Monetary Policy of India

Group 1
Akanksha(F19004); Jeyrashi Johana(F19034); Rebekah Eunice(F19058);
Dulam Sangeetha(F19088); Jhankar Mishra(F19094)
MONETARY POLICY FRAMEWORK AGREEMENT
Under the present Monetary Policy Framework Agreement signed on 20 February 2015, the RBI
will be responsible for containing inflation targets at 4% (with a standard deviation of 2%) in the
medium term.
Under Section 45ZA(1) of the RBI Act, 1934, the Central Government determines the inflation
target in terms of the Consumer Price Index, once in every five years in consultation with the RBI.
This target would be notified in the Official Gazette.

The newly designed statutory framework would mean that the RBI would have to give an
explanation in the form of a report to the Central Government, if it failed to reach the specified
inflation targets.
In the report it shall give reasons for failure, remedial actions as well as estimated time within
which the inflation target shall be achieved.
Further, RBI is mandated to publish a Monetary Policy Report every six months, explaining the
sources of inflation and the forecasts of inflation for the coming period of six to eighteen
months.
MONETARY POLICY COMMITTEE
 Establishment
 Friction between the Government and the Governor of RBI.

 Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary

policy with experts from monetary economics, central banking, financial markets and public

finance advised the Reserve Bank on the stance of monetary policy. However, its role was

only advisory in nature.

 Monetary Policy Committee came into force on 27 June 2016.

 Suggestions for setting up a Monetary policy committee is not new and goes back to 2002

when YV Reddy committee proposed to establish a MPC, then Tarapore committee in 2006,

Percy Mistry committee in 2007, Raghuram Rajan committee in 2009 and then Urjit Patel

Committee in 2013.
 Structure
Composition- 3 members from the RBI and 3 external members nominated by Govt.of India

1. Governor of the Reserve Bank of India – Chairperson, ex officio : Shaktikanta Das

2. Deputy Governor of the Bank, in charge of Monetary Policy—Member, ex officio : BP

Kanungo

3. One officer of the Reserve Bank of India to be nominated by the Central Board -

Member : Michael Patra

4. Shri Chetan Ghate : Professor, Indian Statistical Institute (ISI) – Member;

5. Professor Pami Dua : Director, Delhi School of Economics – Member;

6. Dr. Ravindra H. Dholakia : Professor, Indian Institute of Management, Ahmedabad –

Member.
 Functions
 The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in

formulating the monetary policy. Views of key stakeholders in the economy, and

analytical work of the Reserve Bank contribute to the process for arriving at the

decision on the policy repo rate.

 The Financial Markets Operations Department (FMOD) operationalizes the

monetary policy, mainly through day-to-day liquidity management operations.

 The Financial Markets Committee (FMC) meets daily to review the liquidity

conditions so as to ensure that the operating target of monetary policy (weighted

average lending rate) is kept close to the policy repo rate.

MONETARY POLICY INSTRUMENTS
Quantitative Instruments
These instruments are used to influence the total volume of credit in circulation.

1. Bank Rate (Discount rate) Policy:

It refers to the rate at which the central bank lends money to commercial banks as the lender of last
resort.

Conditions Necessary for Success of Bank Rate Policy:

(i) The lending rates of commercial banks are affected by changes in the bank rate.

(ii) The economic structure of the economy must be flexible. Prices, wages, rent, employment and
production must expand or contract according to the changes in borrowings and investment.

(iii) Commercial banks must possess eligible securities of sufficient amount, which the central bank is
ready to accept.

(iv) Success of Bank Rate Policy depends on the psychology of investors. An increase in bank rate must
discourage the investors and a fall in the bank rate must encourage them for more investment.
2. 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 authorized to sell or purchase treasury bills and
government securities.

1. Sale of securities by 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.
2. Purchase of securities by central bank increases the reserves and raises the bank’s ability to give
credit.

Conditions Necessary for Success of Open Market Operations:

(i) There should exist a well developed and organized security market.

(ii) The reserves of commercial banks should be affected with the sale and purchase of securities.

(iii) The central bank should hold adequate securities to influence money supply in the economy.

(iv) There should not be frequent fluctuations in the value of government securities.
3. Legal Reserve Requirements (Variable Reserve Ratio Method):
Commercial Banks are required to maintain reserves on two accounts:
(i) 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.

(ii) Statutory Liquidity Ratio (SLR):

It refers to 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, unencumbered, government 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.

The Reserve Bank can influence the credit creation power of the banks by making changes in CRR or/and
SLR.
 Repo Rate 5.15%

Reverse Repo Rate 4.90%

Marginal Standing Facility Rate 5.40%

Bank Rate 5.40%

CRR 4.00%

SLR 18.50%
Qualitative Instruments
These instruments are used to regulate the direction of credit.

1. Margin Requirements:
Margin is the difference between the amount of loan and market value of the security offered by
the borrower against the loan.

By changing the margin requirements, the Reserve Bank can alter the amount of loans made
against securities by the banks.
1. An increase in margin reduces the borrowing capacity and money supply.

2. A fall in margin encourages the people to borrow more.

3. RBI may prescribe different margins for different type of borrowers against the security of the
same commodity.

4. Margin is necessary because if a bank gives a loan equal to the full value of security, then bank
will suffer a loss in case of fall in price of security.
2. Moral Suasion:
This is a combination of persuasion and pressure that Central Bank applies on other banks in
order to get them act, in a manner, in line with its policy. Moral suasion is exercised through
discussions, letters, speeches and hints to banks.
The Reserve Bank frequently announces its policy position and urges the banks to cooperate in
implementing its credit policies.

3. Selective Credit Controls:

Under selective credit controls, the RBI gives directions to other banks to give or not to give
credit for certain purposes to particular sectors. This method can be applied in both positive and
negative manner.
In positive manner, it means using measures to channelize credit to priority sectors. The priority
sector includes small-scale industry, agriculture, exports, etc.
In negative manner, it means using measures to restrict flow of credit to particular sectors.
TIGHT MONETARY POLICY
Tight monetary policy implies the Central Bank is seeking to reduce the demand for money and limit the
pace of economic expansion. Usually, this involves increasing interest rates.

The aim of tight monetary policy is usually to reduce inflation.

With higher interest rates there will be a slowdown in the rate of economic growth. This occurs due to
the fact higher interest rates increase the cost of borrowing, and therefore reduce consumer spending
and investment, leading to lower economic growth.
Tight monetary policy can also be termed – deflationary monetary policy.
Tight Monetary policy involves
1.Raising Interest Rates
The RBI could raise the base interest rate. This base rate tends to affect all the other interest rates in the
economy; this is because commercial banks have to borrow from the RBI. So if the base rate rises,
commercial banks tend to put up their own borrowing and saving rates.
Higher interest rates tend to reduce aggregate demand (AD) because:
i. Borrowing becomes more expensive. Therefore firms and consumers are discouraged from
investing and spending.
ii. Saving becomes more attractive. Therefore firms and consumers are more likely to keep saving
money in the bank rather than spend.
iii. Reduced disposable income. Consumers with a variable mortgage will see a rise in monthly
mortgage interest payments. Therefore, they will have less income to spend.
iv. Exchange rate effect:
• the exchange rate tends to appreciate
• help reduce inflationary pressure
• Imports will be cheaper
• less demand for exports
• decline in competitiveness
2. Open Market Operations
The Central bank can also tighten monetary policy by restricting the supply of money. To do this, they
can print less money or sell long-dated government bonds to the banking sector. By selling bonds, banks
see a reduction in liquidity and therefore reduce lending.
A central bank could also raise the minimum reserve ratio. This forces banks to keep more liquidity in
banks.

Effectiveness of tight monetary policy

Higher interest rates may not always bring inflation under control.

There may be time lags, e.g. it can take up to 18 months for interest rates to influence the rest of the
economy, e.g. homeowners may have mortgage rates fixed for a 2 or 5 year period.
If confidence is very high, people may continue to borrow and spend, despite higher interest rates.

If there is cost-push inflation (e.g. rising oil prices), tight monetary policy may lead to lower economic
growth.

Tight monetary policy also conflicts with other macro-economic objectives. The cost of higher interest
rates is a fall in economic growth and possible unemployment.
News 30 January 2018: Livemint
Economic Survey says high interest rates, tight monetary policy slowed GDP
growth
High interest rates, part of a tight monetary policy, caused India’s economic growth to slow at a time
when the world economy had embarked on a synchronous recovery, said the Economic Survey.

According to the survey, until early 2016, India’s growth had been accelerating when other countries
were in the midst of a slowdown. This dynamic later changed with Indian growth “decoupling" from
global growth.

“This tightening of monetary conditions contributed to the divergence in economic activity in two ways.
First, it depressed consumption and investment compared to that in other countries. Second, it
attracted capital inflows, especially into debt instruments, which caused the rupee to strengthen,
dampening both net services exports and the manufacturing trade balance," the survey said.
However, the bigger issues were of the twin balance sheet problem, demonetization and GST, which
disrupted supply chains.

In the previous monetary policy in December,2017, the Reserve Bank of India’s (RBI) monetary policy
committee (MPC) kept key interest rates unchanged, noting risks to inflation, but expressed optimism
that the slowdown in economic growth had bottomed out.
EXPANSIONARY MONETARY POLICY
Expansionary monetary policy aims to increase aggregate demand and economic growth in the economy.
Expansionary monetary policy involves cutting interest rates or increasing the money supply to boost economic
activity.
It could also be termed a ‘loosening of monetary policy’.

How does expansionary monetary policy work?

If the RBI cuts interest rates, it will tend to increase overall demand in the economy.

• Lower interest rates make it cheaper to borrow; this encourages firms to invest and consumers to spend.
• Lower interest rates reduce the cost of mortgage interest repayments. This gives households greater disposable
income and encourages spending.
• Lower interest rates reduce the incentive to save.
• Lower interest rates reduce the value of the Rupee, making exports cheaper and increase export demand.
In addition to cutting interest rates, the Central Bank could pursue a policy of quantitative easing to increase the
money supply and reduce long-term interest rates. Under quantitative easing, the Central bank creates money. It
then uses this created money to buy government bonds from commercial banks.

In theory, this should:

Increase the monetary base and cash reserves of banks, which should enable higher lending.
Reduce interest rates on bonds which should help investment.
Why expansionary monetary policy may not work?
• Cutting interest rates isn’t guaranteed to cause a strong economic recovery. Expansionary
monetary policy may fail under certain conditions.

• If confidence is very low, then people may not want to invest or spend, despite lower
interest rates.
• In a credit crunch, banks may not have funds to lend, therefore although the Central Bank
cuts base rates, it is still difficult to get a loan from a bank.
• Commercial banks may not pass the base rate cut on.
IMPACT OF RATE CUT
On 4 October 2019, RBI brought down repo rate by another 25 bps. Due to this, the current repo
rate is 5.15%.
Bank customer:
The commercial banks usually pass this benefit on to their customers by reducing the interest
rates on the loans they offer. Therefore, every time there is a cut in the repo rate, there usually is
a decline in the interest rates on loans offered by various banks.
Personal loans, car loans, home loans, etc. are expected to get cheaper due to the recent
reduction in the repo rate. However, this will come into effect only if banks decide to pass on the
benefit to their customers.

Industrial sector:
The reduction in the repo rate means that industries may be able to get loans at cheaper interest
rates from lenders. This is likely to result in commodities becoming cheaper due to lower interest
costs, ultimately benefitting you, the end consumer, again.
Why Monetary Policy is unsuccessful?
Some of the reasons are:
• Slow Transmission of Rate Cut By Banks:
There is a slow pass-through of policy rate changes to the interest rates offered by banks.
Banks tend to decrease the deposit rates during rate cuts but do not reduce lending rates right
away. However, when the policy rate increases, lending rates rise quickly, but deposit rates don’t
change that fast.
• Higher proportion of Non-Bank Credit
The credit market in India is largely occupied by non-bank credit providing institutions like
money lenders, cooperatives, relatives, friends etc. This large segment is not affected by
monetary policy instrument.
• Introduction of new financial instruments
Mutual Fund, Venture Capital, IPO etc. have influence on overall liquidity in the economy. The
monetary policy intervention by Reserve Bank of India is insignificant in these segments of
financial system.
• High currency-deposit ratio
The rural economy in India has more inclination towards the usage of cash. Thus there is high
currency-deposit ratio. The monetary policy only touches the deposit section. Thus any
intervention by way of monetary policy has meager effect on economy.
INFLATION TARGETING
Six Principles of Inflation Targeting:
1. The primary role of monetary policy is to provide a nominal anchor (i.e. low, stable long-run inflation expectations) for
the economy; the weights given to any other objective must be consistent with this.

2. Effective inflation-targeting has beneficial first-order effects on welfare by reducing uncertainty, anchoring inflation
expectations and reducing the incidence and severity of boom-bust cycles.

3. Fiscal and other government policies may make the task of monetary policy easier and more credible, or more difficult
and less credible.

4. Because of

• lags in the monetary transmission mechanism, and

• concern for deviations of output from potential, as well as of inflation from the long-run target, following shocks it is
not desirable to aim at keeping inflation exactly on target.

5. In view of possible short-run trade-offs between the inflation targets and other objectives, the conduct of monetary
policy must have sufficient independence from the political process to achieve the announced objectives.

6. Effective monitoring and accountability mechanisms are required to ensure that central banks behave in a manner
consistent with announced objectives and sound practice.
FLEXIBLE INFLATION TARGETING
There was a sharp debate preceding the shift to a flexible inflation target about which measure
of inflation the Indian central bank should target.
India was then in the midst of an inflation crisis. Steep increases in food prices had spilled over
into the general price level after 2010.
The Urjit Patel committee pointed out in its 2014 report that food or fuel price inflation quickly
gets generalized because of inflation expectations. The committee suggested that Indian
monetary policy should thus target headline inflation rather than core inflation.

News on 28.03.2018- LiveMint

It will soon be two years since RBI's monetary policy shifted to flexible inflation targeting. What
has been the record till now?
Flexible inflation targeting seems to have scored some important early victories in India. The
stabilization of inflation expectations as well as the growing credibility of monetary policy means
that monetary policy need not respond frantically to every unexpected shift in price levels.
CONCLUSION
There is a definite and remarkable economic impact of the monetary policy on Indian
economy in the post-reform period. The importance of the monetary policy has been
increasing year after year. Its role is very relevant in attaining monetary objectives,
especially in managing price stability and achieving economic growth. Along with that,
the use and importance of monetary weapons like bank rate, CRR, SLR, repo rate and
the reverse rate have increased over the years. Repo and reverse repo rates are the
most frequently used monetary techniques in recent years. The rates are varied mainly
for curtailing inflation and absorbing excess liquidity thereby maintaining price stability
in the economy. Thus, this short-time objective of price stability is more successful for
the Indian economy rather than other long-term objectives of development.

Monetary policy rules can be active or passive. The passive rule is to keep the money
supply constant, which is reminiscent of Milton Friedman‘s money growth rule. The
second rule, called the price stabilization rule, is to change the money supply in
response to changes in aggregate supply or demand to keep the price level constant.
The idea of an active rule is to keep the price level and hence, inflation in check. In
India, this rule has been dominant, as a stable growth is a healthy growth.
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