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What is Monetary Policy?

MONETARY POLICY

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 in monetary policy 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

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 in monetary policy are as follows:

  1. Reserve ratios: Reserve ratios are calculated over total deposits received by a commercial bank. Reserve ratios are of two types:
  2. 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.
  1. 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)

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).

 Open market operations:

Open market operations in monetary policy 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.

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 in monetary policy 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:

  1. 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.
  2. Consumer credit regulation: This refers to the issuing of rules regarding downpayments and maximum time period of instalment credit for purchase of goods.
  3. 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.
  4. 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.
  5. 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.
  6. 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.

Read more on: https://www.brainyias.com/what-is-money-supply-calculation-of-money-supply-in-india/

Indian Economy

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