the country’s reserves of international currency, and this enables the Reserve Bank to deal with crisis connected with adverse balance of payments position.
  • Lender of last resort: The commercial banks approach the Reserve Bank in times of emergency to tide over financial difficulties, and the Reserve Bank comes to their rescue though it might charge a higher rate of interest.
  • Central clearance and accounts settlement: Since commercial banks have their surplus cash reserves deposited in the Reserve Bank, it is easier to settle the claim of these banks on each other through entries in the books of the Reserve Bank. The clearing of accounts has now become an essential function of the Reserve Bank.
  • Controller of credit: Since credit money forms the most important part of supply of money, and since the supply of money has important implications for economic stability, the importance of control of credit becomes obvious. Credit is controlled by the Reserve Bank in accordance with the economic priorities of the government.
  • Regulator of banks and non-banking financial companies: Opening a bank or a non-banking financial company (NBFC) requires a license from the RBI. It ensures that financial interest of the depositors is not hampered. It also keeps checks that the banks and NBFCs adhere to capital adequacy norms, etc.

TYPES OF BANK ACCOUNTS    | Monetary Policy 

Traditionally, bank accounts are classified into four different types:

  • Current account is mainly for business persons, firms, companies, public enterprises, etc. and is never used for investment or savings. These deposits are the most liquid deposits and there are no limits for the number of transactions or the amount of transactions in a day. While there is no interest paid on the amount held in the account, banks charge certain service charges on such accounts. The current accounts do not have any fixed maturity as these are on continuous basis.
  • Savings account is meant for saving purposes. Most of the salaried persons, pensioners, and students use savings account. The advantage of having a savings account is that the banks pay interest for the savings. The savings account holder is allowed to withdraw money from the account as and when required.
    • The rate of interest ranges from 4% to 6% per annum in India. There is no restriction on the number and amount of deposits. But withdrawals are subjected to certain restrictions. Some banks recommend maintaining a minimum amount to keep it functioning.
  • Recurring deposit account or RD account is opened by those who want to save a certain amount of money regularly for a certain period of time and earn a higher interest rate. In RD account, a fixed amount is deposited every month for a specified period and the total amount is repaid with interest at the end of the particular fixed period.
    • The period of deposit is minimum 6 months and maximum 10 years. The interest rates vary for different plans based on the amount one has to save and the period of time for which it is deposited. No withdrawals are allowed from the RD account. However, the bank may allow closing of the account before the maturity period.
    • These accounts can be opened in single or joint names. Banks also provide nomination facility to RD account holders.
  • Fixed deposit account (FD account) holds a particular sum of money in a bank for a specific period. It is a one-time deposit and one-time take away (withdraw) account. The money deposited in this account cannot be withdrawn before the expiry of period.
    • However, in case of need, the depositor can ask for closing the fixed deposit prematurely by paying a penalty. The penalty amount varies with banks. A high interest rate is paid on fixed deposits. The rate of interest paid for fixed deposits vary according to the amount, period, and also from bank to bank.

Deposits are liabilities of banks

  • The deposits made into a bank are the liabilities of the bank. Fixed and recurring account deposits constitute time liabilities of the bank because banks are required to return the deposits made in these accounts after the expiry of the fixed period of time.
  • On the other hand, savings and current account deposits constitute demand liabilities of the bank because banks are required to return the deposits made in these accounts whenever a depositor demands return of funds.

WHAT IS MONEY SUPPLY?   | Monetary Policy 

  • All the money held with public (in the form of currency or bank deposits), the RBI, and the government is called the total stock of money or monetary aggregate. Money supply is that part of this total stock of money that is with the public. Public includes households, firms, local authorities, companies, etc.
  • Public money does not include the money held by the government and the money held as CRR with the RBI and SLR with banks because this money is out of circulation.
  • To conclude, money supply includes the following:
    • Currency notes and coins
    • Demand deposits such as saving and current account deposits
    • Time deposits such as fixed and recurring deposits
    • Cash with banks and deposit of banks with other banks, except CRR with the RBI

Calculation of money supply in India

The RBI calculates the five types of money supply in India. They are as follows:

M1 (narrow money):

  • At any point of time, the money held by the public with the commercial banks has two components:
    • Currency component: It consists of all the coins and notes in the circulation.
    • Demand deposit component: It is the money of the general public with the banks in the form of savings and current account deposits.
  • M1 is also called narrow money. It is the most liquid form of money supply. To conclude,
  • M1 = Currency with the public + Demand deposits of public in banks

M2 = When Post Office savings deposits are added to M1, it becomes M2.

  • M2 = MI + Post Office savings

M3 (broad money):

  • When we add the time deposits with banks into the narrow money, we get the broad money, which is denoted by M3.
  • M3 = Narrow money + Time deposits of public with banks
  • Narrow money is the most liquid part of the money supply because the demand deposits can be withdrawn at immediate notice. On the other hand, time deposits have a fixed maturity period and hence cannot be withdrawn before the expiry of this period. When we add the time deposits to the narrow money, we get the broad money.

M4:

  • When we add the Post Office savings money to M3, it becomes M4.
  • Both M2 and M4 include Post Office savings deposits. Post Office savings deposits were once important part of money supply but have now become less relevant because the relative share of Post Office savings deposits out of the total savings deposits has significantly reduced. Presently, narrow money (M1) and broad money (M3) are relevant indicators of money supply in India.

M0 (reserve money):

Reserve money is also called “high powered money” or “monetary base”. It has the following components:

  • Currency with the public
  • Statutory reserves of banks held with themselves
  • Cash reserves of banks held with the RBI
  • Other deposits with the RBI

What is the Relevance of Reserve Money?  | Monetary Policy 

  • The RBI manages the money supply in the economy through reserve money. For instance, if the RBI reduces the reserve money, then money supply increases in the economy and vice versa. In other words, if there is more of reserve money in the system, money supply would increase and vice versa. It is to be noted that most of the changes in the money supply are due to changes in the high powered money. Thus, reserve money is also called “monetary base”. Moreover, changes in reserve money have multi-fold impact on the economy.
  • Money multiplier (m): Money multiplier is the ratio of narrow money (M1) or broad money (M3) to reserve money.
  • Money multiplier (m) is calculated as follows:

M1

m= —————

RM

M3

It is also calculated as m =

RM

where “m” is the money multiplier and “RM” is the reserve money

 

  • Thus, it can also be said that supply of money is the product of money multiplier (m) and the amount of high powered money or the reserve money.

How does money multiplier work?

  • For instance, let us say that a bank receives ₹100 in deposits. The reserve requirement is 20%. Thus, the bank can lend the remaining ₹80. This ₹80 is then deposited by the borrower into another bank, which In turn must also keep 20%, or ₹16, in reserve but can lend out the remaining ₹64.
  • This cycle continues as more people deposit money and more banks continue to lend it until finally the initial deposit of ₹100 creates a total of ₹500 (₹100/0.2) in deposits. This creation of deposits is the multiplier effect.
  • Thus, if reserve requirements are reduced or more currency is released in the economy, it has multiple impact on the overall money supply in the economy. In India, the reserve requirements for both SLR and CRR combined together are nearly 26%. Thus, a ₹100 initial deposit creates a total deposit of 100/0.26 = ₹384, approximately.

Indian Economy

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