Monetary Policy: Everything You Need to Understand

Monetary policy plays a pivotal role in shaping the economic landscape of a nation. It serves as a crucial tool wielded by central banks to influence economic activity, price stability, and overall financial well-being. For aspirants preparing for the Union Public Service Commission (UPSC) examinations, grasping the intricacies of monetary policy is indispensable.

Meaning of Monetary Policy

Monetary policy, a macroeconomic strategy overseen by the central bank, focuses on managing both the money supply and interest rates. This demand-side economic approach is employed to achieve various macroeconomic goals such as controlling inflation and ensuring liquidity.

In the context of India, the Reserve Bank of India (RBI) formulates and implements monetary policies. It is aimed at regulating the quantity of money circulating in the economy to cater to the needs of different sectors.

Utilizing any of these tools leads to adjustments in interest rates or the money supply. Thereby influencing economic conditions and steering the economy towards desired outcomes.

Instruments of Monetary Policy

Tools of Monetary Policy can be divided into Quantitative Tools and Qualitative Tools

Quantitative Tools:

Bank Rate:

1. The bank rate, set by RBI, is minimum rate at which it lends money and rediscounts securities held by commercial banks.
2. To control inflation, the central bank may raise the bank interest rates, prompting commercial banks to borrow less and thereby restraining inflation.
3. Commercial banks, in turn, increase lending rates to discourage borrowing, further aiding in inflation control.
4. Conversely, reducing bank rates makes borrowing cheaper, encouraging borrowing and investment, thereby stimulating economic activity.

Repo Rate:

1. Repo rate is the rate at which commercial banks borrow money by selling securities to the RBI to maintain liquidity.
2. It is a tool used by the central bank to control inflation; higher repo rates discourage borrowing and spending.

Reverse Repo Rate:

1. Reverse repo rate is the rate at which the RBI borrows money from commercial banks.
2. Increasing reverse repo rates incentivize banks to park excess funds with the RBI, helping to manage liquidity and control inflation.

Reserve Ratios:

1. Commercial banks must maintain reserve assets in the form of cash, including Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR).
2. CRR is a percentage of a bank’s net demand and time liabilities kept with the central bank, typically ranging from 3-15% in India.
3. SLR mandates a certain percentage of reserves to be maintained in the form of gold and foreign securities, typically between 25-40% in India.
4. Adjustments in SLR and CRR affect the liquidity and lending capacity of commercial banks.

Open Market Operations (OMO):

1. OMO involves the RBI buying or selling securities in the money market to influence interest rates and stabilize the market.
2. Selling securities reduces money supply as funds move from banks to the RBI, while buying securities injects liquidity into the system.
3. Factors affecting OMO include the state of the securities market and commercial bank reserves.

Liquidity Adjustment Facility (LAF)

The Liquidity Adjustment Facility (LAF) is a framework that enables banks to address their short-term liquidity requirement efficiently. Under this mechanism, banks can either obtain funds from the central bank through repurchase agreements (repos) or deploy surplus funds by lending to the central bank through reverse repo agreements.

Marginal Standing Facility (MSF) Rate:

The Marginal Standing Facility (MSF) Rate serves as a means for banks to obtain overnight funds by utilizing their SLR portfolio as collateral. This facility is designed to address sudden liquidity needs, with the MSF Rate set at a higher level than the repo rate as a deterrent for banks. By leveraging the MSF, banks can manage short-term liquidity challenges while upholding financial stability under the oversight of the central bank.

Also learn about Inflation and How Mild Inflation Benefits the Economy.

Qualitative Tools:

Rationing of Credit:

1. The RBI sets credit limits for commercial banks, restricting the amount available to each bank and potentially imposing upper limits for specific purposes.
2. This approach mitigates banks exposure to risky sectors and regulates bill rediscounting.

Marginal Requirement:

1. Marginal requirements dictate the proportion of a loan amount not financed by the bank.
2. Adjusting margins influences loan sizes, directing credit towards priority sectors while limiting exposure to others.
3. For instance, to boost agricultural credit, the RBI might reduce margins, allowing for higher loan allocations.

Moral Suasion:

1. Moral suasion involves the RBI providing guidance to commercial banks to restrain credit during inflationary periods.
2. Rather than enforcing strict measures, the RBI exerts pressure on banks through suggestions and expectations communicated via monetary policy.
3. Directives, guidelines, and suggestions from the RBI prompt banks to reduce credit supply for speculative purposes and adhere to prudent lending practices.

Expansionary and Contractionary Policy:

Expansionary and contractionary monetary policies are two tools used by central banks to manage the money supply.

• Expansionary Monetary Policy- aims to stimulate economic growth and increase aggregate demand during periods of economic downturn or recession.
• Tools:
  • Lowering Interest Rates: Central banks can decrease interest rates to encourage borrowing and spending by both consumers and businesses. Lower interest rates make borrowing cheaper, leading to increased investment and consumption.
  • Quantitative Easing (QE): This involves purchasing government securities or other financial assets by the central bank to inject liquidity into the financial system, lower long-term interest rates, and encourage lending.
  • Reducing Reserve Requirements: Central banks can reduce the reserve requirements for banks, allowing them to lend out more money, which increases the money supply.
• Effects:
  • Increased borrowing and spending by businesses and consumers.
  • Lower interest rates encourage investment in capital projects and housing.
  • Boosts employment and output in the economy.

Contractionary Monetary Policy– aims to cool down an overheating economy, control inflation, and prevent excessive borrowing and spending.

• Tools:
  • Raising Interest Rates: Central banks increase interest rates to discourage borrowing and spending. Higher interest rates make borrowing more expensive, leading to reduced investment and consumption.
  • Open Market Operations: Central banks sell government securities or other financial assets to reduce the money supply.
  • Increasing Reserve Requirements: Central banks can raise reserve requirements for banks, limiting their ability to lend out money and decreasing the money supply.
• Effects:
  • Decreased borrowing and spending by businesses and consumers.
  • Higher interest rates can reduce investment in capital projects and housing.
  • Slows down inflationary pressures and prevents economic overheating.

Monetary Policy Committee

The Finance Act of 2016 amended the Reserve Bank of India (RBI) Act of 1934 to establish the Monetary Policy Committee (MPC). The committee is responsible for determining the benchmark interest rate in India, thereby enhancing transparency and accountability in the country’s monetary policy framework.

Consisting of six members, the MPC includes three officials from the RBI and three external members appointed by the Government of India (GoI), with the RBI Governor serving as the chairperson by virtue of their position.

The current mandate of the committee is to maintain an annual consumer price index-based inflation (CPI) rate of 4%, with a tolerance band of +/- 2%. If inflation exceeds this prescribed range for three consecutive quarters, the committee must report to the Government of India.

In conclusion, Monetary policy involves the utilization of tools within the purview of the central bank to manage factors like interest rates and credit availability. It is all aimed at fulfilling the broader objectives of economic policy.

Learn about Fiscal policy from here.

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