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1. INTRO:
Monetary policy is concerned with the changes in the supply of money and credit. It
refers to the policy measures undertaken by the government or the central bank to
influence the availability, cost and use of money and credit with the help of monetary
techniques to achieve specific objectives. Monetary policy aims at fencing the
economic activity in the economy mainly through two major variables, ie.,
(a) money or credit supply, and
(b) the rate of interest.
Before reading the rest of this project, we need to understand the various
instruments used by the Monetary Policy Committee and the RBI to fulfil its
objectives.
(Take from macro tb)
1. Repo Rate (or Repurchase Rate): Repo rate is the rate at which the central
bank of a country (RBI in case of India) lends money to commercial banks to
meet their short-term needs. The central bank advances loans against
approved securities or eligible bills of exchange. An increase in the repo rate
increases the cost of borrowings from the central bank. It forces the
commercial banks to increase their lending rates, which discourages
borrowers from taking loans. It reduces the ability of commercial banks to
create credit. A decrease in the repo rate will have the opposite effect.
2. Bank Rate (or Discount Rate): Bank rate is the rate at which the central bank
of a country RBI in case of India) lends money to commercial banks to meet
their long-term needs. RBI uses bank rate to control credit and it has the same
effect as that of Repo rate. It discourages borrowers from taking Ins, which
reduces the ability of commercial banks to create credit.
3. Reverse Repo Rate (or Reverse Repurchase Rate): This is the exact opposite of
Repo Rate Reverse Repo Rate is the rate of interest at which commercial
banks can deposit their surplus funds with the Central Bank, for a relatively
shorter period of time. So, it is the rate of interest at which the Central Bank
(Reserve Bank of India) accepts deposits from the Commercial Banks. When
the reverse repo rate is raised, it encourages the commercial banks to deposit
their funds with the central bank. This has the negative effect on the lending
capability of the commercial banks. Lowering the reverse repo rate has the
opposite effect, which raises demand for borrowings from the commercial
banks.
4. Open Market Operations: Open market operations (OMO) refer to buying and
selling of government securities by the Central Bank from/to the public and
commercial banks. RBI is authorised to sell or purchase treasury bills and
government securities. It does not matter whether the securities are bought or
sold to the public or banks because ultimately the amounts will be deposited
in or transferred from some bank. Sale of securities by the central bank
reduces the reserves of commercial banks. It adversely affects the bank's
ability to create credit and therefore decrease the money supply in the
economy. Purchase of securities by the central bank increases the reserves and
raises the bank's ability to give credit.
5. Legal Reserve Requirements (Variable Reserve Ratio Method): According to
Legal reserve requirements, commercial banks are obliged to maintain
reserves. It is a very quick and direct method for controlling the credit creating
power of commercial banks. Commercial Banks are required to maintain
reserves on two accounts:
➔ Cash Reserve Ratio (CRR): It refers to the minimum percentage of net
demand and time liabilities, to be kept by commercial banks with the
central bank. A change in CRR affects the ability of commercial banks
to create the credit. For instance, an increase in CRR reduces the excess
reserves of commercial banks and limits their credit creating power.
➔ Statutory Liquidity Ratio (SLR): It refers to the minimum percentage of
net demand and time liabilities which commercial banks are required
to maintain with themselves. SLR is maintained in the form of
designated liquid assets such as excess reserves and other approved
securities or current account balances with other banks. Change in
SLR affects the freedom of banks to sell government securities or
borrow against them from the Central Bank. An increase in SLR
reduces the ability of banks to give credit and vice-versa.
6. Margin Requirements: Margin is the difference between the amount of loan
and market value of the security offered by the borrower against the loan. If
the margin fixed by the Central Bank is 40%, then commercial banks are
allowed to give a loan only up to 60% of the value of security. By changing the
margin requirements, the Reserve Bank can alter the amount of loans made
against securities by the banks.
➔ An increase in margin reduces the borrowing capacity and money
supply.
➔ A fall in margin encourages the people to borrow more.
➔ RBI may prescribe different margins for different types of borrowers
against the security of the same commodity.
Margin is necessary because if a bank gives a loan equal to the full value of
security, then the bank will suffer a loss in case of fall in price of security.
7. Moral Suasion: This is a combination of persuasion and pressure that the
Central Bank applies to other banks to encourage them to act in line with its
policies. Moral suasion is exercised through discussions, letters, speeches, and
hints to banks. The Reserve Bank frequently announces its policy positions
and urges banks to cooperate in implementing its credit policies. Moral
suasion can be used for both quantitative and qualitative credit control.
Generally, the central bank succeeds in convincing the banks, as it acts as their
lender of last resort. However, no punitive action is taken if they do not follow
the advice or request.
8. Selective Credit Controls: Under selective credit controls, the RBI (Reserve
Bank of India) gives directions to other banks to either provide or not provide
credit for specific purposes and particular sectors. This method can be applied
in both positive and negative ways. In a positive manner, it means using
measures to direct credit to priority sectors, which include small-scale
industry, agriculture, exports, etc. In a negative manner, it means using
measures to restrict the flow of credit to particular sectors.
3. MAIN OBJECTIVES:
2. Economic Growth:
Promoting economic growth is another important objective of monetary policy.
Monetary policy can promote economic growth through ensuring adequate
availability of credit and lower cost of credit. This is done by controlling the Cash
Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
Source: https://www.economicsdiscussion.net/monetary-policy/3-objectives-of-
monetary-policy-of-reserve-bank-of-india-rbi/10509
The Reserve Bank of India (RBI) operates the Monetary Policy Framework of the
country.
● The amended RBI Act explicitly provides the legislative mandate to the
Reserve Bank to operate the monetary policy framework of the country.
● The framework aims at setting the policy (repo) rate based on an assessment
of the current and evolving macroeconomic situation, and modulation of
liquidity conditions to anchor money market rates at or around the repo rate.
Note: Repo rate changes transmit through the money market to the entire
financial system, which, in turn, influences aggregate demand – a key
determinant of inflation and growth.
● Once the repo rate is announced, the operating framework designed by the
Reserve Bank envisages liquidity management on a day-to-day basis through
appropriate actions, which aim at anchoring the operating target – the
weighted average call rate (WACR) – around the repo rate.
Note: Members referred to at 4 to 6 above, will hold office for a period of four years
or until further orders, whichever is earlier.
https://en.wikipedia.org/wiki/Monetary_Policy_Committee_(India)
https://www.clearias.com/monetary-policy/#the-monetary-policy-framework-mpf
● In India, the policy interest rate required to achieve the inflation target is
decided by the Monetary Policy Committee (MPC). MPC is a six-member
committee constituted by the Central Government (Section 45ZB of the
amended RBI Act, 1934).
● The MPC is required to meet at least four times a year. The quorum for the
meeting of the MPC is four members. Each member of the MPC has one vote,
and in the event of an equality of votes, the Governor has a second or casting
vote.
● The resolution adopted by the MPC is published after the conclusion of every
meeting of the MPC. Once in every six months, the Reserve Bank is required
to publish a document called the Monetary Policy Report to explain: (1) the
sources of inflation and(2) the forecast of inflation for 6-18 months ahead.
6. 2013-2016: Set the stage for inflation targeting, culminating in the formal
adoption of flexible inflation targeting in 2016.
https://www.bis.org/review/r200130f.htm
Address by Mr Shaktikanta Das, Governor of the Reserve Bank of India, at
the St. Stephen's College, University of Delhi, Delhi, 24 January 2020.
Cons
Effects Have a Time Lag:
Even if implemented quickly, the macro effects of monetary policy
generally occur after some time has passed. The effects on an
economy may take months or even years to materialise. Some
economists believe money is "merely a veil," and while serving to
stimulate an economy in the short-run, it has no long-term effects
except for raising the general level of prices without boosting real
economic output.
Technical Limitations:
Interest rates can only be lowered nominally to 0%, which limits the
bank's use of this policy tool when interest rates are already low.
Keeping rates very low for prolonged periods of time can lead to a
liquidity trap. This tends to make monetary policy tools more effective
during economic expansions than recessions. Some European
central banks have recently experimented with a negative interest
rate policy (NIRP), but the results won't be known for some time to
come.
Monetary Tools Are General and Affect an Entire Country:
Monetary policy tools such as interest rate levels have an economy-
wide impact and do not account for the fact some areas in the
country might not need the stimulus, while states with high
unemployment might need the stimulus more. It is also general in the
sense that monetary tools can't be directed to solve a specific
problem or boost a specific industry or region.
The Risk of Hyperinflation
When interest rates are set too low, over-borrowing at artificially
cheap rates can occur. This can then cause a speculative bubble,
whereby prices increase too quickly and to absurdly high levels.
Adding more money to the economy can also run the risk of causing
out-of-control inflation due to the premise of supply and demand: if
more money is available in circulation, the value of each unit of
money will decrease given an unchanged level of demand, making
things priced in that money nominally more expensive.
https://www.investopedia.com/articles/investing/050615/fiscal-vs-monetary-
policy-pros-cons.asp