Monetary policy of India

Monetary policy of India

The Reserve Bank of India (RBI) is the country's central bank and is responsible for formulating monetary policy, a set of guidelines governing the nation's monetary affairs.

Monetary policy of India

The Reserve Bank of India (RBI) is the country's central bank and is responsible for formulating monetary policy, a set of guidelines governing the nation's monetary affairs. The policy entails steps taken to control the economy's availability, cost, and supply of credit.

The policy controls borrowing and lending interest rates and how credit is allocated among users. In a developing country like India, monetary policy plays a significant role in fostering economic growth.

Monetary Policy's Goals

Even though economic growth, price stability, and exchange rate management are the monetary policy's primary goals, there are still other areas where it can be helpful.

  • Promotion of saving and investing: Since the country's interest rate and inflation are controlled by the monetary policy, it may impact people's savings and investments. A higher interest rate increases the likelihood of saving and investing, which helps keep the economy's cash flow healthy.
  • Controlling imports and exports: The monetary policy assists export-oriented units in replacing imports and increasing exports by assisting industries in obtaining a loan at a lower interest rate. In turn, this enhances the state of the payment balance.
  • Managing business cycles: A business cycle has two main phases: a boom and a bust. The best tool for regulating the boom and bust phases of business cycles is monetary policy, which manages credit to regulate the money supply. Limiting the supply of money can manage inflation in the market. On the other hand, as the money supply grows, the economy's demand will also rise.
  • Controlling overall demand: Monetary authorities can use monetary policy to balance the supply and demand of goods and services because it can influence an economy's demand. More people can obtain loans to pay for goods and services when credit is expanded, and the interest rate is lowered. This causes the demand to increase. On the other hand, the government can restrict credit and raise interest rates to lower demand.
  • Employment generation: Small and medium-sized businesses (SMEs) can easily obtain loans for business expansion because the monetary policy can lower the interest rate. The employment opportunities, as a result, may be greater.
  • Infrastructure development assistance: Concessional funding is permitted by the country's monetary policy for the construction of infrastructure.
  • Crediting the priority segments more generously: For the development of the priority sectors, such as small-scale industries, agriculture, underdeveloped societal segments, etc., additional funds are allotted under the monetary policy at lower interest rates.
  • Managing and expanding the banking industry: The Reserve Bank of India (RBI) oversees the entire banking sector. While the RBI wants to ensure that banking services are accessible to everyone in the country, it also gives other banks instructions on setting up rural branches whenever necessary for agricultural development. The government has also established cooperative and regional rural banks to assist farmers in quickly obtaining the financial assistance they need.

Monetary Policy Tools

The Reserve Bank of India must reduce the money supply or raise the cost to keep the demand for goods and services under control and prevent inflation.

Quantitative instruments

The tools used by the policy affect how much money is available throughout the economy, including industries like manufacturing, agriculture, transportation, and housing, among others.

  1. Reserve Ratio: Banks must set aside a specific amount of cash reserves or other assets that the RBI has approved. There are two types of reserve ratios: 
  2. CRR (Cash Reserve Ratio) - Banks must keep this portion on deposit with the RBI in cash. The bank is not permitted to lend it to anyone or to profit from CRR in any way. 
  3. SLR, or Statutory Liquidity Ratio: Banks must reserve this sum in liquid assets like gold or securities that have received RBI approval, such as government bonds. Although interest on these securities is permitted to be earned by banks, it is very little.
  4. Open Market Operations (OMO): The RBI buys and sells government securities to regulate the money supply on the open market. They are known as "Open Market Operations" because the Central Bank in the open market carries them out. 
  5. The RBI drains market liquidity when it sells government securities and does the exact opposite when it purchases securities. The latter action reduces inflation. OMOs aim to prevent short-term liquidity imbalances in the market caused by foreign capital flow.

Qualitative tools:

Comparative to quantitative tools, which directly impact the money supply of the entire economy, qualitative tools are targeted tools that impact the money supply of a particular sector of the economy.

  1. Margin requirements – The RBI's prescribed margin against collateral impacts customers' borrowing habits. Customers can borrow less if the RBI increases the margin requirements.
  2. Suasion of morality - The RBI persuades banks to keep money in government securities instead of specific industries.
  3. Controlling credit by avoiding lending to certain sectors of the economy or speculative enterprises is known as selective credit control.

Market Stabilisation Scheme (MSS) -

Policy Rates:

  1. The bank rate is the interest rate that the RBI charges banks for long-term capital loans. However, at the moment, RBI must fully regulate the money supply through the bank rate. In order to establish control over the money supply, it uses the Liquidity Adjustment Facility (LAF) - repo rate as one of the key tools. If the bank maintains the required SLR or CRR, it will be penalised using the bank rate.
  2. Liquidity Adjustment Facility (LAF) – The types of LAF used by RBI to modify liquidity and the money supply are as follows:
    1. Repo rate: The rate at which banks borrow money on a short-term basis from the RBI in exchange for repurchase agreements is known as the repo rate. Following this policy, banks must offer government securities as collateral and then purchase them back after a specified period.
    2. Reverse Repo rate: The rate that the RBI pays to banks in order to keep more money in the RBI is the opposite of the repo rate. The following is how it relates to the repo rate: 

       Repo Rate – 1 = Reverse Repo Rate 

  1. Marginal Standing Facility (MSF) Rate: In comparison to the rate permitted by the rep policy, the MSF Rate is the penalty rate at which the Central Bank lends money to banks. A maximum of 1% of SLR securities may be used by banks using the MSF Rate. 
  2. Repo Rate + 1 = MSF Rate 

Book A Free Counseling Session