MONETARY POLICY & ROLE OF INTEREST RATES IN COUNTRYS

ECONOMY
Third bi-monthly monetary policy meet of Reserve Bank of India (RBI) is
scheduled in August 2016, when the central bank will decide whether to
cut the interest rates or not. Though the RBI is likely to keep the interest
rate unchanged, it is important to understand its implications on different
stakeholders.
RBI uses several monetary policy tools such as Repo Rate a, Reverse Repo
Rateb, Cash Reserve Ratioc, Statutory Liquidityd etc. to influence the supply
of money in the economy.
For e.g., say RBI decreased the Repo Rate. It means that now the banks
can borrow money from RBI at a cheaper rate. In other words, banks cost
of borrowing decreases. This implies that people can borrow money from
banks at a cheaper rate and invest in productive activities, which in turn
will generate growth, employment and productivity in the country.
Two stakeholders are generally keen to experience this phenomenon. First,
the investors who want to gain by investing in business which gives them
comparatively higher returns. Second, the Government as it leads to the
growth of the overall economy reduces the unemployment rate and may
increase the tax collection of the government.
However, there is a trade-off. Whenever RBI increases the money supply
in the economy, the demand of various goods and services also increases.
This is due to the fact that with the increase in the money supply, income
increases which fuels demand of various goods and services. If the
economy is unable to supply the desired goods and services at a rate by
which its demand is increasing then the price of the goods and services
will rise as more money starts chasing a fewer goods. This is called
Inflation. Reverse phenomenon occurs when RBI increases the interest
rate.
Inflation within a limited extent is not disturbing. In fact, any economy
wants to witness some level of inflation because it signals that there is a
demand in the economy which encourages people to invest more and
a

Repo Rate: Rate at which RBI lends the money to banks.

Reverse Repo Rate: Rate at which RBI borrows money back from the
bank; linked to Repo
Rate- 100 basis point less than Repo Rate
c
Cash Reserve Ratio (specified minimum fraction of the total deposits of
b

customers, which commercial banks have to hold as reserves either in cash or

as deposits with the central bank) dStatutory Liquidity Ratio : Ratio (reserve
requirement that the commercial banks require to maintain in the form of gold,
government approved securities before providing credit to the customers). Page
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more leading to more and more growth. Inflation becomes disturbing

when it crosses the desired zone and rises to a significantly higher level.
The benchmark to classify that whether inflation is high or is within the
limit is decided by central bank depending upon the conditions of the
economy. An exercise called Inflation targeting is done to declare this
suitable band.

Repo Rate: Rate at which RBI lends the money to banks.

Reverse Repo Rate: Rate at which RBI borrows money back from the
bank; linked to Repo
Rate- 100 basis point less than Repo Rate
c
Cash Reserve Ratio (specified minimum fraction of the total deposits of
b

customers, which commercial banks have to hold as reserves either in cash or

as deposits with the central bank) dStatutory Liquidity Ratio : Ratio (reserve
requirement that the commercial banks require to maintain in the form of gold,
government approved securities before providing credit to the customers). Page
2

The increase in price of goods and services immediately hurts the poor,
the downtrodden section of the society. Remember, the fruits of growth
are generally not equally shared by all the sections of the society. The
poor, who are also apparently the less skilled, are someone whose
earnings takes time to pick up but meanwhile due to the rise in prices of
goods and services experiences lesser purchasing power. This is a major
concern to the Central Bank (RBI) as their mandate is to keep prices stable
in the economy. This is the key reason why central bank becomes
reluctant at times from cutting the interest rate. In that situation, central
bank tends to choose either to keep the rate unchanged (or increase) if it
feels that some money needs to be taken out of the system.
It becomes imperative here to note that RBI can use these interest rates
instruments to balance inflation & growth, provided that economy
witnesses demand side inflation. If inflation is due to supply side shock,
say lower monsoon, low productivity etc. then these monetary
instruments doesnt offer great help. Sometimes the economy witnesses
high inflation, due to supply side shock, and also witnesses low growth
due to high interest rates. This state of the economy is called Stagflation.
Beyond Growth- Inflation trade off
Apart from balancing growth & Inflation trade off, the interest rates also
decides the capital flows in the economy. As investors and carry traders
tend to maximize their returns on their investments, they tend to look
towards high yielding investments. This implies that a country will witness
higher capital flows if it has higher interest rates and best economic data.
This phenomenon will occur when there are free capital flows. Though, the
capital inflows increases in the economy it also puts pressure on the
exchange rate of the currency. Balancing all three, i.e. free capital flows,
sovereign monetary policy and fixed exchange rate becomes impossible
as explained by conundrum of IMPOSSIBLE TRINITY.
CHALLENGES
The monetary policy transmission may not occur if the commercial banks
refuse to pass on the effect of rate cut (or increase) to the customers. The
rising Non- Performing Asset (NPA) of the banks has led them to keep the
interest rates unchanged even when RBI decreases the rate. The problem
is aggravated by the misalignment of fiscal policy and monetary policy
and the twin deficit in the country.
Further, Indian corporates has witnessed heavy losses in the recent past
(especially due to investments in infrastructure projects under PPP model)
which inhibits them from further investing and has led to the phenomenon
called BALANCE SHEET SYNDROME WITH INDIAN CHARACTERISTICS (as
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the conditions is unique in case of INDIA). This combined by high NPA of

the banks (referred as TWIN BALANCE SHEET SYNDROME) has made the
economic state dismal. Thus even if the money is available people are
not willing to borrow and invest.

Conclusion
For the monetary policy tools to remain influential, several factors should
converge together. Fiscal policy aligned with the monetary policy and
correct measure of inflation is imperative so that central bank can pull the
right lever to its desired effect. Steps such as CLEAN-UP OF BANK
BALANCE SHEETS by RBI, formation of Monetary Policy Committee on the
recommendations of Urjit Patel committee, Fiscal Stability and
Development Council (FSDC) with representation from government and
the central bank have been taken in the right direction. Also, removal of
systematic hindrance in the monetary policy transmission will ensure
better control of central bank in the economy.

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