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Monetary Policy in India: Overview, Tools, and Implementation



Meaning


Monetary policy refers to the strategies and actions taken by a country's central bank (or a similar monetary authority) to control and manage the money supply and interest rates in the economy.


Aim/Objective

  • The primary objective of the RBI's monetary policy is to maintain price stability while keeping in mind the objective of growth.

  • The key macroeconomic indicator targeted by the MPC is ‘inflation’.


Monetary Policy Tools

  1. Repo Rate: The rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) against approved securities.

  2. Standing Deposit Facility (SDF) Rate: Rate for uncollateralized overnight deposits, serving as a financial stability tool alongside liquidity management.

  3. Marginal Standing Facility (MSF) Rate: Penal rate for banks to borrow from the RBI by using a portion of their Statutory Liquidity Ratio (SLR) portfolio.

  4. Liquidity Adjustment Facility (LAF): Operations for injecting/absorbing liquidity, including overnight and term repo/reverse repos, SDF, and MSF.

  5. LAF Corridor: MSF rate as upper bound, SDF rate as lower bound, with the policy repo rate in the middle.

  6. Main Liquidity Management Tool: 14-day term repo/reverse repo auction aligned with the CRR maintenance cycle.

  7. Fine Tuning Operations: Overnight or longer-term operations to address unanticipated liquidity changes.

  8. Reverse Repo Rate: Rate at which the RBI absorbs liquidity from banks under the LAF.

  9. Bank Rate: Rate for buying or rediscounting bills of exchange, acting as a penal rate for reserve requirement shortfalls.

  10. Cash Reserve Ratio (CRR): Required average daily balance maintained with the RBI as a percentage of net demand and time liabilities.

  11. Statutory Liquidity Ratio (SLR): Mandatory assets maintained by banks as a percentage of demand and time liabilities.

  12. Open Market Operations (OMOs): Outright purchase/sale of government securities to inject/absorb durable liquidity in the banking system.


Expansionary vs Contractionary Policy


Expansionary Monetary Policy: Used in economic slowdowns, aims to boost activity by increasing the money supply, including:

  1. Lower Interest Rates: Makes borrowing and spending attractive for businesses and individuals.

  2. Encourage Investment: Businesses borrow for investment, leading to job creation.

  3. Promote Borrowing: Encourages consumer spending and demand.

  4. Support Asset Prices: May boost asset values, stimulating wealth and consumer spending.

Contractionary Monetary Policy: Used to control inflation or prevent an overheating economy, includes:

  1. Raise Interest Rates: Makes borrowing more expensive, reducing spending.

  2. Encourage Saving: Higher rates promote saving over borrowing.

  3. Control Inflation: Slows down the economy to prevent excessive inflation.

  4. Reduce Speculative Bubbles: Prevents excessive borrowing and asset bubbles.

  5. Difference between Monetary Policy and Fiscal Policy

MPC Stances

  1. Hawkish Stance: Central bank focuses on controlling inflation by raising interest rates and tightening monetary policy to maintain price stability, particularly if the economy is at risk of overheating.

  2. Dovish Stance: Central bank aims to support economic growth and reduce unemployment by adopting expansionary measures, such as lowering interest rates and promoting borrowing and spending.

  3. Accommodative Stance: Similar to dovish stance, central bank provides lenient monetary conditions to support the economy. It may involve keeping interest rates low, engaging in quantitative easing, or other measures to encourage borrowing and spending.

Origin of Monetary Policy in India

  • The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to establish a statutory and institutionalized framework for a Monetary Policy Committee.

  • The purpose of this amendment was to maintain price stability and consider the objective of economic growth.

  • The Monetary Policy Committee was tasked with determining the benchmark policy rate (repo rate) with the aim of containing inflation within the specified target level.

  • MPC Decisions are binding

Monetary Policy Committee

  • The setting up of a committee to decide on monetary policy was first proposed by the Urjit Patel Committee.

  • Under Section 45ZB of the amended (in 2016) RBI Act, 1934, the central government is empowered to constitute a six-member Monetary Policy Committee (MPC).

  • As per the RBI Act, the Monetary Policy Committee (MPC) consists of six members.

  • Three members are from the RBI, while the remaining three members are appointed by the Central Government.

  • The composition of the MPC was established through a Gazette Notification in September 2016.

  • The MPC includes

    1. RBI Governor as its ex officio chairperson,

    2. Deputy Governor in charge of monetary policy,

    3. An officer of the Bank to be nominated by the Central Board,

    4. Three persons to be appointed by the central government.

  • This committee came into existence on 27th June 2016.

  • The MPC is required to meet at least four times in 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.

  • RBI’s Monetary Policy Department (MPD) helps the MPC.

  • The primary responsibility for executing monetary policy rests with the Financial Markets Operations Department (FMOD), which carries out routine liquidity management operations.

  • The Financial Market Committee (FMC) convenes daily to assess liquidity conditions, aiming to align the operating target of monetary policy (weighted average lending rate) with the policy repo rate. This parameter is also referred to as the weighted average call money rate (WACR).

  • Semi-annually, the Reserve Bank must release a document known as the Monetary Policy Report. This report serves to elucidate the factors contributing to inflation and to provide inflation forecasts for the forthcoming 6 to 18 months.


 

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