You are on page 1of 4


Monetary policy is the process by which the monetary authority of a country, generally the central
bank controls the supply of money in the economy, by exercising its control over interest rates and
other instruments, in order to maintain price stability and achieve high economic growth. In India, the
central monetary authority is the Reserve Bank of India, who maintains price stability in the

Monetary policy is associated with interest rates and availability of credit. Instruments of monetary
policy have included short-term interest rates and bank reserves through the monetary base. For many
centuries there were only two forms of monetary policy:

(i) Decisions about coinage; (ii) Decisions to print paper money to create credit.

Paper money called "jiaozi" originated from promissory notes in 7th century China. With the creation
of the Bank of England in 1694, which acquired the responsibility to print notes and back them with
gold, the idea of monetary policy as independent of executive action began to be established. The goal
of monetary policy was to maintain the value of the coinage, print notes which would trade at par to
specie, and prevent coins from leaving circulation.

During the period 1870–1920, the industrialized nations set up central banking systems, with one of
the last being the Federal Reserve in 1913. By this point the role of the central bank as the "lender of
last resort" was understood. It was also increasingly understood that interest rates had an effect on the
entire economy, in no small part because of the marginal revolution in economics, which demonstrated
how people would change a decision based on a change in the economic trade-offs.

Monetary decisions today take into account a wider range of factors, such as:

 short-term and long term interest rates;

 velocity of money through the economy;

 exchange rates;

 credit quality;

 bonds and equities (corporate ownership and debt);

 government versus private sector spending/savings;

 international capital flows of money on large scales;

 financial derivatives such as options, swaps, futures contracts, etc.

The RBI or the central bank of India was established in 1935. The RBI formulates and implements the
government’s monetary policy, issues bank notes and coins, manages the country’s international
payments and its foreign-exchange market, acts as an investment bank for the central and state
governments, and maintains the accounts of, and extends credit to, commercial banks.

the share of foreign currency assets in the balance sheet of the Reserve Bank has substantially increased. is vested with the responsibility of managing their investment. Exchange rate is a key parameter of a country’s financial decisions made by Forex Investors. after which C D Deshmukh took over. The Reserve Bank’s reserves management function has in recent years grown both in terms of importance and sophistication for two main reasons. each member country should . appointed by the British. Types of Exchange rate systems:  Fixed Exchange Rate (Pegged)  Adjustable Peg  Crawling Peg  Managed Float (Followed in India)  Winder Band System  Free Floating As we move from top to bottom the government intervention in managing the Exchange rate reduces with Free float is fully determined by the market supply and demand.. investment patterns and hence has a major impact on GDP growth.The first Governor of the central bank was Sir Osborne Smith. Sir James Braid Taylor in 1937. Second. Importers.  Prevent speculation and destabilization  Eliminate market constraints and ensure healthy Forex market. EXCHANGE RATE STABILITY The Reserve Bank. History India was following the Bretton Woods System of Exchange rate determination which was introduced by IMF in 1946. Presently the office is assumed by Urjit Ravindra Patel since September 2016. Forex Reserves by RBI.  Maintaining adequate level of Forex reserves. with the increased volatility in exchange and interest rates in the global market. by ensuring proper intervention by RBI. Exporters. Objectives of Exchange Rate System: The major objective of any Exchange Rate management is to ensure that the economic fundamentals remain intact to promote growth. As per this pegged exchange rate system. Bankers. the task of preserving the value of reserves and obtaining a reasonable return on them has become challenging. as the custodian of the country’s foreign exchange reserves. First. Currency value of debt payments. Exchange rate affect the mix of investment portfolios of FIIs. etc. He was succeeded by another Britisher and Indian Civil Services officer.  Reduce volatility in exchange rates. The legal provisions governing management of foreign exchange reserves are laid down in the Reserve Bank of India Act. Hence the movement of Exchange rate is closely related to the country’s business cycle. 1934. Businesses and other Financial Institutions.

In 1971 Bretton Woods system collapsed and Indian currency was pegged to British Pound Sterling for 4 years and later to a basket of 5 currencies. 1975 Rupee was pegged to a basket of currencies. . After the liberalization India moved on to the state of Managed Float Exchange rate system.determine the value of its currency in terms of Gold or USD. 1990-1991 Balance of Payments crisis July 1991 a two-step downward exchange rate adjustment was done (9% and 11%). 1978-1992 . Rupee was linked to the pound sterling in December 1971. the ‘Guidelines for Internal Control over Foreign Exchange Business’ were framed in 1981. India until economic liberalization of 1991 was following a closed economy with fixed rate exchange management by the Government and RBI. Currency selection and weight assignment was left to the discretion of the RBI and not publicly announced. Table 2. Also they should maintain the market value within the specified par value. March 1992 Liberalized Exchange Rate Management System (LERMS) was put in place. Foreign exchange transactions were controlled through the Foreign Exchange Regulations Act (FERA).1 : Chronology of the Indian Exchange Rate Year The Foreign Exchange Market and Exchange Rate 1947-1971 Bretton Woods System 1971 Breakdown of the Bretton-Woods system. which used a dual exchange rate system. With a view of sustaining in the global economy Indian Currency was depreciated twice in the year of 1991 by 18% in terms of USD. 1978 RBI allowed the domestic banks to undertake intra-day trading in foreign exchange. As trading volumes increased.

The Tarapore Committee in its report on Capital Account Convertibility had. therefore. . in contrast. Intervention by RBI: i. ii. Direct Intervention: It refers to purchases and sales in international currency (i. Intervention by the RBI has raised a question as to whether or not there should be an exchange rate band within. while suggesting transparency in the exchange rate policy of the central bank. US dollars and euro) both on the spot and also in forward markets. All foreign exchange receipts could now be converted at market determined exchange rates. Free floating exchange rate system is followed under a specific framework. recommended a band within which it would allow the currency to move. saying that there cannot be such rigidities in exchange rate policy.March 1993 The dual rates converged. the bank should have the right to intervene at its discretion. Indirect Intervention: It refers to the use of reserve requirements and interest rate flexibility to smoothen temporary mismatches between demand and supply of foreign currency. Exchange rates are determined by the market. Source : Reserve Bank of India Features of Current Exchange Rate Regime: The USD is considered as the principal currency for all transactions related to Forex. India has been slowly moving to the completely free floating exchange rate system from the present system of Managed Float. which the central bank should allow the currency to fluctuate. Current receipt management is done by the Banking system which contributes to the demand of Forex. The RBI has been. and. and the market determined exchange rate regime was introduced. RBI announces a Reference Rate at twelve noon every day.e. RBI can intervene in the market whenever there is high rates of volatility and depreciation of rupee. Such interventions are considered necessary till the rupee is made fully convertible.