Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA

Notes for Bachelor of Commerce Students
Commerce Notes

Q.1: Define Monetary Policy. Discuss the objectives of RBI’s Monetary policy. OR Write note on objectives of RBI’s Monetary Policy. Ans.A) MONETARY POLICY :Monetary policy is a regulatory policy by which the central bank or monetary authority of a country controls the supply of money, availability of bank credit and cost of money, that is, the rate of Interest.
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Monetary policy / monetary management is regarded as an important tool of economic management in India. RBI controls the supply of money and bank credit. The Central bank has the duty to see that legitimate credit requirements are met and at the same credit is not used for unproductive and speculative purposes. RBI rightly calls its credit policy as one of controlled expansion. B)OBJECTIVES OF MONETARY POLICY OF INDIA :The main objective of monetary policy in India is ‘growth with stability’. Monetary Management regulates availability, cost and use of money and credit. It also brings institutional changes in the financial sector of the economy. Following are the main objectives of monetary policy in India :1. Growth With Stability :Traditionally, RBI’s monetary policy was focused on controlling inflation through contraction of money supply and credit. This resulted in poor growth performance. Thus, RBI have now adopted the policy of ‘Growth with Stability’. This means sufficient credit will be available for growing needs of different sectors of economy and at the same time, inflation will be controlled with in a certain limit. 2. Regulation, Supervision And Development Of Financial Stability :Financial stability means the ability of the economy to absorb shocks and maintain confidence in financial system. Threats to financial stability can come from internal and external shocks. Such shocks can destabilize the country’s financial system. Thus, greater importance is being given to RBI’s role in maintaining confidence in financial system through proper regulation and controls, without sacrificing the objective of growth. Therefore, RBI is focusing on regulation, supervision and development of financial system. 3. Promoting Priority Sector :Priority sector includes agriculture, export and small scale enterprises and weaker section of population. RBI with the help of bank provides timely and adequately credit at affordable cost of weaker sections and low income groups. RBI, along with NABARD, is focusing on microfinance through the promotion of Self Help groups and other institutions. 4. Generation Of Employment :Monetary policy helps in employment generation by influencing the rate of investment and allocation of investment among various economic activities of different labour Intensities. 5. External Stability :With the growth of imports and exports India’s linkages with global economy are getting stronger. Earlier, RBI controlled foreign exchange market by determining eaxchange rate. Now, RBI has only indirect control over external stability through the mechanism of ‘managed Flexibility’, where it influences exchange rate by buying and selling foreign currencies in open market. 6. Encouraging Savings And Investments :-




FUNCTIONS OF RBI :RBI performs many functions. relating to licensing. buys and sells foreign currencies for it and gives it advice on all banking matters. 2.10/13/13 Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA RBI by offering attractive interest rates encourage savings in the economy. 7. RBI achieves this aim through appropriate monetary fiscal and trade policies and exchange control.in/2012/07/chapter-3monetary-policy-of-reserve. A. The bank makes ways and meets advances of the government. Its share capital was Rs. IDBI. Due to country’s development it has also undertaken developmental and promotional functions. E. Issue Of Currency Notes :Under section 22 of RBI Act. 4. RBI acts as a lender of last resort.html 2/7 . 8. RBI has centralized all foreign exchange reserves (FOREX). It provides financial assistance to scheduled banks and state co-operative banks in form of rediscounting of eligible bills and loans and advances against approved securities. ‘The Report on currency and finance’ is an annual publication. remits its funds. Controller Of Credit :RBI has power to control the volume of credit created by banks. For this. like UTI. The RBI through its various quantitative and qualitative techniques regulates total supply of money and bank credit in the interest of economy. amalgamation. Banker’s bank And Lender Off Last Resort :RBI acts as a banker to other banks. It has obligation to transact the banking business of Central Government as well as State Governments. Ans. It has to maintain external valu of Rupee. A high rate of saving promotes investment.2:Discuss / Explain the various functions of RBI. However it can indirectly affects the policies and functions of NBFIs through its monetary policy. The Reserve Bank Of India’ Bulletian is a monthly publication. the bank has the sole right to issue currency notes of all denominations except one rupee coins and notes. 100 each. Redistribution Of income And Wealth :By control of inflation and deployment of credit to weaker sectors of society the monetary policy may redistribute income and wealth favouring to weaker sections. establishment. Regulatory And Supervisory Functions :The RBI has wide powers of supervision and control over commercial and co-operative banks. like any other bank performs almost all traditional Central banking functions.blogspot. RBI pumps in money during busy season and withdraws money during slack season. 5. Q.g.RBI receives and makes all payments on behalf of government. Banker To The Government :The RBI acts as a banker agent and adviser to the government. Exchange control And Custodian Of Foreign Reserve :RBI has the responsibility of maintaining fixed exchange rates with all member countries of IMF. branch expansion. It provides funds to bank when they fail to get it from other sources. Regulation Of NBFIs:Non – Banking Financial Institutions (NBFIs). Its headquarters is at Mumbai. but also results of important studies and investigations conducted by reserve bank are given. Thus the monetary management by influencing rates of interest can influence saving mobilization in the country. The RBI has a separate issue department which is entrusted with the issue of currency notes. management and methods of working. IFCI plays an important role in deployment of credit and mobilization of savings. 6.RESERVE BANK OF INDIA (RBI) :The Reserve Bank of India is the central bank of India it was established as a shareholder’s bank on 1st April 1935. It not only provides information. RBI does not have any direct control on the functioning of such institutions. Collection And Publication Of Data :The RBI collects and complies statistical information on banking and financial operations of the economy.:. RBI. It also acts as a clearing house. Through RBI. banks make interbanks payments. re-construction and liquidation. divided in to 5 lakhs fully paid up shares of Rs. On behalf of central government it sells treasury bills and thereby provides short-term finance. RBI helps the Government – both Central and state – to float new loans and manage public debt. 7. It provides review of various developments of economic and financial importance. some of them are:1. RBI functions as custodian of nations foreign exchange reserves. A. 3. 5 crore. The supervisory functions of RBI have helped a great in improving the standard of banking in India to develop on study-material4u. The one-rupee notes and coins and small coins are issued by Central Government and their distribution is undertaken by RBI as the agent of the government. liquidity of Assets. On 1st January 1949 it was nationalized.

Agricultural Refinance and Development Corporation (ARDC). RBI increased the CRR from 5% to 5. The RBI has also taken measures to promote organized bill market to create elasticity in Indian Money Market in order to satisfy seasonal credit needs. NABARD etc. A high CRR reduces the cash for lending and a low CRR increases the cash for lending. the repo and reverse repo rates are becoming important. Repo is a swap deal involving the immediate Sale of Securities and simultaneous purchase of those securities at a future date. the bank rate has been reduced to 6% p. As of March 2011. OR Explain Monetary Management of RBI.5%. it hopes to achieve its monetary policy. were established. Bank rate is also called discount rate. at a predetermined price. The RBI has power to fix SLR in the range of 25% and 40% between 1990 and 1992 SLR was as high as 38. promote saving habits and to provide industrial and agricultural finance. It further increased in April 2010 to 6% as inflationary pressures had started building up in the economy. This avoids unnecessary transfer of funds between the various banks. Statutory Liquidity Ratio (SLR) Under SLR. Narasimham Committee did not favour maintenance of high SLR. Clearing House Functions :The RBI acts as a clearing house for all member banks. In January 2010. Repo means Sale and Repurchase Agreement. these institutions were set up to mobilize savings.It was further reduced to 24% on November 2008. It further reduced to 5. Open market operations :It refers to buying and selling of government securities in open market in order to expand or contract the amount of money in the banking system. commercial papers etc) held by commercial banks.in/2012/07/chapter-3monetary-policy-of-reserve.html 3/7 . I) 5. 3. State Financial Corporations (SFCs). Under the RBl Act of.10/13/13 Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA sound lines and to improve the methods of their operation. 8. For this Regional Rural banks. The CRR has been brought down from 15% in 1991 to 7. By 2003. RBI has a special Agricultural Credit Department (ACD) which studies the problems of agricultural credit. Purchases inject money into the banking system while sale of securities do the opposite. 1949. Co-operative. Some of the important general credit control methods are:1. These involve the purchase of one loan against the sale of another or. but it has also the duty to see that legitimate credit requirements are met and at the same time credit is not used for unproductive and speculative purposes RBI has various weapons of monetary control and by using them. Bank Rate Policy :Bank rate is the rate at which the Central bank lends money to the commercial banks for their liquidity requirements. Ans.5% in December 2001.maintain a certain ratio to its total deposits with RBI in the form of liquid assets like cash. Repo rate helps commercial banks to acquire study-material4u. In other words bank rate is the rate at which the central bank rediscounts eligible papers (like approved securities. industrial financing.a. At present it is 25%. Repo And Reverse Repo Rates In determining interest rate trends. l934 every commercial bank has to keep certain minimum cash reserves with RBI. 9.This technique is superior to bank rate policy. the government has imposed an obligation on the banks to . A) MONETARY POLICY OF RBI :The Monetary Policy of RBI is not merely one of credit restriction. vice-versa. 1934 and the Banking RegulationAct. Deposit Insurance Corporation. Q. The RBI is empowered to vary the CRR between 3% and 15%. bills of exchange. Cash Reserve Ratio (CRR) The Gash Reserve Ratio (CRR) is an effective instrument of credit control. Quantitative credit controls are used to maintain proper quantity of credit o money supply in market.blogspot.75%. Development And Promotional Functions :The RBI has helped in setting up Industrial Finance Corporations of India (IFCI). During last two decades the RBI has been undertaking switch operations. the legal framework of RBI’s control over the credit structure has been provided Under Reserve Bank of India Act. OR Write note on Quantitative I Selective methods ofcredit control. CRR is 6%. This policy aims at preventing unrestricted increase in liquidity. gold and other securities. Thus RBI has contributed to economic growth by promoting rural credit. units Trust of India (UTI) etc. The SLR was lowered down to 25% from 10thOctober 1997.3): Explain the quantitative and selective methods ofcredit controlused by RBI. export trade etc. General I Quantitative Credit Control Methods :In India. Bank rate is important because its is the pace setter to other marketrates of interest. 4.OR Explain the Monetary Policy of RBI Imeasures takenby RBI to control credit. It stood at 5% on January 2009.5% in May 2001. Bank rates have been changed several times by RBI to control inflation and recession. 2.

Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds with RBI. So RBI adopted Multiple indicator Approach in which it looks at a variety of economic indicators and monitor their impact on inflation and economic growth.75% in March 2011 and Reverse repo rate was 5. Repo rate was 6. This has been done as a part of financial sector reforms. After 1991 reforms this approach became difficult to follow. It may involve refusal by RBI to rediscount bills or cancellation of license. Ceiling On Credit The Ceilingon level of credit restricts the lending capacity of a bank to grant advances against certain controlled securities. issue of guarantees.blogspot. A)RECENT CHANGES IN RBI’s MONETARY POLICY :Since 1991 RBI’s monetary management has undergone some major changes. Margin against a particular security is reduced or increased in order to encourageor to discourage the flow of credit to a particular sector. With phasing out of Bills. Directives:The RBI issues directives to banks regarding advances. 3.html 4/7 . RBI has introduced the 4) 5) 6) study-material4u. This has led to the growth of economy. As a result. To reduce inflation it hiked repo rate to. MarginRequirements :A loan is sanctioned against Collateral Security. Directives are regarding the purpose for which loans may or may not be given. Higher the margin lesser will be the loan sanctioned. 6. Since 1990s this system has changed and lending rates are determined by commercial banks on the basis of market forces. For agricultural commodities it is as high as 75%. 4 :Examine the recent changes that have taken place in RBIs Monetary Policy.25% II) SELECTIVE / QUALITATIVE CREDIT CONTROL METHODS :Under Selective Credit Control.in/2012/07/chapter-3monetary-policy-of-reserve. 2. (Mar. 3) Reduction In Reserve Requirements :In post-reform period the CRR and SLR have been progressively lowered. Monetary targeting refers to a monetary policy strategy aimed at maintaining price stability by focusing on changes in growth of money supply. Delinking Of Monetary Policy From Budget Deficit :In1994 government phased out the use of adhoc treasury Bills. if the bank has failed to comply with the directives of RBI. Moral Suasion Under Moral Suasion. RBI issues periodical letters to bank to exercise control over credit in general or advances against particular commodities. 7) Provision Of Micro Finance By linking the banking system with Self Help Groups. RBI contracts credit by increasing the repo and reverse repo rates and by decreasing them it expands credit. Discriminatory Interest Rate (DIR) Through DIR. On May 2011 RBI announced Monetary Policy for 2011-12. The funds under LAF are used by banks to meet day-to-day mismatches in liquidity.25% and Reverse repo to 6. in phases. 4. 5. RBI would no longer lend to government to meet fiscal deficit. Direct Action It is too severe and is therefore rarely followed. Deregulation Of Administered Interest Rate System :Earlier lending rate of banks was determined by RBI. RBI used the ‘Monetary targeting approach’ to its monetary policy. Let us explain 1) Multiple Indicator Approach :Upto late 1990s. 2000. Periodic discussions are held with authorities of commercial banks in this respect. making advances etc. more bank funds have been released for lending.These bills were used by government to borrow from RBI to finance fiscal deficit. RBI makes credit flow to certain priority or weaker sectors by charging concessional rates of interest. Liquidity Adjustment Facility (LAF):LAF allows banks to borrow money through repurchase agreement LAF was introduced by RBI during June. credit is provided to selected borrowersfor selected purpose. Margin means that proportion of the value of security against which loan is not given. RBI issues supplementary instructions regarding granting of additional credit against sensitive commodities. The Selective Controls are :1.7. depending upon the use to which the control try to regulate the quality of credit the direction towards thecredit flows.10/13/13 Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA funds from RBI by selling securities and also agreeing to repurchase at a later date. ‘11) Ans. . Repo and reverse repo operations are used by RBI in its Liquidity Adjustment Facility.75% for the same period. the selective methods of credit control are being slowly phased out. It varies from 20% to 80%. 2) Selective Methods Being Phased Out :With rapid progress in financial markets. Q. Quantitative methods are becoming more important.

2. To provide stability in financial markets. increasing the money supply. Sterlization :Sterlization means re-cycling of foreign capital inflows to prevent appreciation of domestic currency and to check the inflationary impact of such capital. 5. Under LAF. RBl. Along with NABARD. RBI is promoting various other microfinance institutions.uses a variety of other measures to manage interest rates. (Mar. Due to lack of demand repos auctions were discontinued in March 1995. But Sterlization can also leads to some problems. at a predetermined price. there were four key channels of monetary policy transmission :-Interest rate. introduced repos in December 1992.5:Discuss RBI’s short term Liquidity Management. they get injected into the economy thereby. Interest rate is the most dominant transmission channel as any change in monetary policy has immediate effect on it. It (ILAF) provided a mechanism for liquidity management through a combination of repos. In India. liquidity absorption through reverse repo reached its peak on 4th September 2009 at Rs. 4. India rose to US $15 billions in 2004-05.With this. Thus RBI also. It has been revised further. Future expectations about asset prices. 1. credit availability. In recent years fifth channel. in 1990’s. Q. Liquidity Adjustment Facility (LAP) V RBI introduced-full-fledged LAF. So to maintain price stability RBI has to mange the exchange rate and Interest rate. Such deals takes place between RBI and banks.blogspot. general price and Income levels influence the four traditional channels. they are determined by demand and supply. export credit refinance and collateralised lending facilities supported by Open Market Operations. OR Why has short term Liquidity Management gained importance in post reform India? Discuss measures taken by RBI for Management of short term Liquidity. In RBI’s overall management short term liquidity management occupies a very important place due to following factors:1) In financial sector.in/2012/07/chapter-3monetary-policy-of-reserve. capital flows to.68. Sterlization is carried out through open market operations. asset prices and exchange rate channels. Reverse repo auctions and Repo auctions are conducted on daily basis.A. ‘11) Ans. set of instruments and the rules that the central bank follows in order to manage the amount of money supply to control short term interest rates with the objective of price stability”. Repo is Sale and Repurchase Agreement. Accordingly in 1999 RBI introduced ILAF. the emergence of LAF was a single biggest factor which helped RBI to manage short term liquidity and maintain interest rate stability.html 5/7 . 4) When capital inflows are converted into rupees. RBI in absence of direct intervention indirectly influences these rates by using multiple indicators approach. The important reforms are deregulation of interest rates and exchange rates. 3. Earlier these rates were determined by RBI.RBI’S SHORT TERM LIQUIDITY MANAGEMENT :Liquidity Management of Central bank means supplying to the market the amount of liquidity that is consistent with a desired level of short-term interest rate. It adds to the supply of foreign exchange and have resulted into appreciation of domestic currency. many reforms were introduced. From US $118 Million during 1991-92. Expectation has been added. In 200910. after reforms. they were resumed again in 1997. It is a swap deal involving the immediate Sale of Securities and simultaneously purchase of those securities at a future date. Market Stabilization Scheme (MSS):- study-material4u. Repo I Reverse Repo To improve short term liquidity management. Interim Liquidity Adjustment Facility (ILAR) To develop short term money market Narasimham Committee 1998 recommended LAF. theexports have become more expensive. 9) Expectation As A Channel Of Monetary Transmission Traditionally. 2) Due to liberalization capital flows between countries have increased. Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds with RBI.10/13/13 Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA scheme of micro finance for rural poor.215crore. It is defined “as the framework. 8) External Sector With globalisation large amount of foreign capital is attracted. RBI uses sterlization and LAF to absorb the excess liquidity that comes in with huge inflow of foreign capital. 3) Foreign capital flows have increased employment. B) RBI’S MEASURES FOR SHORT TERMLlQUIDITY MANAGEMENT 1.

10/13/13 Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA Till 2003-04 the impact of large capital inflows was managed through day-to-day LAF and OMO. the government securities available with RBI declined. 6. Effective supervision of RBI over banks and financial institutions is largely responsible for trust and confidence of public in banking sector. 3. regulation and supervision mechanism. Financial Inclusion :Along with NABARD. are not set out in specific terms and there is insufficient freedom in the use of instruments.blogspot. Now-a-days due to professionalism banks provide better service to customers. its monetary policy becomes less effective. Financial Stability :With the help of controls. 7. OMO and MSS. inflation also results from deficit financing and scarcity of goods on which RBI may not have any control. RBI has made a great impact in the growth of microfinance. as it changes with time. 4. Black Money :There is a growing presence of black money in the economy. 6 :Evaluate RBI’s Monetary Policy. The performance of monetary policy can be seen from its achievements and failures. As RBI has no power over the unorganised sector of money market. Adaptability:In India monetary policy is flexible. However Central Government's huge budgetary deficits have made monetary policy ineffective. On one hand it was taking steps to expand bank credit. but in India. In such a setting. RBI has supported Self Help Group Model and promoted other microfinance institutions. Achievements I Positive Aspects Of Monetary Policy :1. I. as they were being used for absorbing excess liquidity. RBI has been successful in maintaining financial stability. During the period of global crisis it has also been able to maintain macro economic stability. 5. Unorganised Money Market :Presence of unorganised sector of money market is one of the main obstacle in effective working of the monetary policy. The competition is due to deregulation of interest rates and other measures taken by RBI. A)EVALUATION OF MONETARY POLICY :The RBI aims at one time was controlled expansion. Ans. Less Accountability:At present time. FAILURES I LIMITATIONS OF MONETARY POLICY 1. Competition Among Banks :The monetary policy of RBI has resulted in healthy competition among banks in the country. Coverage Of Only Commercial Banks :Instruments of monetary policy cover only commercial banks so inflationary pressures caused by banking finance can be controlled by RBI. RBI has also managed its sterlization operations very well. Black money falls beyond the purview of banking control of RBI. 5. Huge budgetary deficits have resulted in excessive monetary growth. Give an appraisal (Achievements and Failures) of monetary policy of RBI.html 6/7 . II. Increase In Growth:To maintain the growth of economy RBI has used its instruments' effectively. On other hand RBI uses quantitative and qualitative methods to control credit. 4. It means large proposition of total money Supply in a study-material4u. These two contradictory objectives limited the success of monetary policy. 2. Huge Budgetary Deficits :RBI makes every possible attempt to control inflation and to balance money supply in the market. 6.in/2012/07/chapter-3monetary-policy-of-reserve. In the process. RBI signed a Memorandum of Understanding (MOU) with Government for issuance of Treasury Bills and dated government securities under Market Stabilization Scheme (MSS). In order to handle these issues. 2. At present India has the second highest rate of GDP growth after China. Increase In Bank Deposits:The increase in bank deposits over the years indicates trust and confidence of people in banking sector. accountability tends to be weak as there is lack of clarity in the responsibility of governments and RBI. the goals of monetary policy in India. These Bills and Securities are used to absorb excess liquidity from market and: maintain stability in foreign exchange market. let us discuss. Short Term Liquidity Management :RBI has developed various methods to maintain stability in interest rate and exchange rate like LAF.OR. Q. 3. Many officials of banks and financial institutions are corrupt and inefficient which leads to financial scams in this way overall economy is affected. Problem Of Management Of Banks And Financial Institutions :The monetary policy can succeed to control inflation and to bring overall development only when the management of banks and Financial institutions are efficient and dedicated. Thus monetary policy has played an important role. RBI has developed new methods of credit control and shifted from monetary targeting to multiple indicator approach.

10/13/13 Notes for Bachelor of Commerce Students: CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA country remains outside the purview of RBI's monetary management.blogspot. For a more effective policy.in/2012/07/chapter-3monetary-policy-of-reserve. Powered by Blogger. CONCLUSION :Thus. B. Lack Of Transparency :According to S. it would be necessary to have greater transparency in the policy formulation and transmission process and the RBI would need to be clearly demarcated. from above we can say that despite several problems RBI has made a good effort for effective implementation of the monetary policy in India. 7. Increase Volatility :The integration of domestic and foreign exchange markets could lead to increased volatility in the domestic market as the impact of exogenous factors could be transmitted to domestic market. 8. The widening of foreign exchange market and development of rupee . Simple template.html 7/7 . S. cannot be continued indefinitely. Tarapore. in its present form in India. study-material4u.foreign exchange swap would reduce risks and volatility. the monetary policy formulation.

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