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MONETARY POLICY

This document discuss various objectives of monetary policy in India, its
implications and the recently introduced new framework for monetary policy
in India.

SUBMITTED BY –
PRATEEK SINGLA
MBA GENERAL (SECTION A)

MARCH 20, 2014
UBS CHANDIGARH

............................. 8 Nominal Anchor.................................................. 2 Monetary Policy Meaning Definitions Objectives............................ 2 Objectives of Monetary Policy .......................................................................................................................................................................................................................................................................... 2 Monetary Policy Operations ... 2 Definition of Monetary Policy ..................................................................Page 1 Table of Contents Meaning of Monetary Policy .............................................................. 5 Bank Rate Policy ......................... 5 Open Market Operations ................................................................ 6 Repo Rate and Reverse Repo Rate ............... 6 Moral Suasion ................................................................................................................................................................................................................................................................................. 5 Cash Reserve Ratio ........................................................................................ 6 Credit Authorization Scheme ................................................................................................................................................................................................................... 9 .... 6 Key Indicators of Monetary Policy ............................... 5 Credit Ceiling ........................................................................................................................................ 5 Statutory Liquidity Ratio .............................................. 7 New Framework of Monetary Policy ..................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... 9 The anatomy of the RBI..................................................................................

In India. Objectives of Monetary Policy The objectives of a monetary policy in India are similar to the objectives of its five year plans. stability and social justice." From both these definitions.        Rapid Economic Growth Price Stability Exchange Rate Stability Balance of Payments (BOP) Equilibrium Full Employment Neutrality of Money Equal Income Distribution These are the general objectives which every central bank of a nation tries to attain by employing certain tools (Instruments) of a monetary policy. Harry Johnson. Such questions are considered in the monetary policy. "A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy. Monetary Policy Meaning Definitions Objectives Definition of Monetary Policy Many economists have given various definitions of monetary policy.G. The Central Bank of a nation keeps control on the supply of money to attain the objectives of its monetary policy. "A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy. From the name itself it is understood that it is related to the demand and the supply of money. In a nutshell planning in India aims at growth. After the Keynesian revolution in economics. the RBI has always . it is clear that a monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives.Page 2 Meaning of Monetary Policy The term monetary policy is also known as the 'credit policy' or called 'RBI's money management policy' in India. How much should be the supply of money in the economy? How much should be the ratio of interest? How much should be the viability of money? etc. Hart." According to A. According to Prof. Some prominent definitions are as follows. many people accepted significance of monetary policy in attaining following objectives.

If the monetary policy succeeds in maintaining monetary equilibrium. money should play only a role of medium of exchange and not more than that.e. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffers from the Disequilibrium in the BOP. the monetary policy having an objective of price stability tries to keep the value of money stable. It could help in creating more jobs in different sector of the economy. with special attention to the seasonal needs of a credit. The former reflects an excess money supply in the domestic economy. It can also be called as Price Instability. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate. the 'BOP Surplus' and the 'BOP Deficit'. This increased investment can speed up economic growth. then the BOP equilibrium can be achieved. It helps in reducing the income and wealth inequalities. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. If the monetary policy is expansionary then credit supply can be encouraged. Price Stability: All the economics suffer from inflation and deflation. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If the RBI opts for a cheap or easy credit policy by reducing interest rates. According to them. Monetary policy can be used for achieving full employment. while the later stands for stringency of money. It refers to absence of involuntary unemployment. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. Robertson have always considered money as a passive factor. Both inflation are harmful to the economy. the investment level in the economy can be encouraged. However it does not mean that there is a Zero unemployment. Neutrality of Money: Economist such as Wicksted. Thus. The monetary policy aims at maintaining the relative stability in the exchange rate.Page 3 aimed at the controlled expansion of bank credit and money supply. the international community might lose confidence in our economy. When the economy suffers from recession the monetary policy should be an 'easy money policy but when there is inflationary situation there should be a 'dear money policy'. Let us now see objectives of monetary policy in detail :Rapid Economic Growth: It is the most important objective of a monetary policy. the monetary policy should regulate the . Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability. In that senses the full employment is never full. The BOP has two aspects i. Therefore.

The change in money supply creates monetary disequilibrium.Page 4 supply of money. and provide them with cheaper credit for longer term. etc. small-scale industries. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. Monetary policy can make special provisions for the neglect supply such as agriculture. village industries. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. . monetary policy can help in reducing economic inequalities among different sections of society. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is maintaining economic equality. This can prove fruitful for these sectors to come up. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability. Thus in recent period.

Industrial Development Bank of India. the CRR is 4. Stable exchange rate. yield on government securities and cost of bank credit.75% . Statutory Liquidity Ratio Every financial institution has to maintain a certain quantity of liquid assets with themselves at any point of time of their total time and demand liabilities. This banking system involves commercial and co-operative banks. EXIM Bank. The RBI sells government securities to contract the flow of credit and buys government securities to increase credit flow. Increase in Bank Rate increases the cost of borrowing by commercial banks which results into the reduction in credit volume to the banks and hence declines the supply of money. interest rates and availability of credit aimed to maintain Price Stability. the bank rate was 8. also known as the discount rate. Cash Reserve Ratio Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep with RBI in the form of reserves or balances . Economic growth. Bank Rate Policy The bank rate. precious metals. This mechanism influences the reserve position of the banks.5% to 25% because of the suggestion by Narshimam Committee. approved securities like bonds etc. RBI. IFC. As of October 2013. Funds are provided either through lending directly or rediscounting or buying money market instruments like commercial bills and treasury bills. Open market operation makes bank rate policy effective and maintains stability in government securities market.Higher the CRR with the RBI lower will be the liquidity in the system and vice-versa. But as per the suggestion by the Narshimam committee Report the CRR was reduced from 15% in the 1990 to 5 percent in 2002. As of 1 January 2013. RBI takes into account the following monetary policies: Open Market Operations An open market operation is an instrument of monetary policy which involves buying or selling of government securities from or to the public and banks.75% and as on 29 October 2013 bank rate is 8.RBI is empowered to vary CRR between 15 percent and 3 percent.Page 5 Monetary Policy Operations Monetary operations involve monetary techniques which operate on monetary magnitudes such as money supply. Healthy Balance of Payment. These assets can be cash.There was a reduction of SLR from 38.00 percent. The ratio of the liquid assets to time and demand liabilities is termed as the Statutory liquidity ratio. Increase in the bank rate is the symbol of tightening of RBI monetary policy. the apex institute of India which monitors and regulates the monetary policy of the country stabilizes the price by controlling Inflation. The current SLR is 23%. is the rate of interest charged by the RBI for providing funds or loans to the banking system. Financial stability. and other approved financial institutes.

RBI may request commercial banks not to give loans for unproductive purpose which does not add to economic growth but increases inflation. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks. the repo rate was 7. Credit Authorization Scheme Credit Authorization Scheme was introduced in November.00 % and reverse repo rate by 25 basis points to 7. On January 28. This increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy.00%.75%.Page 6 Credit Ceiling In this operation RBI issues prior information or direction that loans to the commercial banks will be given up to a certain limit. Few example of ceiling are agriculture sector advances. In this case commercial bank will be tight in advancing loans to the public. Moral Suasion Moral Suasion is just as a request by the RBI to the commercial banks to take so and so action and measures in so and so trend of the economy. They will allocate loans to limited sectors. priority sector lending. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation. 2014. As of October 2013. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. Under this instrument of credit regulation RBI as per the guideline authorizes the banks to advance loans to desired sectors.75 % and reverse repo rate was 6. RBI raised repo rate by 25 basis points to 8. . Repo Rate and Reverse Repo Rate Repo rate is the rate at which RBI lends to commercial banks generally against government securities. The increase in the Repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. 1965 when P C Bhattacharya was the chairman of RBI.

52% Bank rate 9% CRR 4.00% Reverse repo rate 7.Page 7 Key Indicators of Monetary Policy Below is the list of key indicators of Monetary and their values as on 29 January 2014.00% SLR 23% Repo rate 8. Indicator Current rate Inflation 7.00% Marginal Standing facility rate 9.00% .

wages and interest rates are impediments to transmission of monetary policy and should be eliminated. The key recommendations of the Committee are: (i) The headline Consumer Price Index (CPI) should be the nominal anchor for monetary policy and the Reserve Bank of India (RBI) should make this the predominant objective. (viii) All sector specific refinance should be phased out as committed to the Asian Development Bank in 1992. Since the present CPI inflation is 10 per cent the Committee recommends a ‘glide path’ of 8 per cent for January 2015 and 6 per cent for January 2016. . The decisions of the MPC will be by voting.Page 8 New Framework of Monetary Policy The merit of the Urjit Patel Committee Report to Review and Strengthen the Monetary Policy Framework (January 2014) is its analytical rigour and clear recommendations on improving the efficacy of monetary policy. (iv)The real policy rate should be positive. The Patel Report would become the locus classic on monetary policy in India. The funds available at the repo rate would be restricted and increasingly liquidity would be provided at the 14 day term repo. The implications of the key recommendations are discussed below. Members will be accountable for failure to attain the target—failure being defined as inability to attain the target for three successive quarters. (iii) The Central Government needs to reduce the fiscal deficit to 3. (v) In the second phase. longer-term repo auctions should be introduced. the Deputy Governor and Executive Director in charge of monetary policy and two external full-time members. the 14-day repo rate would be the operative target and recourse to outright two-way open market operations (OMO) would determine liquidity. (iv) Monetary policy decisions should be vested in a Monetary Policy Committee (MPC) comprising the Governor. Administered prices.0 per cent of GDP by 2016-17. (vi)There should be a remunerated standing deposit facility at the RBI to sterilise excess liquidity. (vii) With an independent debt management office. (ii)The nominal anchor for inflation should be set for a two-year horizon at 4 per cent with a band of plus or minus 2 per cent. OMO should not used to manage yields on government securities. the market stabilisation scheme and cash management bills should be phased out. In the first phase the weighted average call rate would be the operative target and the repo rate would be the single policy rate.

The Patel Committee endorses the setting up of an independent Debt Management Office (DMO). While this would allow sterilisation of capital inflows. unlike the reverse repo. Those apprehensive of a strong and effective monetary policy will try to stall this recommendation. without any limit it would be detrimental to the RBI balance sheet as there is no provision in the law to ensure that all losses of the RBI will be met by the government. The anatomy of the RBI The RBI could explore the scope for converting the present Technical Advisory Committee into a five member MPC with voting by members as envisaged by the Patel Committee. In the absence of such a legislative clause it would be hazardous to introduce a remunerated standing deposit facility. in its Report (March 2013). that CPI inflation would be its nominal anchor. would not require government securities as collateral. C. The MPC will have two external full-time members with a fixed three year non-renewable term. The Financial Sector Legislative Reforms Commission (FSLRC). The RBI would do well to recall the dictum that autonomy is never given. The gliding to the 4 per cent plus or minus the CPI nominal anchor would be nondisruptive and the RBI should. Rangarajan has argued that all the autonomy the RBI needs is headroom to operate monetary policy. with two External Members who could be members of the RBI Board. continue to stress the 8 per cent CPI inflation for January 2015 and 6 per cent for January 2016. but rightly cautions that the RBI’s OMO should be strictly limited to liquidity requirements and not be a vehicle for enabling government borrowing at low interest rates. . it is earned and taken. The RBI should unequivocally emphasise. There are media headlines that the Patel Committee advocates full autonomy on interest rates.Page 9 Nominal Anchor The CPI inflation is quite clearly the appropriate anchor. in its policy statements. besides the Finance Secretary or Secretary Economic Affairs would also be a non-voting member of the MPC. The Patel Committee recommends a remunerated standing deposit facility which. The FSLRC recommendation that RBI should be a member of the DMO Council as also the Management Committee is flawed as the Chairman of the DMO is enjoined to obtaining unanimous decisions which would make the RBI monetary policy subservient to the DMO. If the RBI is to be accountable it should have some degree of flexibility to attain its objectives. Such a structure would make the RBI into a vassal state. envisaged a MPC with two RBI members and five external members nominated by the government. The structure and composition of the MPC are pre-eminently suitable. The RBI should study the experience of Korea and other countries which have full-time members in the MPC. There could be some hierarchical problems about these members questioning executive decisions. This could obviate the need for legislative changes which could take years.