Monetary Policy of India- Definition, Types, Instruments, and Objectives of Monetary Policy
Monetary policy is a set of tools or a process the monetary authority of a country, the central bank, uses to control the supply of money in the economy by having control over the interest rates for maintaining price stability and achieving high economic growth. In India, the Reserve Bank of India (RBI) is the central monetary authority.
In this blog, Fintra will provide insights on monetary policy by highlighting the following topics:
- What is Monetary Policy?
- Types of Monetary Policy
- What are the Instruments of Monetary Policy?
- What are the Objectives of Monetary Policy?
What is Monetary Policy?
In short, monetary policy is adopted by a country to control either the interest rate for a short-term borrowing, such as borrowing by banks from each other for meeting their short-term requirements or the money supply, attempting to decrease inflation or the interest rate, ensuring price stability and general trust of the value and stability of the country's currency.
The monetary policy strives to control the amount of funds that are available in an economy and the means by which the new money is supplied. Economic statistics like gross domestic product (GDP), the rate of inflation, and industry and sector-specific growth rates have a major influence on the monetary policy strategy.
At times, the central bank will revise the interest rates it charges to loan money to the nation's banks. As rates rise or fall, financial institutions will adjust rates accordingly for their customers such as home buyers or businesses. Moreover, it may also buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks are needed to maintain as reserves.
Speaking about India, the Reserve Bank of India's monetary policy strives to manage the quantity of money to fulfil the requirements of various sectors of the economy along with improving the pace of economic growth. The RBI enforces the monetary policy via open market operations, reserve system, credit control policy, bank rate policy, moral persuasion, and numerous other instruments. It's by using any of these instruments that lead to changes in the interest rate or the money supply in the economy. As an example, since liquidity is a vital aspect for an economy to stimulate growth, to maintain liquidity, RBI is dependent on the monetary policy. By buying bonds via open market operations, the RBI introduces funds into the system and decreases the interest rate.
Types of Monetary Policy
Monetary policies are seen as expansionary or contractionary in nature. For example, during times of slowdown or a recession when there's an increase in money supply and interest rates are reducing, it indicates an expansionary policy. On the other hand, contractionary monetary policy is the reverse of expansionary policy. For example, to slow growth and reduce inflation, the contractionary policy is used as it raises interest rates and limits the outstanding money supply. The prices of goods and services rise, reducing the purchasing power of money.
What are the Instruments of Monetary Policy?
There are several direct and indirect instruments used to implement monetary policy. They're as follows:
- Repo Rate: Repo Rate refers to the interest rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) to every LAF participant against the collateral of government and other approved securities.
- Standing Deposit Facility (SDF) Rate: On an overnight basis, SDF is the rate at which the Reserve Bank accepts the uncollateralised deposits from all LAF participants. Along with being a financial stability tool, SDF also plays its role in liquidity management. Since SDF was introduced in April 2022, it replaced the fixed reverse repo rate as the floor of the LAF corridor.
- Marginal Standing Facility (MSF) Rate: On an overnight basis, the penal rate at which banks can borrow from the Reserve Bank by plunging into their Statutory Liquidity Ratio (SLR) portfolio up to a predefined limit. To the banking system, this acts as a safety valve against unanticipated liquidity shocks.
- Liquidity Adjustment Facility (LAF): The LAF refers to the Reserve Bank’s operations via which it injects and/or absorbs liquidity into/from the banking system. It consists of overnight along with term repo/reverse repos (fixed and variable rates), SDF, and MSF. Apart from LAF, the other instruments of liquidity management include forex swaps, outright open market operations (OMOs), and the market stabilisation scheme (MSS).
- LAF Corridor: LAF corridor has the marginal standing facility (MSF) rate as its upper bound, ceiling, and the standing deposit facility (SDF) rate as the lower bound, floor, and the policy repo rate is in the middle of the corridor.
- Main Liquidity Management Tool: This is a 14-day term repo/reverse repo auction operation at a variable rate, and it's conducted to overlap with the cash reserve ratio (CRR) maintenance cycle, which is the main liquidity management tool to manage frictional liquidity requirements.
- Fine Tuning Operations: The main liquidity operation is backed by fine-tuning operations, overnight and/or longer tenor, to wave over any unanticipated liquidity shifts during the reserve maintenance period. In addition, if needed, the Reserve Bank even conducts longer-term variable rate repo/reverse repo auctions of more than 14 days.
- Reverse Repo Rate: This is the interest rate at which the Reserve Bank takes in the liquidity from banks against the collateral of qualified government securities under the LAF. Since the introduction of SDF, the fixed rate reverse repo operations are done under the supervision of the RBI for purposes specified from time to time.
- Bank Rate: Bank rate is the rate at which the Reserve Bank is willing to purchase or rediscount bills of exchange or other commercial papers. It acts as the penal rate that's levied on banks when there are shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio). The Bank Rate was published under Section 49 of the RBI Act, 1934, and the rate has been aligned with the MSF rate. Moreover, it changes automatically whenever the MSF rate changes alongside the policy repo rate changes.
- Cash Reserve Ratio (CRR): CRR refers to the average daily balance a bank is mandated to maintain with the Reserve Bank as a per cent of its net demand and time liabilities (NDTL) as on the last Friday of the second preceding fortnight, which the Reserve Bank will notify from time to time in the Official Gazette.
- Statutory Liquidity Ratio (SLR): In India, every bank is required to maintain assets and their value must not be less than the percentage of the total of its demand and time liabilities as on the last Friday of the second preceding fortnight, which the Reserve Bank will notify by giving notification in the Official Gazette. Unless it's specified in what type of manner the assets should be maintained, typically they should be in unencumbered government securities, cash and gold.
- Open Market Operations (OMOs): These operations include outright purchase/sale of government securities by the Reserve Bank for injection and/or absorption of durable liquidity in the banking system.
What are the Objectives of Monetary Policy?
The main objectives of the monetary policy are to boost economic growth, price and exchange rate stability. Some other objectives of the monetary policy of India, as expressed by RBI are as follows:
Promotion of saving and investment: Monetary policy governs the rate of interest and inflation within India, hence, it does have an impact on the savings and investments of the people. Higher rates of interest increase the chances greatly of savings and investment, thereby, preserving a healthy cash flow within India's economy.
Governing the imports and exports: By assisting industries to secure loans at a reduced rate of interest, the monetary policy enables export-oriented units to supersede imports and improve exports. In turn, this helps to improve the condition of the balance of payments.
Managing business cycles: Boom and depression are the two primary stages of a business cycle. Thus, monetary policy acts as the greatest tool with which the boom and depression of business cycles can be controlled by managing the credit in order to control the supply of money. Inflation in the market is generally controlled by decreasing the supply of money. On the other hand, as the money supply increases, demand in the economy also rises.
Regulation of aggregate demand: Since the demand in an economy can be controlled by monetary policy, the policy can also be used by monetary authorities to retain a balance between demand and supply of goods and services. As credit gets expanded and the rate of interest reduces, it enables more people to secure loans for purchasing goods and services. This leads to a rise in demand, and on the other hand, when authorities desire to reduce demand, they can reduce credit and raise interest rates.
Generation of employment: When monetary policy reduces the interest rates, small and medium enterprises (SMEs) easily secure loans for business expansions. This may lead to greater employment opportunities.
Helping with the evolution of infrastructure: The monetary policy permits concessional funding for developing infrastructure within India.
Assigning more credit for the priority segments: Under the monetary policy, the extra funds get allocated at lower rates of interest for developing the priority sectors like small-scale industries, agriculture, underdeveloped sections of society, etc.
Managing and developing the banking sector: The Reserve Bank of India (RBI) manages the entire banking industry. Aiming to make banking facilities available across the whole nation, RBI also demands other banks use the monetary policy for establishing rural branches wherever necessary for agricultural development. Moreover, the government also has set up regional rural banks along with cooperative banks to assist farmers to receive the financial aid they require.
Price stability: Price stability signifies fostering economic development with a significant focus on price stability. The main focus is to promote an environment favourable to the architecture, which enables developmental projects to operate swiftly while also maintaining reasonable price stability.
Promotion of fixed investment: Here the aim is to boost the productivity of investment by restraining non-essential fixed investment.
Restriction of inventories and stocks: Overloading of stocks and products that are becoming outdated due to excess stock usually results in the sickness of the unit. Thus, to avoid this problem, RBI carries out an essential function of restricting inventories. The primary objective of this policy is to avoid overstocking and idle money in the organisation.
Reducing rigidity: RBI endeavours to bring more flexibilities in operations which provide considerable autonomy. It encourages a more competitive environment and diversification. RBI also maintains control over the financial system whenever required to maintain discipline and prudence in the operations of the financial system.
Conclusion
As described above, monetary policy is a set of tools used by central bankers or the government to maintain and keep a nation's economy stable while limiting inflation and unemployment. Moreover, an expansionary monetary policy spurs a receding economy, and a contractionary monetary policy slows down an inflationary economy. A nation's monetary policy is frequently coordinated with its fiscal policy.
