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.
- Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Act.
- The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.
The goal(s) of monetary policy
- The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
- In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
- The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government has notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
- The Central Government notified the following as factors that constitute failure to achieve the inflation target:(a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.
- Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India of February 20, 2015.
The Monetary Policy Framework
- The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to operate the monetary policy framework of the country.
- The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation; and modulation of liquidity conditions to anchor money market rates at or around the repo rate. Repo rate changes transmit through the money market to the entire the financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
- Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.
- The operating framework is fine-tuned and revised depending on the evolving financial market and monetary conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework was last revised significantly in April 2016.
The Monetary Policy Process
- Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. Accordingly, the Central Government in September 2016 constituted the MPC as under:
- 1. Governor of the Reserve Bank of India – Chairperson, ex officio;
- 2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex officio;
- 3. One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio;
- 4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member;
- 5. Professor Pami Dua, Director, Delhi School of Economics – Member; and
- 6. Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad – 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.)
- The MPC determines the policy interest rate required to achieve the inflation target. The first meeting of the MPC was held on October 3 and 4, 2016 in the run up to the Fourth Bi-monthly Monetary Policy Statement, 2016-17.
- The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.
- The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure that the operating target of monetary policy (weighted average lending rate) is kept close to the policy repo rate.
- Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets and public finance advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in nature. With the formation of MPC, the TAC on Monetary Policy ceased to exist.
Instruments of Monetary Policy
There are several direct and indirect instruments that are used for implementing monetary policy.
- Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
- 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.
- Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range of tenors. 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 transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.
- Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow 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.
- Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
- 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.
- Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
- 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.
- 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 sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.
For current operative policy rates, please see “Current Rates” section on the home page.
Open and Transparent Monetary Policy Making
- Under the amended RBI Act, the monetary policy making is as under:
- The MPC is required to meet at least four times in a year.
- The quorum for the meeting of the MPC is four members.
- Each member of the MPC has one vote, and in the event of an equality of votes, the Governor has a second or casting vote.
- The resolution adopted by the MPC is published after conclusion of every meeting of the MPC in accordance with the provisions of Chapter III F of the Reserve Bank of India Act, 1934.
- On the 14th day, the minutes of the proceedings of the MPC are published which include:
- a. the resolution adopted by the MPC;
- b. the vote of each member on the resolution, ascribed to such member; and
- c. the statement of each member on the resolution adopted.
- Once in every six months, the Reserve Bank is required to publish a document called the Monetary Policy Report to explain:
- a. the sources of inflation; and
- b. the forecast of inflation for 6-18 months ahead.
- Reserve Bank of India Act, 1934 as amended from time to time.
Objectives of Monetary Policy
The primary objective of central banks is to manage inflation. The second is to reduce unemployment, but only after they have controlled inflation.
The U.S. Federal Reserve, like many other central banks, has specific targets for these objectives. It seeks an unemployment rate below 6.5 percent. The Fed says the natural rate of unemployment is between is between 4.7 percent and 5.8 percent. It wants the core inflation rate to be between 2.0 percent and 2.5 percent. It seeks healthy economic growth. That’s a 2-3 percent annual increase in the nation’s gross domestic product.
Types of Monetary Policy
Central banks use contractionary monetary policy to reduce inflation. They have many tools to do this. The most common are raising interest rates and selling securities through open market operations.
|We Recommend Testbook APP|
|100+ Free Mocks For RRB NTPC & Group D Exam||Attempt Free Mock Test|
|100+ Free Mocks for IBPS & SBI Clerk Exam||Attempt Free Mock Test|
|100+ Free Mocks for SSC CGL 2021 Exam||Attempt Free Mock Test|
|100+ Free Mocks for Defence Police SI 2021 Exam||Attempt Free Mock Test|
|100+ Free Mocks for UPSSSC 2021 Exam||Attempt Free Mock Test|
They use expansionary monetary policy to lower unemployment and avoid recession. They lower interest rates, buy securities from member banks and use other tools to increase liquidity.
Monetary Policy Versus Fiscal Policy
Ideally, monetary policy should work hand-in-glove with the national government’s fiscal policy.
It rarely works this way. That’s because government leaders get re-elected for reducing taxes or increasing spending. That means rewarding voters and campaign contributors, to put it bluntly. As a result, fiscal policy is usually expansionary. To avoid inflation in this situation, monetary policy must be restrictive.
Ironically, during the Great Recession, politicians became concerned about the U.S. debt. That’s because it exceeded the benchmark debt-to-GDP ratio of 100 percent. As a result, fiscal policy became contractionary just when it needed to be expansionary. To compensate, the Fed injected massive amounts of money into the economy with quantitative easing.
Six Tools of Monetary Policy
All central banks have three tools of monetary policy in common. Most have many more. They all work together in an economy, by managing banks’ reserves.
The Fed has six major tools. First, it sets a reserve requirement, which tells banks how much of their money they must have on reserve each night. If it weren’t for the reserve requirement, banks would lend 100 percent of the money you’ve deposited. Not everyone needs all their money each day, so it is safe for the banks to lend most of it out.
The Fed requires that banks keep 10 percent of deposits on reserve. That way, they have enough cash on hand to meet most demands for redemption. When the Fed wants to restrict liquidity, it raises the reserve requirement. The Fed only does this as a last resort because it requires a lot of paperwork.
It’s much easier to manage banks’ reserves using the Fed funds rate.
This is the interest rate that banks charge each other to store their excess cash overnight. The target for this rate is set at the eight annual Federal Open Market Committee meetings. The Fed funds rate impacts all other interest rates, including bank loan rates and mortgage rates.
The Fed’s third tool is its discount rate. That’s how it charges banks to borrow funds from the Fed’s fourth tool, the discount window. The FOMC usually sets the discount rate a half-point higher than the Fed funds rate. That’s because the Fed prefer banks to borrow from each other.
Fifth, the Fed uses open market operations to buy and sell Treasurys and other securities from its member banks. This changes the reserve amount that banks have on hand without changing the reserve requirement.
Sixth, many central banks including the Fed use inflation targeting.
It clearly sets expectations that they want some inflation. That’s because people are more likely to buy if they know prices are rising.
In addition, the Fed created many new tools to deal with the Great Recession. To find out more, see Federal Reserve Tools.
To Clear English Sections You must Have English Tricks Book Buy Now From Here
To Clear Quantitative Aptitude Section You must Have Quantitative Aptitude Tricks Book Buy Now From Here
To Clear Reasoning Section You must Have Reasoning Tricks Book Buy Now From HereBuy Now
To Clear Computer Awareness Section You must Have Computer Awareness Book Buy Now From HereBuy Now