CHAPTER 1

“AN EMPIRICAL STUDY ON MEASURING THE IMPACT

OF RBI POLICIES ON VARIOUS FACTORS OF INDIAN
ECONOMY.”
TABLE OF CONTENT:

CH PARTICULAR PAGE
NO

1 INTRODUCTION PHASE

1.1 INTRODUCION OF TOPIC

1.2 HISTORY EVOLUTION
1.3 CURRENT PERSPECTIVE
1.4 CHALLAGES OF INDUSTRY
1.5 ADVANTAGES OF BANKING SECTOR
1.6 NEED OF STUDY
1.7 IMPORTANCE OF STUDY
1.8 IDENTIFICATION OF PROBLEM
1.9 RESEARCH QUESTIONS
1.1. INTRODUCTION OF THE RBI POLICIES:

Reserve Bank of India is also known as India's Central Bank. It was established on 1st
April 1935. Although the bank was initially owned privately, it has been taken up the
Government of India ever since, it was nationalized. The bank has been vested with
immense responsibility of reviewing and reconstructing the economic stability of the
country by formulating economic policies and ensuring a proper exchange of currency. In
this regard, the Reserve Bank of India is also known as the banker of banks. The Central
Office of the Reserve Bank was initially established in Calcutta but was permanently
moved to Mumbai in 1937. The Central Office is where the Governor sits and where
policies are formulated.

THE PREAMBLE OF THE RESERVE BANK OF INDIA DESCRIBES THE

BASIC FUNCTIONS OF THE RESERVE BANK AS:

"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of the
country to its advantage."

The Preamble of the RBI speaks about the basic functions of the bank. It deals with the
issuing the bank notes and keeping reserves in order to secure monetary stability in the
country. It also aims at operating and boosting up the currency and credit infrastructure of
India.
THE RBI LOGO
The selection of the Bank‘s common seal to be used as the emblem of the Bank on
currency notes, cheques and publications, was an issue that had to be taken up at an early
stage of the Bank‘s formation.

The Government’s general ideas on the seal were as follows:

1. The seal should emphasize the Governmental status of the Bank, but not too closely;
2. It should have something Indian in the design;
3. It should be simple, artistic and heraldically correct; and
4. The design should be such that it could be used without substantial alteration for letter
heading, etc.

For this purpose, various seals, medals and coins were examined. The East India
Company Double Mohur, with the sketch of the Lion and Palm Tree, was found most
suitable; however, it was decided to replace the lion by the tiger, the latter being regarded
as the more characteristic animal of India!

To meet the immediate requirements in connection with the stamping of the Bank‘s share
certificates, the work was entrusted to a Madras firm. The Board, at its meeting on
February 23, 1935, approved the design of the seal but desired improvement of the
animal‘s appearance. Unfortunately it was not possible to make any major changes at that
stage. But the Deputy Governor, Sir James Taylor, did not rest content with this. He took
keen interest in getting fresh sketches prepared by the Government of India Mint and the
Security Printing Press, Nasik. As a basis for good design, he arranged for a photograph
to be taken of the statue of the tiger on the entrance gate at Belvedere, Calcutta.

It was possible to have better proofs prepared by the Security Printing Press, Nasik.
However, it was eventually decided not to make any change in the existing seal of the
Bank, and the new sketches came to be used as an emblem for the Bank‘s currency notes,
letter-heads, cheques and publications issued by the Bank.
RBI POLICIES:

The liquidity or the money supply in the economy is controlled by the RBI. The RBI
decides on this policy after taking into consideration the current economic scenario and
what the future economic scenario of the country should be. This is very important
considering the fact that, the money supply in the economy has far reaching
consequences than what a normal man thinks it has.

The amount of money supply in the economy has its direct effect on the prices of the
goods which are sold/bought in the economy. This is because of a very simple reason, the
money supply is actually the amount of money a person has. So if a person has a lot more
money than his demands for goods and services will increase. This is very essential for
the economy to function but excess demand lead to rise in prices or in technical terms,
inflation. If the money market transactions continue to feed the inflation, in the long run
it’s very harmful for the economy as it results in very high prices, reduction in demand,
fall in the value of money which in turn leads to more money supply which results in
hyper-inflation and complete rundown of the economy. This is the reason why the RBI
has such a stand against inflation and considers it to be Economy Finance Enemy No. 1.
And it does everything possible to control the rate of inflation.

Repo Rate Repo or repurchase rate is the benchmark interest rate at which the RBI lends
money to all other banks for a short-term. When the repo rate increases, borrowing from
RBI becomes more expensive and hence customers or the public bear the outcome of
high-interest rates. Reverse Repo Rate (RRR) Reverse Repo rate is the short-term
borrowing rate at which RBI borrows money from other banks. The Reserve Bank of
India uses this method to reduce inflation when there is excess money in the banking
system. Cash Reserve Ratio (CRR) is the particular share of any bank’s total deposit that
is mandatory and to be maintained with the Reserve Bank of India in the form of liquid
cash. Statutory liquidity ratio (SLR) Leaving aside the cash reserve ratio; banks are
required to maintain liquid assets in the form of gold and approved securities. A higher
SLR disables the banks to grant more loans.
THE MAIN MEASURES OF THE MONETARY POLICY
FOLLOWED BY THE RBI ARE:

1. CRR (CASH RESERVE RATIO):

Every commercial bank has to keep certain minimum cash reserves with RBI.
RBI can vary this rate between 3% and 15%. RBI uses this tool to increase or
decrease the reserve requirement depending on whether it wants to affect a
decrease or an increase in the money supply. An increase in CRR will make it
mandatory on the part of the banks to hold a large proportion of their deposits in
the form of deposits with the RBI. This will reduce the size of their deposits and
they will lend less. This will in turn decrease the money supply.

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. The higher the
CRR with the RBI, the lower will be the liquidity in the system, and vice versa.
RBI is empowered to vary CRR between 15 percent and 3 percent. Per the
suggestion by the Narsimham Committee report, the CRR was reduced from 15%
in 1990 to 5 percent in 2002. As of 27 December 2018, the CRR is 4.00 percent.

CRR refers to the ratio of bank's cash reserve balances with RBI with reference to
the bank's net demand & time liabilities to ensure the liquidity & solvency of the
scheduled banks. The share of net demand and time liabilities that banks must
maintain as cash with RBI. The RBI has set CRR at 4%. 1% change in it today
affects the economy with Rs. 1000000 crores. An increase sucks this amount from
the economy, while a decrease injects this amount into the economy.So if a bank
has 200 Crore of NDTL then it has to keep Rs. 8 Crore in cash with RBI. RBI
pays no interest on CRR.

2. SLR(STATUTORY LIQUIDITY RATIO):

Apart from the CRR, banks are required to maintain liquid assets in the form of
gold, cash and approved securities. RBI has stepped up liquidity requirements for
 two reasons: - Higher liquidity ratio forces commercial banks to maintain a larger
proportion of their resources in liquid form and thus reduces their capacity to
grant loans and advances thus it is an anti-inflationary impact. A higher liquidity
ratio diverts the bank funds from loans and advances to investment in government
and approved securities.

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. These
assets have to be kept in non-cash form such as G-secs precious metals, approved
securities like bonds etc. The ratio of the liquid assets to time and demand
liabilities is termed as the ratio. There was a reduction of SLR from 38.5% to 25%
because of the suggestion by Narsimham Committee. The current SLR is 19.50%.

The RBI is resorting more to open market operations in the more recent years.
Generally, RBI uses

 Minimum margins for lending against specific securities.

 Ceiling on the amounts of credit for certain purposes.
 The discriminatory rate of interest charged on certain types of advances.

3. REPO RATE:

Repo (Repurchase) rate also known as the benchmark interest rate is the rate at
which the RBI lends money to the commercial banks for a short-term (max. 90
days). When the repo rate increases, borrowing from RBI becomes more
expensive. If RBI wants to make it more expensive for the banks to borrow
money, it increases the repo rate similarly, if it wants to make it cheaper for banks
to borrow money it reduces the repo rate. If the repo rate is increased, banks can't
carry out their business at a profit whereas the very opposite happens when the
repo rate is cut down. Generally, repo rates are cut down whenever the country
needs to progress in banking and economy.
 If banks want to borrow money (for short term, usually overnight) from RBI then
banks have to charge this interest rate. Banks have to pledge government
securities as collateral. This kind of deal happens through a re-purchase
agreement. If a bank wants to borrow Rs. 100 crores, it has to provide government
securities at least worth Rs. 100 crore (could be more because of margin
requirement which is 5%–10% of loan amount) and agree to repurchase them at
Rs. 106.75 crore at the end of borrowing period. So the bank has paid Rs. 6.75
crore as interest. This is the reason it is called repo rate. The government
securities which are provided by banks as collateral cannot come from SLR quota
(otherwise the SLR will go below 19.5% of NDTL and attract penalty). Banks
have to provide these securities additionally.

To curb inflation, RBI increases Repo rate which will make borrowing costly for
banks. Banks will pass this increased cost to their customers which make
borrowing costly in whole economy. Fewer people will apply for loan and
aggregate demand will get reduced. This will result in inflation coming down.
RBI does the opposite to fight deflation. Although when RBI reduce Repo rate,
banks are not legally required to reduce their base rate.The RBI increased the
Repo rate from 6% to 6.25% in June 2018.

4. REVERSE REPO RATE:

Reverse Repo rate is the short term borrowing rate at which RBI borrows money
from banks. The Reserve bank uses this tool when it feels there is too much
money floating in the banking system. An increase in the reverse repo rate means
that the banks will get a higher rate of interest from RBI. As a result, banks prefer
to lend their money to RBI which is always safe instead of lending it others which
is always risky. Repo Rate signifies the rate at which liquidity is injected in the
banking system by RBI, whereas Reverse Repo rate signifies the rate at which the
central bank absorbs liquidity from the banks.
 As the name suggest, reverse repo rate is just the opposite of repo rate. Reverse
Repo rate is the short term borrowing rate at which RBI borrows money from
banks. The reserve bank uses this tool when it feels there is too much money
floating in the banking system. An increase in the reverse repo rate means that the
banks will get a higher rate of interest from RBI. As a result, banks prefer to lend
their money to RBI which is always safe instead of lending it to others (people,
companies etc.) which is always risky.

Repo Rate signifies the rate at which liquidity is injected into the banking system
by RBI, whereas Reverse Repo rate signifies the rate at which the central bank
absorbs liquidity from the banks. Currently, Reverse Repo Rate is pegged to be
0.25% below Repo Rate.

5. BANK RATE:

RBI (Reserve Bank of India) lends to the commercial banks through its discount
window to help the banks meet depositor’s demands and reserve requirements.
The interest rate the RBI charges the banks for this purpose is called bank rate. If
the RBI wants to increase the liquidity and money supply in the market, it will
decrease the bank rate and if it wants to reduce the liquidity and money supply in
the system, it will increase the bank rate.

It is defined in Sec 49 of RBI Act of 1934 as the ‘standard rate at which RBI is
prepared to buy or rediscount bills of exchange or other commercial papers
eligible for purchase'. When banks want to borrow long term funds from RBI, it is
the interest rate which RBI charges to them. It is currently set to 6.75% (Second
Bi-monthly Monetary Policy Statement, 2018–19). The bank rate is not used to
control money supply these days. Although penal rates are linked to bank rate. If a
bank fails to keep SLR or CRR then RBI will impose penalty & it will be 300
basis points above bank rate.

6. MSF(MARGINAL STANDING FACILITY):

 This scheme was introduced in May 2011 and all the scheduled commercial bank
can participate in this scheme. Marginal standing facility (MSF) is a window for
banks to borrow from the Reserve Bank of India in an emergency situation when
inter-bank liquidity dries up completely.
Banks can borrow up to 2.5%percent of their respective Net Demand and Time
Liabilities. RBI receives application under this facility for a minimum amount of
Rs. One crore and in multiples of Rs.Onecrore thereafter. The important
difference with repo rate is that bank can pledge government securities from SLR
quota (up to one percent). So even if SLR goes below 20.5%(RBI/2014-15/445
DBR.Ret.BC.70/12.02.001/2014-15, dt. 16 October 2016) by pledging SLR quota
securities under MSF, bank will not have to pay any penalty. The MSF rate is set
to 100 basis point above bank rate and currently is at 6.50%.
In April 2016, RBI changed its monetary policy stance to favor a narrow the
policy rate corridor from +/-100 basis points (bps) to +/- 50 bps by reducing the
MSF rate by 75 basis points and increasing the reverse repo rate by 25 basis
points, with a view to ensuring finer alignment of the weighted average call rate
(WACR) with the repo rate. Thus MSF is now placed at 0.5% above the Repo
Rate. The new repo rate is 6.5%, while MSF is at 7% and Reverse Repo rate is at
6%.The Bank Rate which is aligned to the MSF rate also stands adjusted to 7%.

7. LIQUIDITY ADJUSTMENT FACILITY (LAF):

Liquidity Adjustment facility was introduced in 2000.LAF is a facility extended

by the Reserve Bank of India to the scheduled commercial banks (excluding
RRBs) and primary dealers to avail of liquidity in case of requirement or park
excess funds with the RBI in case of excess liquidity on an overnight basis against
the collateral of Government securities including State Government securities.
Basically LAF enables liquidity management on a day to day basis.

LAF is a facility provided by the Reserve Bank of India to scheduled commercial

banks to avail of liquidity in case of need or to park excess funds with the RBI on
an overnight basis against the collateral of Government securities. RBI accept
 application for a minimum amount of Rs.5 crore and in multiples of Rs. 5 crore
thereafter. LAF enables liquidity management on a day-to-day basis. The
operations of LAF are conducted by way of repurchase agreements called Repos
& Reverse Repos.

8. OPEN MARKET OPERATION (OMO):

Open market operation is the activity of buying and selling of government

securities in open market to control the supply of money in banking system. When
there is excess supply of money, central bank sells government securities thereby
sucking out excess liquidity. Similarly, when liquidity is tight, RBI will buy
government securities and thereby inject money supply into the economy.

In India, liquidity conditions usually tighten during the second half of the
financial year (mid-October onwards). This happens because the pace of
government expenditure usually slows down, even as the onset of the festival
season leads to a seasonal spike in currency demand. Moreover, activities of
foreign institutional investors, advance tax payments, etc. also cause an ebb and
flow of liquidity.

However, the RBI availability of money through the year to make sure that
liquidity conditions don’t impact the ideal level of interest rates it would like to
maintain in the economy.

Liquidity management is also essential so that banks and their borrowers don’t
face a cash crunch. The RBI buys g-secs if it thinks systemic liquidity needs a
boost and offloads them if it wants to mop up excess money.
RATES AS OF 6TH BI-MONTHLY (7 FEBRUARY 2019)
MONETARY POLICY MEET OF FY1819:
COMPARISON RBI POLICIES WITH WORLD:

In India, since the financial system did not face a crisis, the damage to the transmission
channel was minimal, even though the pre-global crisis time structural rigidities
continued to limit the effectiveness of Reserve Bank‘s monetary policy actions. The
recent switch over to the new base rate system is expected to help in improving and
enhancing the visibility of the transmission of monetary policy signals to credit markets.
As global central banks embark on a tightening spree, the debate on the effect of
monetary policy actions of developed economy central banks on emerging market
economies is likely to resurface.

The US Fed, the ECB (European Central Bank) and the BoE (Bank of England) members
have all hinted at a withdrawal of policy accommodation citing improvement in
economic conditions and diminishing downside risks to inflation.The stark monetary
policy divergence between the US Fed and other major global central banks is now
fading, at least as far as recent commentary is concerned.

It now remains to be seen which central bank will bite the bullet first as far as action is
concerned, as there are risks associated with being ahead of the curve as well as being
behind the curve.The only major central bank, which has not yet turned hawkish, is the
BoJ (Bank of Japan).Since for emerging markets like India, the US Federal Reserve
policy spill over would be most crucial, we explore it in greater detail below.

Low inflation and wage growth have given the US Federal Reserve the comfort to hike
rates gradually even when the labor market is tight and S&P 500 is soaring.The US Fed
has stated that the neutral federal funds rate (a rate which is neither expansionary nor
contractionary) currently is lower than that in previous decades.

One of the reasons why the wage growth is not picking up despite the low unemployment
rate is that a significant number of jobs on offer are part time jobs that do not pay too
well.The inability of the Trump administration to push through fiscal reforms has also
given the Fed leeway in removing policy accommodation gradually.The dilemma before
the Fed in removing policy accommodation is whether to do so by continuing to hike the
federal funds rate or by beginning to trim its balance sheet size or use a combination of
the two.

A recent speech by Fed member LaelBrainard explores the tradeoff between hiking
Federal Funds rate and balance sheet trimming.While hiking the Federal Funds rate
increases the short term rates, balance sheet trimming increases the tenor premiums and
therefore the longer term rates. Hike in short term rates is known to cause more disruptive
currency movements.Therefore as a result of a hike in the Federal funds rate, USD would
appreciate more and for an emerging economy like India, it would be disruptive on two
counts.

Firstly it would stoke imported inflation (imports become more expensive as Rupee
depreciates) and secondly depreciation of Rupee would boost exports and therefore
domestic demand drove inflation (i.e. increase demand for goods used as raw materials
for exports).Therefore in this scenario, the emerging market central banks would be more
hawkish and reluctant to cut interest rates. If the US Federal Reserve were to withdraw
accommodation only by trimming its balance sheet size, it would be less disruptive for
emerging markets like India as USD would not appreciate to that extent.Therefore the
emerging market central banks can afford to be less hawkish.

As things stand currently, the Fed seems keen in hiking Federal funds rate to a level away
from the effective lower bound (ELB) from where it can cut rates if economic conditions
deteriorate later.Therefore it is likely to use Federal funds rate as the primary monetary
policy adjustment tool. Given that wage growth, latest June core CPI and Retail sales
prints have been below estimates, Fed can afford to hike rates gradually.This means that
August would be the best opportunity for the RBI to cut the repo rate by 25bps as Fed is
not hiking rates aggressively.

Given that domestic core CPI is below 4 percent (i.e. at 3.98 percent which is within
RBI’s comfort zone) and industrial activity as indicated by May IIP (0.9 percent) is tepid,
domestic factors too are supportive of a rate cut. 1 month OIS (at 6.19 percent as on 14th
July) is currently pricing in a 65 percent probability of rate cut on 2nd August.
The fact that US Federal Reserve policy influences RBI actions are evident from the
surprise OMO sale announced a couple of weeks back when US 10yr yields spiked from
2.10 percent to 2.30 percent .The announcement of OMO sale was intended to push
domestic bond yields higher so as to prevent outflows. Also, sucking out liquidity allows
RBI to intervene in currency markets to absorb inflows, if needed, without infusing
excess liquidity into the system.

The RBI currently seems content allowing the Rupee to perform in line with Asian
currencies and curbing intraday volatility. The realized volatility has been less than
implied volatility for quite some time now.Over the last fortnight, price action suggests
that the central bank has been mopping up USD and swapping them forward.The 1 year
annualized forward premium has risen from 4.51 percent to 4.65 percent over the period.
After the weak US CPI and Retail sales data on Friday, the US Dollar got sold off across
the board.It seems the Rupee would spend some more time in 64-65 range and USD bulls
would have to be patient a while longer.
 Key Features of Major Central Banks Operating Procedures
FEATURES FED ECB BOE* RBI
Policy Rate Federal fund Main refinancing Bank Rate Repo Rate
target rate operations rate
Target rate Federal funds EONIA (Euro Overnight market Weighted average
overnight index interest rate call rate
average)
Reserve 0 to 10 % of 2% on deposits Optional with 6% of net demand

requirements transactions with terms less individual bank and time liabilities
accounts, 0 for than 2 years, 0 on setting its own of banks
non-transactions longer term target.
accounts deposits
Definition of Balances at the Balances at the Balances at the Balances at the RBI

Reserves Fed + vault cash ECB, excluding BoE

deposited funds
Reserve Two weeks One month 4-5 weeks Two weeks

maintenance
Period
Reserve Lagged two Lagged one month Reserve target set Lagged two weeks

accounting weeks at least 2 days

ahead of reserve
maintenance
period

Standing Lending (as of Both lending and Both lending and Both Lending (MSF

Facilities Jan 2003) deposit facilities deposit facilities and ECR) and
Interest on deposit facility
reserves (as of (collateralized
Oct. 2008) reverse repo)
Open market Daily, at market Weekly, at the Weekly and once Daily LAF auction

operations rate higher of the main in a maintenance at fixed rate. Long-

refinancing rate or period at the term operations as
the market rate Bank rate. and when required at
market rate
1.2. HISTORY OF RESERVE BANK OF INDIA’ POLICIES:

The central bank was founded in 1935 to respond to economic troubles after the First
World War. The Reserve Bank of India was set up on the recommendations of the Hilton
Young Commission. The commission submitted its report in the year 1926, though the
bank was not set up for another nine years. The Preamble of the Reserve Bank of India
describes the basic functions of the Reserve Bank as to regulate the issue of bank notes,
to keep reserves with a view to securing monetary stability in India and generally to
operate the currency and credit system in the best interests of the country. The Central
Office of the Reserve Bank was initially established in Kolkata, Bengal, but was
permanently moved to Mumbai in 1937. The Reserve Bank continued to act as the central
bank for Myanmar till Japanese occupation of Burma and later up to April 1947, though
Burma seceded from the Indian Union in 1937. After partition, the Reserve Bank served
as the central bank for Pakistan until June 1948 when the State Bank of Pakistan
commenced operations. Though originally set up as a shareholders’ bank, the RBI has
been fully owned by the government of India since its nationalization in 1949. Between
1950 and 1960, the Indian government developed a centrally planned economic policy
and focused on the agricultural sector. The administration nationalized commercial banks
and established, based on the Banking Companies Act, 1949 (later called Banking
Regulation Act) a central bank regulation as part of the RBI. Furthermore, the central
bank was ordered to support the economic plan with loans. Between 1969 and 1980 the
Indian government nationalized 20 banks. The regulation of the economy and especially
the financial sector was reinforced by the Gandhi administration and their successors in
the 1970s and 1980s. The central bank became the central player and increased its
policies for a lot of tasks like interests, reserve ratio and visible deposits. The measures
aimed at better economic development and had a huge effect on the company policy of
the institutes. The banks lent money in selected sectors, like agri-business and small trade
companies.

The branch was forced to establish two new offices in the country for every newly
established office in a town. The oil crises in 1973 resulted in increasing inflation, and
the RBI restricted monetary policy to reduce the effects.
A lot of committees analyzed the Indian economy between 1985 and 1991. Their results
had an effect on the RBI. The Board for Industrial and Financial Reconstruction, the
Indira Gandhi Institute of Development Research and the Security & Exchange Board of
India investigated the national economy as a whole, and the security and exchange board
proposed better methods for more effective markets and the protection of investor
interests.

The national economy came down in July 1991 and the Indian rupee was devalued. The
currency lost 18% relative to the US dollar, and the Narsimha Committee advised
restructuring the financial sector by a temporal reduced reserve ratio as well as the
statutory liquidity ratio. New guidelines were published in 1993 to establish a private
banking sector. This turning point should reinforce the market and was often called neo-
liberal The central bank deregulated bank interests and some sectors of the financial
market like the trust and property markets. This first phase was a success and the central
government forced a diversity liberalization to diversify owner structures in 1998.

The National Stock Exchange of India took the trade on in June 1994 and the RBI
allowed nationalized banks in July to interact with the capital market to reinforce their
capital base. The central bank founded a subsidiary company—the Bharatiya Reserve
Bank Note Mudran Limited—in February 1995 to produce banknotes. The Foreign
Exchange Management Act from 1999 came into force in June 2000. It should improve
the foreign exchange market, international investments in India and transactions. The
RBI promoted the development of the financial market in the last years, allowed online
banking in 2001 and established a new payment system in 2004 - 2005 (National
Electronic Fund Transfer). The Security Printing & Minting Corporation of India Ltd., a
merger of nine institutions, was founded in 2006 and produces banknotes and coins.

The national economy's growth rate came down to 5.8% in the last quarter of 2008 - 2009
and the central bank promotes the economic development. In year 2010 reserve bank of
India announced the new symbol of rupee and officially declared it.
 THE ROLE AND FUNCTIONS OF R.B.I IN INDIAN ECONOMY:

TRADITIONAL FUNCTIONS:

Traditional functions are those functions which every central bank of each nation
performs all over the world. Basically these functions are in line with the objectives with
which the bank is set up. It includes fundamental functions of the Central Bank. They
comprise the following tasks.

1. Issue of Currency Notes:

The RBI has the sole right or authority or monopoly of issuing currency notes except
one rupee note and coins of smaller denomination. These currency notes are legal
tender issued by the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20, 50, 100,
500, and 1,000. The RBI has powers not only to issue and withdraw but even to
exchange these currency notes for other denominations. It issues these notes against the
security of gold bullion, foreign securities, rupee coins, exchange bills and promissory
notes and government of India bonds.

2. Banker to other Banks:

The RBI being an apex monitory institution has obligatory powers to guide, help and
direct other commercial banks in the country. The RBI can control the volumes of
banks reserves and allow other banks to create credit in that proportion. Every
commercial bank has to maintain a part of their reserves with its parent's viz. the RBI.
Similarly in need or in urgency these banks approach the RBI for fund. Thus it is called
as the lender of the last resort.

3. Banker to the Government:

The RBI being the apex monitory body has to work as an agent of the central and state
governments. It performs various banking function such as to accept deposits, taxes
and make payments on behalf of the government. It works as a representative of the
government even at the international level. It maintains government accounts, provides
 financial advice to the government. It manages government public debts and maintains
foreign exchange reserves on behalf of the government. It provides overdraft facility to
the government when it faces financial crunch.

4. Exchange Rate Management:

It is an essential function of the RBI. In order to maintain stability in the external value
of rupee, it has to prepare domestic policies in that direction. Also it needs to prepare
and implement the foreign exchange rate policy which will help in attaining the
exchange rate stability. In order to maintain the exchange rate stability it has to bring
demand and supply of the foreign currency (U.S Dollar) close to each other.

5. Credit Control Function:

Commercial bank in the country creates credit according to the demand in the
economy. But if this credit creation is unchecked or unregulated then it leads the
economy into inflationary cycles. On the other credit creation is below the required
limit then it harms the growth of the economy. As a central bank of the nation the RBI
has to look for growth with price stability. Thus it regulates the credit creation capacity
of commercial banks by using various credit control tools.

6. Supervisory Function:

The RBI has been endowed with vast powers for supervising the banking system in the
country. It has powers to issue license for setting up new banks, to open new branches,
to decide minimum reserves, to inspect functioning of commercial banks in India and
abroad, and to guide and direct the commercial banks in India. It can have periodical
inspections an audit of the commercial banks in India.
 DEVELOPMENTAL OR PROMOTIONAL FUNCTIONS:

Along with the routine traditional functions, central banks especially in the developing
country like India have to perform numerous functions. These functions are country
specific functions and can change according to the requirements of that country. The RBI
has been performing as a promoter of the financial system since its inception. Some of
the major development functions of the RBI are maintained below.

1. Development of the Financial System:

The financial system comprises the financial institutions, financial markets and
financial instruments. The sound and efficient financial system is a precondition of the
rapid economic development of the nation. The RBI has encouraged establishment of
main banking and non-banking institutions to cater to the credit requirements of
diverse sectors of the economy.

2. Development of Agriculture:

In an agrarian economy like ours, the RBI has to provide special attention for the credit
need of agriculture and allied activities. It has successfully rendered service in this
direction by increasing the flow of credit to this sector. It has earlier the Agriculture
Refinance and Development Corporation (ARDC) to look after the credit, National
Bank for Agriculture and Rural Development (NABARD) and Regional Rural Banks
(RRBs).

3. Provision of Industrial Finance:

Rapid industrial growth is the key to faster economic development. In this regard, the
adequate and timely availability of credit to small, medium and large industry is very
significant. In this regard the RBI has always been instrumental in setting up special
financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM BANK etc.
4. Provisions of Training:

The RBI has always tried to provide essential training to the staff of the banking
industry. The RBI has set up the bankers' training colleges at several places. National
Institute of Bank Management i.e. NIBM, Bankers Staff College i.e. BSC and College
of Agriculture Banking i.e. CAB is few to mention.

5. Collection of Data:

Being the apex monetary authority of the country, the RBI collects process and
disseminates statistical data on several topics. It includes interest rate, inflation, savings
and investments etc. This data proves to be quite useful for researchers and policy
makers.

6. Publication of the Reports:

The Reserve Bank has its separate publication division. This division collects and
publishes data on several sectors of the economy. The reports and bulletins are
regularly published by the RBI. It includes RBI weekly reports, RBI Annual Report,
Report on Trend and Progress of Commercial Banks India., etc. This information is
made available to the public also at cheaper rates.

7. Promotion of Banking Habits:

As an apex organization, the RBI always tries to promote the banking habits in the
country. It institutionalizes savings and takes measures for an expansion of the banking
network. It has set up many institutions such as the Deposit Insurance Corporation-
1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These organizations
develop and promote banking habits among the people. During economic reforms it
has taken many initiatives for encouraging and promoting banking in India.
 SUPERVISORY FUNCTIONS:

The reserve bank also performs many supervisory functions. It has authority to regulate
and administer the entire banking and financial system. Some of its supervisory functions
are given below.

1. Granting license to banks:

The RBI grants license to banks for carrying its business. License is also given for
opening extension counters, new branches, even to close down existing branches.

2. Bank Inspection:

The RBI grants license to banks working as per the directives and in a prudent manner
without undue risk. In addition to this it can ask for periodical information from banks
on various components of assets and liabilities.

3. Control over NBFIs:

The Non-Bank Financial Institutions are not influenced by the working of a monitory
policy. However RBI has a right to issue directives to the NBFIs from time to time
regarding their functioning. Through periodic inspection, it can control the NBFIs.

4. Implementation of the Deposit Insurance Scheme:

The RBI has set up the Deposit Insurance Guarantee Corporation in order to protect the
deposits of small depositors. All bank deposits below Rs. One lakh are insured with
this corporation. The RBI work to implement the Deposit Insurance Scheme in case of
a bank failure.
EVOLUTION OF THE MONETARY POLICY:

Monetary policy, usually understood to represent “policies, objectives, and instruments

directed towards regulating money supply and the cost and availability of credit in the
economy”, is highly dependent on the prevailing context. The context, in turn, is
determined by domestic and external factors.Domestic factors such as economic and
political structure, the demands of growth, poverty reduction, financial inclusion and the
gradual development of institutions and markets are considered while making monetary
policy decisions. External factors such as changes in global monetary policy, external
shocks, dependence on foreign capital and the impact of opening up the economy are also
considered. At different points in time, the degree of influence of these factors has
changed, and as has the strategy of the central bank. From the 1950’s to the late 1980’s,
the focus of the central bank was largely on stability and development.

There was a huge requirement of funds to finance development in the country. The RBI
then had to manage short term pressures arising from inflation and balance of payments,
while also keeping in mind the investment targets laid out in the five-year plans. There is
an inherent struggle between managing inflation to promote saving and investment on
one hand and managing large fiscal deficits on the other. This is a recurrent theme
throughout much of the history of the monetary policy India. Inflation has always been a
major problem in the country. This period was no exception.

The bank rate was a major tool during this period. The RBI increased the bank rate to 3.5
per cent and kept it there until 1957 as inflation started falling. However, with the
increase in inflationary pressure, the RBI successively kept increasing the bank rate until
1965 when it reached 6 per cent, before lowering it to 5 per cent in March 1968. The
second five-year plan had an ambitious outlay of investment which caused inflation to
rise. The bank followed the path of ‘controlled expansion’ of generally restraining
demand in the economy while selectively easing credit. The RBI always used its tool of
moral suasion by ‘advising’ (sometimes exhorting) commercial banks to observe restraint
in lending. We must remember, this was a time before the nationalization of banks where
banks were privately owned.

During the early 50s, the RBI decided to ‘refrain’ from buying government securities.
This was a major departure from past practice, as one of the major roles of the bank is
help finance the deficit of the government. The central bank focused on increasing
priority sector lending as an intermediate target, in line with the five-year plans. During
this period, the exchange rate was a pegged exchange rate. The global monetary policy
was largely influenced by the Bretton Woods system. Even after the collapse of the
Bretton Woods system, India continued with a pegged exchange rate. However, to
minimize the risk associated with one currency, they expanded to a basket of currencies
in 1975.

With the 1991 crisis and the liberalization of the economy, the RBI also had to shift its
approach. The focus for the next decade was on inflation and credit supply. The
intermediate target shifted to monetary targeting with annual growth in money supply
(M3, to be specific). It used instruments such as Gradual interest rate deregulation CMR;
Direct instruments (selective credit control, SLR, CRR). By 1994, selective credit control
operations had been phased out. Current account and partial capital account liberalization
were accompanied by a gradual move towards more flexible exchange rates.

The sequencing of the entire process was well thought out and executed. While controls
continued on domestic portfolios and debt inflows, equity inflows were liberalized as
there is repayment burden linked to equity. On foreign debt, the sequence of relaxation
favored commercial credit and longer-term debt. Major reforms were undertaken towards
development of equity, forex money and government securities markets. Although low
by developing country standards, Indian inflation was higher than world rates.

Accumulation of large public debt made the fiscal-monetary combination followed in the
past unsustainable. The automatic monetization of the government deficit was stopped
and auction based market borrowing adopted for meeting the fiscal deficits. The
repressed financial regime was dismantled, interest rates became more market determined
and the government began to borrow at market rates. From 1998-99 to till about 2014,
most of the focus has been on inflation and growth with multiple intermediate targets.
The RBI has used a host of Direct (CRR, SLR) and indirect instruments (repo operations
under LAF and OMOs) to achieve its mandate.

Since 2014, after RaghuramRajan took over as governor, the central bank has moved to
directly targeting inflation. Under the current governor, Urjit Patel, the RBI has continued
to focus on its objective of inflation targeting. The current target is of 4% with (with a
tolerance level of 2% either ways). This has been done in order to set expectations in the
economy regarding inflation and ensure price stability in the economy. Under inflation
targeting, rates are set is response to inflation and the ‘output gap’ (the difference
between the potential output and actual output).How this gets transmitted throughout the
economy is that changes in rates affect long-term and short-term interest rates, asset
prices and exchange rates. These in turn affect bank credit and the aggregate demand in
the economy which helps bring the economy bridge the output gap. Thus, over time, a
marked evolution in monetary policy has taken place. Today, India has monetary
policies that are in line with international standards, as envisioned by highly respectable
and influential governors.
OBJECTIVES OF MONETARY POLICY:

1. Price stability:
The chakravarty committee argued that, in the context of plannedeconomic
development, monetary authorities should aim at ―price stability‖ in the broadest
sense. Price stability here does not mean constant price level but it is consistent
with an annual rise of 4% in the wholesale price index. To achieve this objective,
the government should aim at raising output levels, while RBI should control the
expansion in reserve money and the money supply.

2. Monetary targeting:
Emphasizing the inter-relation between money, output andprices, thechakravarty
committee has recommended the formation of a monetary policy based on
monetary targeting. According to the committee, target for growth in money
supply in a broad sense during a given year should be in terms of a range.

a) Based on anticipated growth in output

b) In the light of the price situation.

The target range should be announced in advance, the target for money supply
should be reviewed in the course of the year to accommodate revisions, if any, in
the anticipated growth in output and any change in the price situation

3. Change in the definition of budgetary deficit:

Till now the budgetary deficit ofthe central government essentially took from
increase in treasury bills outstanding. Not all the treasury bills were held by RBI
but part of treasury bills were absorbed by the public. Since the present concept of
budget deficit did not distinguish between the amounts held by RBI, it overstated
the extent of monetary impact of fiscal operation. Accordingly, the
 chakravartycommittee suggested a change in the definition of budgetary deficit,
so that there could be clear distinction between revenue deficit, fiscal deficit and
overall budgetary deficit.

4. Interest rate policy:

At present the interest rate structure is completelyadministered by the monetary
authorities under the general direction of the government. According to the
chakravarty committee, the present system of administered interest rates has
become unduly complex and needs to be modified the committee has mentioned
some of the important aspects of interest rate policy which need to be taken into
account, while modifying the administered interest rate structure as for example
increasing the pool of financial savings, providing a reasonable return on saving
of small savers, reinforcing anti-inflationary policies the need to provide credit at
concessional rate of interest to the priority sector and the profitability of banks ,
etc. Thus, the chakravarty committee envisaged a strong supportive role for
interest rate policy in monetary regulating based on monetary targeting.

5. Restructuring of the money market in India:

The committee envisage (predicted) an important role in treasury bill market, the
call money market, the commercial bills market and the inter-corporate funds
market in the allocation of short term resources, with minimum of cost and
minimum of delay, further, according to the committee, a well-organized money
market provided an efficient mechanism for the transmission of the monetary
regulation to the rest of economy. Accordingly, the committee has recommended
that RBI should take measures to develop an efficient INDIA.
1.3. CURRENT TRENDS:

Global trends:

Global growth has shed some momentum in 2018 in an environment of volatile crude
prices, geopolitical tensions and escalating trade wars. Financial conditions—especially
in the emerging market economies (EMEs)—have tightened with capital outflows and
asset price volatility sparked by interest rate increases, balance sheet normalization by the
Fed and some evidence of shortages of US dollar liquidity. Across the world, alignment
of national regulatory and supervisory architectures with Basel III standards progressed,
albeit at varying speeds in different jurisdictions.

Domestic trends:

Domestically, a pickup in GDP growth took hold in the first half of 2018-19, having
shrugged off the transient effects of demonetization and implementation of the goods and
services tax (GST), and supported by incipient firming up of the investment cycle and
exports. While provisioning against the overload of deterioration in asset quality pulled
down the banking sector into losses in 2017-18, a strong revival in bank credit growth
during the first half of 2018-19 by private and public sector banks (PSBs) suggests that
an overall improvement in the health of banks is on the cards.

Focus on stressed assets:

The Insolvency and bankruptcy code, replaced all previous resolution mechanisms in a
step towards a steady state in which maximum value could be realized by all the
stakeholders. While leaving the definition of a non-performing asset unchanged, it lays
down broad principles that should be followed in the resolution of stressed assets, with
clearly defined rules for ensuring credible outcomes. An Internal Advisory Committee
(IAC) has guided these processes since June 2017, with a focus on large value
stressed accounts.

In the revised framework, all lenders must put in place board-approved policies for
resolution of stressed assets, including timelines for resolution. Stress in loans has to be
identified immediately on default, classifying them as special mention accounts (SMA).
Growth in NBFC:

One segment of the Indian financial system that has been growing robustly in spite of the
adverse macro-financial environment is the nonbanking financial companies (NBFCs)
sector, with a consolidated balance sheet expansion of over 17 per cent in the first half of
2018-19, led by asset finance companies and investment companies.
1.4. CHALLENGES OF BANKING INDUSTRY:

Developing countries like India, still has a huge number of people who do not have
access to banking services due to scattered and fragmented locations. But if we talk about
those people who are availing banking services, their expectations are raising as the level
of services are increasing due to the emergence of Information Technology and
competition. Since, foreign banks are playing in Indian market, the number of services
offered has increased and banks have laid emphasis on meeting the customer
expectations. Now, the existing situation has created various challenges and opportunity
for Indian Commercial Banks. In order to encounter the general scenario of banking
industry we need to understand the challenges and opportunities lying with banking
industry of India.

1. Demonetised currency:

The RBI report also revealed that 99.30 per cent of the demonetised Rs 500 and Rs 1,000
notes have come back. The top bank said: “The value of banknotes in circulation
increased by 37.7 per cent over the year to Rs 18,037 billion as at end-March 2018.

The volume of banknotes, however, increased by 2.1 per cent.” It may be noted that
before November 8, 2016, Rs 500 and Rs 1,000 rupee notes worth Rs 15.41 lakh were in
circulation and out of that, Rs 15.31 lakh crore was returned to the RBI.

This essentially means that Rs 10,000 crore worth scrapped notes did not come back to
the RBI. Considering that more than 99.3 per cent of the demonetised cash was returned,
the government’s demonetisation exercise may not have been successful in cracking
down on black money.

2. Bad loans:

The RBI has also warned against rising bad loans. The latest report predicts that the
number of bad loans may rise in 2018-19. As of now, the bad loans in the banking sector
is at around 11.5 per cent.
“Going forward, the stress tests carried out by the Reserve Bank suggest that under the
baseline assumption of the current economic situation prevailing, the gross NPA ratio of
scheduled commercial banks may increase further in 2018-19,” the report highlighted.

The RBI also pointed out that the impact of increased provisions towards NPAs and
mark-to-market (MTM) treasury losses because of tightening of yields have eroded the
profitability of banks, thus resulting in huge losses.

Worth mentioning that the aggregate losses of 21 public sector banks for the April-June
quarter stood at over Rs 16,000 crore. In the fourth quarter of FY18, the combined losses
of the 21 banks were over Rs 62,000 crore.

3. GDP growth:

The annual report has also projected the GDP growth for the year 2018-19 at a robust 7.4
per cent. While this remains unchanged from the August monetary policy, the growth
will be driven by foreign investments, consumption and exports. However, for the real
GDP growth to inch higher, there is a need to boost industrial production and also to
reduce overall borrowing. Thus, the economic growth on GDP terms will be dictated by
policy reforms.

4. Global trade environment & crude oil price:

Another factor that may affect the Indian economy in future is the worsening global trade
scenario, triggered by a series of protectionist policies. Not to forget the rising price of
crude oil and increased demand, this has led to a sharp spike in India’s import bill.

Other than that, the RBI spoke about its roadmap to improve the banking sector and
revive the economy further. The report also gave insights about how the government
plans to resolve the issue of widening current account deficit through higher foreign
direct investment inflows.

Despite all the risks, the report suggested that India is currently poised to grow robustly if
structural reforms are implemented to address the banking sector mess, taxation woes and
also strengthen the business environment.
1.5. ADVANTAGES OF BANKING INDUSTRY:

The speed with which changes can be implementedUnlike fiscal policy — which could
take months to implement the first steps toward changing the money supply can be taken
the day the decision to do so is made.

Using monetary policy is its flexibility with regard to the size of the change to be
implemented. Reserves can be increased or decreased in small or large increments.

It can bring out the possibility of more investments coming in and consumers spending
more. In an expansionary monetary policy, where banks are lowering interest rates on
loans and mortgages, more business owners would be encouraged to expand their
ventures, as they would have more available funds to borrow with affordable interest
rates. Plus, prices of commodities would also be lowered, so consumers will have more
reasons to purchase more goods. As a result, businesses would gain more profit while
consumers can afford basic commodities, services and even property.

It allows for the imposition of quantitative easing by the Central Bank. The Federal
Reserve can make use of a monetary policy to create or print more money, allowing them
to purchase government bonds from banks and resulting to increased monetary base and
cash reserves in banks. This also means lower interest rates and, eventually, more money
for financial institutions to lend its borrowers.

It can lead to lower rates of mortgage payments. As monetary policy would lower interest
rates, it would also mean lower payments home owners would be required for the
mortgage of their houses, leaving homeowners more money to spend on other important
things. It would also mean that consumers will be able to settle their monthly payments
regularly—a win-win situation for creditors, merchandisers and property investors as
well!

It can promote low inflation rates. One of the biggest perks of monetary policy is that it
can help promote stable prices, which are very helpful in ensuring inflation rates will stay
low throughout the country and even the world. As inflation essentially makes an impact
on the way we spend money and how much money is worth, a low inflation rate would
allow us to make the best financial decisions in life without worrying about prices to
drastically rise unexpectedly.
It promotes transparency and predictability. A monetary policy would oblige
policymakers to make announcements that are believable to consumers and business
owners in terms of the type of policy to be expected in the future.

It promotes political freedom. Since the central bank can operate separately from the
government, this will allow them to make the best decisions based upon how the
economy is performing doing at a certain point in time. Also, the banks would operate
based on hard facts and data, rather than the wants and needs of certain individuals. Even
the Federal Reserve can operate without being exposed to political influences.

Expansionary monetary policy makes it possible for more investments come in and
consumers spend more. With the banks lowering the interest rates on mortgages and
loans, more business owners will be encouraged to expand their businesses since they are
more available funds to borrow with interest rates that they can afford. On the other hand,
prices of commodities will be lowered and the buying public will have more reason to
buy more consumer goods. In the end, companies will profit while their customers are
able to afford what they need like basic commodities, property and services.

Lowered interest rates also lower mortgage payment rates. Another advantage of
monetary policy in relation to lowered rates is that it also affects the payments home
owners need to meet for the mortgage of their homes. Reduced mortgage fees will leave
home owners more money to spend. Also, they will be able to settle their monthly
payments regularly. This is a win-win situation for merchandisers, creditors and property
investors as well.

It allows the Central Bank to apply quantitative easing. The Federal Reserve can make
use of this policy to print or create more money which enables it to purchase government
bonds from banks. The end result is increased cash reserves in banks and also monetary
base. This also leads to reduced interest rates and more money for the bank to lend its
borrowers.

It promotes predictability and transparency.Supporters say that policymakers are obliged

to make announcements that are believable to business owners and the consumers when it
comes to the type of monetary policy to be expected in the coming months for it to be a
success,
1.6. NEED OF THE STUDY:

 One of the key roles of the Reserve Bank of India or any central bank is to ensure
economic stability in the country.For the purpose, the central bank adopts various
measures to ensure that the inflation rates, interest rates, exchange rates and
money supply remains under control.
 It uses tools like Cash Reserve Ratio and Repo rates to control liquidity and
inflation in the country. The effectiveness of such policy rates in ensuring
economic stability needs to be verified and tested.
 The decision maker needs to understand the effect of these changes on the
affected variable.
 This given research is such an attempt to test and verify the effectiveness of the
changes in monetary and policy rates on the desired critical factors.
 The research is aimed to provide inputs to decision makers in formulating
monetary and economic policies and contributes to the limited existing literature
on the subject.
1.7. IMPORTANACE OF THE STUDY:

Reserve Bank of India (RBI) is the central banking and monetary authority of India. The
loans which the banks and non-banking financial institutions offer to government entities,
businesses, and consumers, are controlled by the Reserve Bank of India (RBI).

The study that will be conducted can be of use for the following:

1. This will give an idea about the impact of RBI policies on various factors of
Indian economy.
2. This will helpful to controls the supply of money in the economy by its control
over interest rates in order to maintain price stability and achieve
high economic growth.
3. It will also show a comparison of RBI policies with other countries policies and
give a brief about which factor is highly impact on Indian economy by world’
policies and how it’s different from Indian policies.
1.8. IDENTIFICATION OF THE PROBLEM:

The monetary policy strategy of a Central bank depends on a number of factors that are
unique to the country and the context. Given the policy objectives, any good strategy
depends on the macroeconomic and the institutional structure of the economy.

It is important to recognize that all the objectives cannot be effectively pursued by any
single arm of economic policy. Hence, there is always the problem of assigning to each
instrument the most appropriate target or objective. It is clear from both the theoretical
literature and the empirical findings that, among various policy objectives, monetary
policy is best suited to achieve the goal of price stability in the economy.

It is well recognized that monetary policy is conducted within a particular framework.

The relationship among different segments of the market and sectors of the economy is
also involved in this framework. As part of the ongoing process of reforms, it is
necessary to improve standards, codes and practices in matters relating to financial
system and bring them on par with international ones.

Here, are some items of significance for further research in the realm of monetary policy
in India.

1. To unrelenting regime of very high real rates of interest that the Reserve Bank
of India has imposed upon the country.
2. To use of monetary policy to maintain credit and deposit rates in the economy
by Inflation targeting that are higher than the actual or anticipated rate of
inflation.
3. The general objective of the research is to understand the interrelationship
amongst selected macroeconomic variables, for effective monetary policy
making.
4. The specific objective is to understand the dynamics between monetary policy
rates and ratios with inflation, liquidity and foreign exchange as the three key
functions of the Reserve Bank of India (RBI) are controlling inflation, liquidity
management and stabilizing foreign exchange rate.
5. RBI has been using the policy rates such as Repurchase rate (Repo), Reverse
Repurchase rate (Reverse Repo), Bank Rate and statutory ratios such as Cash
Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) to tame inflation and
control liquidity in the economy but the effectiveness of this policy needs to be
studied.
6. The study tries to understand the dynamics between monetary policy, inflation
and liquidity by working on various tools and drawing conclusions based on the
analysis.
7. In today‘s altered economic context, a low and stable price environment is being
increasingly regarded as an essential condition for bringing down the nominal
interest rate and for improving the growth and productive potential of the
economy.
1.9. RESEARCH QUESTION:

The research aims to study RBI policy and its impact on the country’s economic
variables. For the purpose of this research the following questions arises

1. What is the impact of RBI policy on India’s macroeconomic factors?

2. Are the tools used by RBI sufficient enough to cater economic growth?
3. How RBI controls the working of Indian economy with the help of such tools?
4. What changes can be made to suggest the overall country’s progress/
5. Hoe RBI policies are different from other nations? Are there any changes that
could be adaptable to the Indian economy?
6. What would be the impact on the country if any changes in the RBI policies are
made?
 CHAPTER 2

LITERATURE REVIEW
LITERATURE REVIEW:

The contributions made by various scholars and experts in the field of Monetary Policy
are really praiseworthy. Although various studies have been reviewed, only those works
which are closely related to the present study are included here.

Author Conceptual Research methodology Analysis & Conclusion

name with framework question / research
date hypothesis

Suggestions:

Read the all literature review and make it fit in the table.
Fulfill all tables if possible and if not than keep that table
blank and I will start research gap.

1. Paulson (1989) examines the impact of monetary policy on Indian economy in the
pre-reform period. The study reveals that the single important factor that
influences the money supply in the economy is the reserve money. He points out a
positive correlation between inflationary pressures and administered prices, and
what is required, he suggests, to achieve price stability, is a cordial and symbiotic
relationship between monetary policy and fiscal policy.
2. Inflation is a monetary phenomenon (which is) fuelled by the excessive creation
of money. In article inflation, Monetary Policy, and Financial Sector Reform,
‘published in Southern Economist, Tarapore (1993) mentions inflation as a tax on
the weaker sections of society. The need for a monetary relaxation is often argued
as being helpful to the weakest sections of society. Nothing could be farther from
the truth. The curtailment of inflation is the best anti-poverty programmed and
therefore a strong anti-inflationary monetary policy is in consonance with societal
 concerns.He also predicts that the imminent developments in the securities market
in the foreseeable future call for development of entirely new skills in the Reserve
Bank, the commercial banks and financial institutions.
3. Our present policy-makers appear to be believers in shock therapy (ArunGhosh,
1994). According to him, the objection to interest rates does not imply that all
interest rates should suddenly and precipitately be brought down. Rather, two
steps are necessary. First is a gradual lowering of the interest rate structure.
Second, and more important, putting in place an institutional structure which
would make adequate and timely credit available to small farmers, small
industries, artisans etc…The ongoing reform of the financial sector is thus wholly
misdirected, the reform has to be differently designed and implemented. The
policy of imposing high interest rates on a stagnant economy is the direct result of
the obsession of the present policy-makers with success in the financial markets
rather than in the matter of growth of the real economy.
4. Unusual conditions leading up to the business cycle of 1989-93, made it difficult
to recognize inflationary pressures. Several industrial countries pursued
expansionary policies that caused their economies to overheat; policy corrections
then led to asset-price deflation and severe recessions. Valuable lessons can be
drawn from this experience (Garry Schinasi, 1995). The most important question
is whether future business cycles, in a liberalized global financial environment,
are likely to have a similar profile. Uncertainty about this issue reinforces the
need for monetary policy to remain flexible in the future and for the development
of more reliable tools for monitoring cyclical developments – including tools
making it possible to assess assetmarket conditions with greater accuracy.
5. Sinha (1995), remarks that it is very urgent to keep the finance sector in sound
health. This calls for great vigilance on the part of the regulatory authorities- the
RBI, SEBI and the Central Government. The rate of monetary expansion should
be brought down drastically. That is the real test of success of central banking
policy. For all this, we need a truly independent central bank, whose most
important quality must be to be able to say No‘to excessive credit demand, be it
from Government or thecommercial sector. Otherwise, inflation will become
 worse, contrary to the complacency one observes in this regard, on the part of
Government and the RBI.
6. The case of price stability as the objective of monetary policy rests on the fact that
volatility in prices creates uncertainty in decision making. Rising prices
affectsavings adversely while making speculative investments more attractive.
The most important contribution of the financial system to an economy is its
ability to augment savings and allocate resources more efficiently. A regime of
rising prices initiates the atmosphere for promotion of savings and allocation of
investment. While concluding his article, Rangarajan (1997) suggests that
monetary growth should be so moderated that while meeting the objective of
growth it does not push inflation rate beyond six percent.
7. Rangarajan (1997) addresses these issues against the backdrop of theoretical
developments as well as empirical evidence on the impact of monetary policy in
India and elsewhere in the world. As the role of monetary policy is considered,
the stress has been laid on monetary management. What the policy has been
seeking to do is to modulate money supply growth consistent with expected real
growth. Ensuring price stability requires the pursuit of a consistent policy over a
period of time. This may at times make the central bankers unpopular. The need
to take a view which is not short-term has indeed been one of the arguments
advanced for greater autonomy for central banks.
8. Partha Ray et al. (1998) explores new dimensions in the monetary transmission
mechanism in the environment of liberalization initiated in the early 1990s and in
the context of growing integration of financial markets. An examination of the
Chakrabarty committee paradigm in this changed milieu is what motivated the
author. The article tries to examine the role of two key variables in the conduct of
monetary policy, viz., interest rates and exchange rates. The long-run relationship
between money, prices, output, and exchange rate is examined and the impact of
money market disequilibrium on interest rate is traced by testing the joint
significance of the lags of disequilibrium errors. Interest rates and exchange rates
are seen to be endogenously determined in the liberalized regime beginning 1992-
 93, raising the possibility of the change in transmission mechanism following the
advent of financial reforms.
9. Ranjanendra Narayan Nag and MallinathMukhopadhyay (1998) published an
article about Macro-Economic Effects of stabilization under Financial
Repression‘. The upshot of their analysis is that exchange rate flexibility
increases the likelihood that monetary stabilization and financial liberalization can
succeed in bringing down the inflation rate and in improving performance of the
real sector specifically in the context of ever-increasing exposure of developing
countries to the globalization process. The broad message of the paper is that
light monetary policy and financial liberalization should be integrated with other
components of stabilization, particularly exchange rate flexibility. One can also
study about the nature of exchange rate dynamics in a financially repressed
economy.
10. The amount of research efforts that has gone in to prove or disprove the basic
premises of monetary economics, depending on one's predilections, is
phenomenal. Fortunately, it has given rise to rich, innovative ideas, and
influenced the thinking of those who wield considerable power in policy-making
and decision- taking. In the process, it has enriched the Keynesian logic and
framework and has brought about a sharp change in the processes that form part
of the operating procedures of central banking (Reddy, 1998).
11. ManoharRao (1999) discusses the real and monetary aspects of short-run
structural adjustment using a flow-of-funds methodology. Based upon such a
framework, he then specifies an analytical basis which is capable of integrating
the financial programming model of the Fund with the financial requirements
approach of the Bank in a manner which removes the existing dichotomies
between the real and financial sectors of the economy. The merged model, which
defines monetary,external, real and financial sector equilibrium, is then used to
prescribe feasible stabilization policy options for the Indian Economy over the
current fiscal year. The twin issues of interest rate and exchange rate
determination, is becoming increasingly important. Only when its behavior is well
understood, it will be possible to predict their effects on key macro-economic
 variables such as GDP, inflation, savings, investment and, above all, economic
growth.
12. As part of financial sector reforms, a number of steps have been taken to enhance
the effectiveness of monetary policy and these include improvement in the
payment and settlement systems, development of secondary market in
government securities with a diversification of investor base, reduction in non-
performing assets and reduction in the overall transactions costs. In particular, the
recent initiatives of RBI to develop money market and debt markets should
contribute to improving the transmission mechanisms of monetary policy. All the
reforms in the monetary and financial sectors may not have the desired results
with creditable fiscal adjustment (Reddy, 1999).
13. The relationship between budget deficits, money creation and debt financing
suggests that interest rate targeting and inflation control are both monetary and
fiscal policy issues. ManoharRao (2000) formalized these links within two
analytical frameworks, static as well as dynamic. By highlighting the concepts of
the high interesttrap‘ and the tight money paradox‘, respectively, he suggests that,
for any given deficit, there exist optimal levels of monetization and market
borrowings. Byensuring this optimal split between monetization and borrowings
in the present, it would be possible to balance the future needs of the economy
vis-a–vis the needs of the government and thereby avoid the high interest/inflation
trap and the subsequent specter of an economic slowdown.
14. There have been significant financial sector reforms through 1990s. One of the
major policy changes affecting the financial markets has been the reduction in
government‘s recourse to claims on loanable funds through statutory liquidity
ratio as well as high levels of cash Reserve Ratios. There is a general move
towards market determined rates and flows in the financial sector. One area where
administered rates are still important is the small saving instruments. If the overall
balance of demand and supply of loanable funds is such that interest rates can be
lower, the small saving rates do not let that emerge. Further, as interest rates
decline, there would be significant gains in economic growth. Deepak Lal et al.
(2001) made an attempt to examine this viewpoint. They develop a monetarist
 model of the economy and assess the implications of alternative methods of
financing the fiscal deficit of the government, central and states combined. The
results support the view that overall interest rates would decline if the small
saving rates were to be liberalized but the gains in economic growth would not be
dramatic.
15. In the recent past, the RBI has been using open market operations to sterilize the
inflows of foreign capital so as to contain domestic monetary expansion. Due to a
risein the income velocity of base money this has created an incentive for the
government to resort more to market borrowings from banks which has raised real
interest rates and which exerts a depressing impact on the growth of economic
activity along with creating pressures for the inflation rate to increase. The
changed environment calls for a reduction in government expenditures which,
while reducing interest rates and enhancing the level of economic activity, will
also help nudge the economy to a lower inflation level (Errol D‘Souza, 2001).
16. Kangasabapathy (2001) captures the historical perspective in respect of monetary
policy underpinnings with particular reference to India. He also points out the
limitations and constraints in pursuing monetary policy objectives and throws
light on current mainstream economic thinking and perspective in the context of
the changing economic environment worldwide. In the recent times, due to the
emergence of interest rate as an efficient variable in the transmission mechanism,
the RBI has begun placing greater reliance on indirect instruments such as Repo,
Bank rate, OMO etc., rather than the earlier practice of greater dependence on
CRR alone. Another issue debated in the context of Central Bank autonomy is the
separation of debt management and monetary management functions. At the same
time, it would require a co-ordinated operation with monetary management to
achieve a stable interest rate environment and market condition.
17. There are continuing debates on several issues connected with monetary policy.
Questions have been raised on the objectives, instruments and impact of monetary
policy. Monetary management in the 1980s and more particularly in the 1990s in
India offers interesting insights on the role of monetary policy as an instrument of
economic policy. The paper written by Rangarajan (2001) draws some important
 lessons from this experience. Assigning to each instrument the most appropriate
objective favors monetary policy as the most appropriate instrument to achieve
the objective of price stability. It is this line of reasoning which has led to the
single objective approach. A considerable part of the relevant research effort has
been devoted to the trade-off between economic growth and price stability.
According to the author, the efforts aimed at strengthening the institutional
structure are a necessary part of the functions of a central bank.
18. In the pursuit of non-inflationary growth and stability and efficiency of the
financial system and in the context of the recent moderation in economic activity
in India, the current policy preference is towards softer interest rates while
imparting greater flexibility to the interest rate structure in the medium term
(Barman, 2002). Model estimated forecasts of output, inflation and liquidity
comprise important elements of the information set used by the policy makers in
the conduct of monetary policy. These forecasts are generated by using structural
models, time series models and industrial outlook surveys. The short-term
liquidity forecast is a more complex area and the appropriate approach and
method for generating liquidity forecasts is beingexplored in India. The paper
discusses these issues and highlights the problems that often warrant
methodological refinements.
19. Mere expansionary signals from the RBI through reduction of the repo rate and
the Bank rate and through money market instruments will not be enough (EPW
Research Foundation, 2002) . The RBI will need to address structural disabilities
and distorted commercial banking behavior in response to financial sector
reforms.
20. With a series of monetary measures undertaken by the Reserve Bank of India in
the recent period combined with somewhat sharp reductions of nominal interest
rates on small savings, the overall structure of interest rates in the economy has
attained a state of relative stability and it can also be characterized as generally
well-balanced. EPW Research Foundation (2002) commends that with all-round
downward movement of rates of all types and maturities in the past three years,
near-stability in the interest rates profile has been achieved. RBI policies of low
 Bank rate, active management of liquidity and signaling its preference for
softening of interest rates have contributed to this development.
21. RaghbendraJha (2002) tries to assess why lowering interest rates is proving to be
hard in India. He highlights the role of three factors, namely, high public debt and
its structure, the overhang of non-performing assets and the policy being pursued
with respect to accumulation of foreign exchange reserves. These three factors are
causally linked to each other and should not be looked upon as mutually exclusive
contributors. While it is good to have the benefits of the policy of high foreign
exchange reserves, this is levying a cost on the economy in terms of interest rates
and debt service payments that are higher than they need be and lead to partial
loss of control over money supply. However, as the Thai experience in 1977
vividly illustrates, high foreign exchange reserves alone cannot provide security
against macro-economic downturns and it is important to design an appropriate
foreign exchange reserve policy.
22. Reddy (2002) remarks that in order to gain greater effectiveness in money market
operations of the Reserve Bank through Liquidity Adjustment Facility, the
automatic access of refinance facility from the RBI to banks also have to be
reassessed. Thus, as CRR gets lowered and repo market develops, the refinance
facilities may be lowered or altogether removed and the access to the non-
collateralized call money market restricted with the objective of imparting greater
efficacy to the conduct of monetary policy.
23. Monetary policy is increasingly focused on efficient discharge of its objective
including price stability and this, no doubt, will lead to poverty alleviation,
indirectly; while the more direct attack on poverty alleviation would rightfully be
the preserve of fiscal policy. Monetary and financial sector policies in India
should perhaps be focusing increasingly on what Dreze and Sen Call growth
mediated security(Reddy, 2002).
24. The modern central banker needs to be open to the reality of the ongoing
structural changes around him and to keep an open mind as to how monetary
policy might best be used to enhance the welfare of the citizens for whom he is
responsible (William, 2002). According to him, a longer-term commitment to
 price stability, supplemented by concerns as to how financial instability might
impede the pursuit of this objective, should be the principal objective for
monetary policy today.
25. Kannan et al. (2003), in an article Liquidity Measures as Monetary Policy
Instruments,‘ attempts to build a frame work to quantify the developments in the
money markets in quantum terms through autonomous and discretionary liquidity
measures. The concepts of discretionary and autonomous liquidity measures make
LAF a powerful instrument of monetary policy and the development of the money
market is necessary for its efficient management. He also points out that, an active
open market operation was pursued by the RBI as an indirect instrument of
Monetary Policy in the last three-four years.
26. The objective of the study, Exchange Rate Policy and Management-The Indian
Experience‘written by Pattnaik et al. (2003), is to present the Indian experience of
exchange rate management against the backdrop of international developments
both at the theoretical and empirical levels. Monetary policy has been successful
in ensuringorderly conditions in the foreign exchange market and containing the
impact of exchange rate pass-through effect on domestic inflation. Real shocks
are predominantly responsible for movements in real as well as nominal exchange
rate, monetary policy shocks have been relatively unimportant. A policy of benign
neglect of the exchange rate is impractical and unrealistic since movements in
exchange rate influence the monetary transmission. Overall, the analysis indicates
that exchange rate management in India has been consistent with macroeconomic
stability.
27. The working paper published by The Levy Economics Institute of Bard College
(2003) considers the nature and role of monetary policy when money is envisaged
as credit money endogenously created within the private sector, i.e., by
thebanking system. Monetary policy is now based in many countries on the
setting or targeting of a key interest rate, such as the Central Bank discount rate.
The amount of money in existence then arises from the interaction of the private
sector and the banks, based on the demand to hold money and the willingness of
banks to provide loans. Monetary policy has become closely linked with the
targeting of the rate of inflation. This paper considers whether monetary policy is
well-equipped to act as a counter inflation policy and discuss the more general
role of monetary policy in the context of the treatment of money as endogenous.
Currently, two schools of thought view money as endogenous. One school has
been labeled the "new consensus" and the other the Keynesian endogenous (bank)
money approach. Significant differences exist between the two approaches; the
most important of these, is in the way in which the money is viewed. Although
monetary policy is essentially interest rate policy and it appears to be the same in
both schools of thought, it is not. This paper investigates the differing roles of
monetary policy as per these two schools.