Understanding Monetary Policy and its Components

What is Monetary Policy ?     

• Monetary policy, managed by a country's central bank, plays a crucial role in shaping a nation's economic landscape. It involves the strategic management of money supply and interest rates, influencing critical variables such as inflation, consumption, savings, investment, and capital formation.
• In India, the Reserve Bank of India (RBI) holds the responsibility for formulating and executing monetary policy, employing a range of tools like interest rate adjustments and bank reserve requirement modifications to achieve specific economic objectives and foster desired outcomes.

Objectives of Monetary Policy :

• Control inflation within tolerable range, and ensure that purchasing power of the currency remains stable, creating conducive environment for consumers and business.
• promote economic growth and development in a country by fostering an environment that encourages investment and consumption.
• Contribute to employment generation and manage fluctuation in business cycles through policies that stimulate economic activity..
• To help with the development of Infrastructure.
• Maintain stability in the exchange rate of domestic currency against other major currencies to facilitate international trade and investment.
• Ensure stability and Growth of banking sector to support the over all financial system and economic stability.

Tools of Monetary Policy.

Quantitative Tools:

      Quantitative tools of monetary policy are measures used by central banks, to regulate the money supply, interest rates, and overall liquidity in the economy. These tools directly impact the quantity or volume of money circulating in the financial system.

1. Cash Reserve Ratio (CRR) :

• CRR is the percentage of bank's total deposits that it required to keep in the form of cash reserves with the RBI.
• By adjusting the CRR, the RBI can influence the liquidity in the banking system.
• Increasing the CRR reduces the lendable amount of banks and vice versa.
• CRR is mandated under RBI Act, 1934

2. Statutory Liquidity Ratio (SLR) :

• SLR is the percentage of bank's total deposits that it must maintain with themselves in specified liquid assets, such as cash, gold, G-Sec, T-bills, State Development Loan Bonds and other securities notifies by RBI.
• By adjusting the SLR, the RBI can influence the liquidity in the banking system and  Increasing the SLR reduces the lendable amount of banks and vice versa.
• Legally SLR cant be more than 40%.
• SLR is mandated under Banking Regulation Act, 1949.

Liquidity Adjustment Facility (LAF) :  LAF is monetary policy tool used by the RBI to manage the short term liquidity in the banking system.It consists of two mechanisms : the Repo Rate and the Reverse Repo rate.

3. Repo Rate :

• Repo means - Repurchase Option and it is also called 'Ready Forward Transaction'
• Repo rate is the rate at which RBI lends money to commercial banks against government securities as collaterals.
• Changes in the repo rate directly affects the cost of borrowing.
• Increase in the Repo rate results in increased cost of borrowing leading to reduced money supply and vice versa.
• Repo rate is our policy rate to control inflation.

4. Reverse Repo Rate:

• The reverse repo rate is the rate at which the RBI borrows money from commercial banks for the short term by selling government securities.
• When banks have excess funds that they want to invest securely, they can deposit these funds with the RBI, earning interest at the reverse repo rate.
• This rate acts as a tool for the RBI to absorb surplus liquidity from the banking system.

5.Marginal Standing Facility (MSF) :

• It is the rate at which RBI lends short term loans to Scheduled commercial Banks on overnight basis with their SLR quota government securities.
• It acts as a penal rate for banks that exhaust all other borrowing option and need additional funds.
• MSF is the higher than the Repo rate.

6. Bank Rate :

• Bank Rate is the rate at which RBI lends money to the commercial banks on long term basis typically for one year or more without requiring any securities or collaterals.
• The bank rate is higher than the repo rate and serves as the reference rate for the long- term lending market.

7. Open Market Operations (OMO) :

• Through OMO's, RBI buys or sell government securities in the open market to adjust money supply.
• When the RBI buys government securities, it injects money into the system, leading to increased liquidity.
• When the RBI sell government securities, it absorb money from the system, leading to decreased liquidity.

8. Market Stabilisation Scheme (MSS) :

• MSS is used by RBI to manage excess liquidity in the financial system.
• The primary purpose of this MSS to absorb excess liquidity in the market by selling G-Sec, T- Bills, Cash management Bills (CMB).
• The money thus collected is not a part of government borrowing but government pays interest on it.
• Though this instrument was introduced in 2004, It was enhanced during Demonetisation to sterilise the impact of excess liquidity and crashing of lending rates.

Qualitative Tools :

    Qualitative tools of monetary policy are regulatory measures employed by the Reserve Bank of India to influence the flow of credit in specific sectors of the economy.

1. Priority Sector Lending (PSL) :

• ThePriority Sector Lending mandates that a certain portion of bank loans should be directed towards priority sectors, like agriculture, education, small scale industries and weaker section of the society etc.
• The PSL targets are set to ensure that the banking sector contributes to the development of specific sectors that are crucial for the overall economic growth and welfare of the country.
• It plays a significant role in achieving social and developmental goals by ensuring that credit is extended to segments of the population that may have limited access to financial services.

2. Moral Suasion:

• The RBI uses informal communication and persuasion to influence banks' lending behaviour.
• Through meetings, guidelines, and recommendations, the central bank encourages banks to align their lending practices with the desired monetary policy goals.
• Example: RBI Governor can ask banks to...
• transmit the benefits of repo rate cuts to the borrowers,
• Open new branches in remote and unserved area.
• Spread financial literacy.
• Moral Suasion is a method of Persuasion and this has no punitive measures against Banks.

3. Margin requirements or Loan to Value :

• RBI can prescribe minimum margin requirement for specific loans such as Housing Loans, Gold loans or other securities backed loans.
• Increasing the margin requirement makes borrowing more expensive and thus reduces speculative borrowing.

4. Selective Credit Control :

• The central bank may impose credit ceilings on banks, restricting the total amount of loans they can extend to particular sectors. This measure helps control credit expansion in overheated sectors and ensures a more balanced credit allocation.
• The RBI can also set sector-specific credit limits or lending guidelines to manage credit flows to vulnerable sectors and ensure financial stability.

Types of Monetary Policy :

Expansionary Monetary Policy :

        An expansionary monetary policy, also known as Easy Monetary Policy, aims to increase the money supply in an economy to promote economic growth. It is implemented by the central bank, such as the Reserve Bank of India (RBI), through the reduction of key interest rates. By lowering rates like Repo, Reverse Repo, MSF, and Bank Rate, the central bank increases market liquidity and makes borrowing cheaper for businesses and consumers.

        The injection of liquidity into the market encourages more economic activity, as businesses are more willing to invest and expand, and individuals are encouraged to spend and borrow. This, in turn, can lead to higher levels of consumption, investment, and job creation, helping to stimulate overall economic growth.

        The primary goal of an expansionary monetary policy is to combat economic downturns and support the economy during periods of low growth or recession. However, it's essential for the central bank to carefully monitor the impact of these measures to avoid potential risks, such as inflationary pressures or the formation of asset bubbles. Properly calibrated expansionary measures can help maintain price stability while encouraging sustainable economic expansion.

Contractionary Economic Policy :

        A contractionary monetary policy, also known as Tight Monetary Policy, aims to reduce the money supply in an economy to control inflation and stabilise economic growth. This policy is implemented by the central bank, such as the Reserve Bank of India (RBI), through the raising of key interest rates. By increasing rates like Repo, Reverse Repo, MSF , and Bank Rate, the central bank reduces market liquidity, making borrowing more expensive for businesses and consumers.

        The reduction in market liquidity can lead to decreased levels of consumption and investment as borrowing becomes less attractive due to higher interest costs. As a result, economic activity may slow down, which can help prevent the economy from overheating and keep inflation in check.

        The primary goal of a contractionary monetary policy is to combat inflationary pressures and maintain price stability. By reducing the money supply and curbing excessive spending, the central bank aims to prevent the economy from experiencing unsustainable price increases. However, it's essential for the central bank to carefully calibrate these measures to avoid excessively dampening economic growth, as overly tight monetary policy can lead to a slowdown or recession.

Monetary Policy Committee (MPC) :

The Monetary Policy Committee (MPC) of India is a crucial statutory body responsible for formulating and implementing monetary policy in the country. It was established in 2016 through an amendment to the RBI act 1934, based on the recommendations of the 'Urjit Patel Committee'. The main objective of the MPC is to maintain price stability through inflation targeting and to ensure the growth of the Indian economy.

Origin : The RBI Monetary Policy Committee (MPC) is a statutory body constituted as per Section 45ZB under the RBI Act of 1934 by the Union Government of India. 

Objective: Section 45ZB of RBI act 1934 lays down that “the Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target”.

• The decision of the MPC is binding on the bank

Composition of MPC :

Section 45ZB of the RBI act specifies that the MPC shall consists of 6 members.

1. Governor of the RBI, as Ex officio chairman
2. Deputy Governor of RBI responsible for the Monetary Policy
3. An officer of the RBI nominated by the RBI central Board.
4. Three persons to be appointed by the Central Government.
• Appointments of this category must be from “persons of ability, integrity, and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy"

Selection and Terms of Members :

Selection: 

• The government nominees to the MPC will be selected by a Search-cum-Selection Committee headed by  Cabinet Secretary with RBI Governor and Economic Affairs Secretary and three experts in the field of economics or banking or finance or monetary policy as its members.
• RBI's ex officio representatives are included in the MPC.

Tenure : 

• The Government nominees of the MPC will be appointed for a period of four years and shall not be eligible for reappointment.
• The tenure of the RBI's ex officio representatives is tied to their respective office tenure.

Working and Decisions making process of the MPC:

• Quorum of the meeting is 4 members including governor.
• As per legal requirements, the MPC should meet at least four times a year. However, in practice, the Committee holds meetings every two months to determine the bi-monthly monetary policy update.
• Policy rates are decided by the Majority vote, in case of tie the governor has second casting vote.
• To ensure transparency and accountability, the government is required to communicate exclusively in writing, and the Committee must publish the minutes of its meetings within 14 days. Additionally, the Committee is obligated to release the "Monetary Policy Report" every six months.
• Inflation target decided by the Union Government after consultation with the RBI Governor.
• In the event that the MPC fails to achieve its set inflation targets, it is obligated to submit a report to the government, providing an analysis of the reasons behind the shortfall and suggesting appropriate remedies.

UPSC Previous Year Questions:

1. When the Reserve Bank of India reduces the Statutory Liquidity ratio by 50 basis points which of the following is likely to happen ? (2015)
a. India's GDP growth rate Increases drastically
b.Foreign Institutional Investors may bring capital into our Country.
c. Scheduled Commercial Banks may cut their lending rates.
d. It may drastically reduce the liquidity to the banking system

Answer: Option (c)

2. Which of the following Measures would result in an increase in the money supply in the economy ? (2012)
1.Purchase of G-Sec from the public by the Central Bank
2. Deposit of Currency in commercial banks by the public.
3. Borrowing by the government from the Central Bank.
4.Sale of Government securities to the public by the central Bank.

Select the correct answer from the codes given below

(a) 1 only                                   (b) 2 and 4 only
(c) 1 and 3 only                        (d) 2, 3, and 4

Answer: Option (c) 1 and 3 only

3. With reference to Indian economy, consider the following: (2015)
1. Bank rate
2. Open market operations
3. Public debt
4. Public revenue

Which of the above is/are component/ components of Monetary Policy?
(a) 1 only
(b) 2, 3 and 4
(c) 1 and 2
(d) 1, 3 and 4

Answer :Option(c) 1 and 2

4. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? (2020)
1. Cut and optimise the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only

(b) 2 only

(c) 1 and 3 only

(d) 1, 2 and 3

Answer: Option (b) 2 only

5.Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)?  (2017)
    1. It decides the RBI’s benchmark interest rates.
    2. It is a 12-member body including the Governor of RBI and is reconstituted every year
    3. It functions under the chairmanship of the Union Finance Minister.

Select the correct answer using the code given below:
(a) 1 only
(b) 1 and 2 only
(c) 3 only
(d) 2 and 3 only

Answer : Option (a) 1 only

6. With reference to Inflation in India, find the correct state statement. (2015)
a. Controlling the inflation in India is the responsibility of the government of India Only
b. The RBI has no role in in controlling the inflation
c. Decreased money circulation helps in controlling the inflation
d. Increased money circulation helps in controlling the Inflation

Answer : Option (c)