Monetary Policy

Economy - Monetary Policy

Monetary Policy+ Financial Inclusion

• Monetary Policy refers to the measures pertaining to policy undertaken by the Central Bank (RBI) to influence the availability; determine the size and rate of growth of the money supply in the economy.
• In other words, monetary policy can be defined as a process of managing a nation’s money supply to contain/control the inflation, achieving higher growth rates and achieving full employment.
• Generally, all across the globe, monetary policy is announced by the central banking body of the country, for example the RBI announces it in India. India entered into the era of economic planning in 1951.
• The Monetary and Fiscal Policies had to be adjusted to the requirements of the planned development in the country and accordingly, the economic policy of the Reserve Bank was emphasized on two objectives:
  • To speed up the economic development of the nation and raise the national income and standard of living of the people.
  • Control and reduce the “Inflationary” pressure on the economy.

Monetary policy is of two kinds:

• Expansionary Monetary Policy: It increases the supply of money in an economy by making credit supply easily available. Money produced through such a policy is called as cheap money. An expansionary monetary policy is required when an economy goes through a phase of recession accompanied by lower levels of growth/high levels of unemployment. But risk associated with EMP is inflation.
• Contractionary Monetary Policy: It decreases the supply of money in the economy. Contractionary monetary is used to tackle the menace of inflation in the economy by raising the interest rates.

Objectives of Monetary Polity

• In India, as defined by former RBI governor C. Rangarajan, broad objectives of monetary policy are:
  • To regulate monetary expansion so as to maintain a reasonable degree of price stability; and
  • To ensure adequate expansion in credit to assist economic growth
• Further the objectives of Monetary Policy are:
  • It leads to economic growth: The monetary policy can influence economic growth by controlling real interest rates and its resultant impact on the investment. If the RBI opts for a cheap credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth.
  • Price Stability: Inflation and deflation both are not suitable for an economy. Price stability is defined as a low and stable order of inflation. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable.
  • Exchange Rate Stability: If exchange rate of an economy is stable it shows that economic condition of the country is stable. Monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability.
  • It generates employment: Monetary policy can be used for generating employment. If the monetary policy is expansionary then credit supply can be encouraged. It would thus help in creating more jobs in different sector of the economy.
  • Equitable distribution of income: Earlier many economists used to justify the role of the fiscal policy in maintaining economic equality. However, in recent years economists have given the opinion that the monetary policy can play a supplementary role in attainting economic equality.

Methods for Regulation of Monetary Policy

The methodology can be classified into two categories:

1. Quantitative Credit Control Methods:

These are the instruments of monetary policy that affect over all supply of money/credit in the economy. Some are as follows:

Statutory Liquidity Ratio: 

• The Statutory Liquidity Ratio refers to that proportion of total deposits which the commercial banks are required to keep with themselves in a liquid form. The commercial banks generally make use of this money to purchase the government securities.
• Thus, the Statutory Liquidity Ratio, on the one hand, is used to siphon off the excess liquidity of the banking system, and on the other, it is used to mobilize revenue for the government.
• The Reserve Bank of India is empowered to raise this ratio up to 40 per cent of aggregate deposits of commercial banks. At present it is 18.5 per cent. It used to be as high as 38.5 percent at one point of time.

Cash Reserve Ratio: 

• The Cash Reserve Ratio (CRR) is the ratio fixed by the RBI of the total deposits of a bank in India, which is kept with the RBI in cash form.
• CRR deposits do not earn any interest for banks.
• Initially, limits of 4% (lower) and 20% (upper) were set for CRR, but respective amendments removed the limits, therefore providing RBI with much needed operational flexibility. The more the CRR the less the money available for lending by the banks to players in the economy. RBI increases CRR to tighten many supple and lowers CRR to expand credit in the economy.
• CRR as a tool of monetary policy is used when there is a relatively serious need to manage credit and inflation.
• Otherwise, RBI relies on signaling its intent through the policy rates of repo and reverse repo. At present it is 4 percent.

Bank Rate: 

• In basic terms, bank rate is the interest rate at which RBI provides long term credit facility to commercial banks. A change in bank rate affects the other market rates of interest. An increase in bank rate leads to an increase in other rates of interest, and conversely, a decrease in bank rate results in a fall in other rates of interest. Bank rate is also referred to as the discount rate. A deliberate manipulation of the bank rate by the Reserve Bank to influence the flow of credit created by the commercial banks is known as bank rate policy.
• An increase in bank rate results in an increase in the cost of credit or cost of borrowing. This in turn leads to a contraction in demand for credit. A contraction in demand for credit restricts the total availability of money in the economy, and hence results as an anti-inflationary measure of control.
• Likewise, a fall in the bank rate causes other rates of interest to come down. The cost of credit falls, i.e., borrowing becomes cheaper. Cheap credit may induce a higher demand both for investment and consumption purposes. More money through increased flow of credit comes into circulation. A fall in bank rate may, thus, prove an anti-deflationary instrument of control. Penal rates are linked with Bank Rates. For instance if a bank does not maintain the required levels of CRR and SLR, then RBI can impose penalty on such banks. Currently Bank Rate is 7%.
• Nowadays, bank rate is not used as a tool to control money supply, rather Liquidity Adjustment Facility (LAF) (Repo Rate) is used to control the money supply in economy.

Repo Rate:

• If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate.
• Similarly, if RBI wants to make it cheaper for banks to borrow money, it reduces the repo rate. Repo rate stood at 5.75%.

Reverse Repo Rate:

• Reverse Repo is the rate at which the Central Bank (RBI) borrows from the market. This is called as reverse repo as it the reverse of repo operation. Reverse repo rate at present is 50 basis points (or 0.5%) lower than the Repo Rate. Repo and Reverse
• Repo Rates are also referred to as the Policy rates and are often used by the Central Bank (RBI) to send single to the financial system to adjust their lending and borrowing operations.
• Repo rates and reverse repo rates form a part of the liquid adjustment facility.

Open Market Operations (OMOs): 

• It refers to buying and selling of government securities in open market in order to expand or contract the amount of money in the banking system. This technique is superior to bank rate policy. Purchases inject money into the banking system while sale of securities do the opposite.
• It is a common misconception that OMOs change the total stock of government securities, but in reality they only change the proportion of Government Securities held by the RBI, commercial and co-operative banks.
• The Reserve Bank of India has frequently resorted to the sale of government securities to which the commercial banks have been generously contributing. Thus, open market operations in India have served, on the one hand as an instrument to make available more budgetary resources and on the other as an instrument to siphon off the excess liquidity in the system.

Marginal Standing Facility: 

• Marginal Standing Facility is a liquidity support arrangement provided by RBI to commercial banks if the latter doesn’t have the required eligible securities above the SLR limit.
• It is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter-bank liquidity dries up completely.
• The MSF was introduced by the RBI in its monetary policy for 2011-12.
• Under MSF, a bank can borrow one-day loans from the RBI, even if it doesn’t have any eligible securities excess of its SLR requirement (maintains only the SLR). This means that the bank can’t borrow under the repo facility.
• In the case of MSF, the bank can borrow up to 1 % (can be changed by the RBI) below the SLR (means 1% of Net Demand and Time Liabilities or liabilities simply).
• The working of MSF is thus related with SLR. For example, imagine that a bank has securities holding of just 19.5 % (of NDTL). This is equal to its mandatory SLR holding. The bank can’t borrow using the repo facility. But as per the MSF, the bank can borrow 1 % of its liabilities from the RBI. Sometimes the RBI increases the limit of borrowings to 2% of NDTL. As in the case of repo, the bank has to mortgage the securities with the RBI.
• MSF rate and the Repo rate: The bank has to give higher interest rate to the RBI. The interest rate for MSF borrowing was originally set at one percent higher than the repo rate. As on November 2017, the RBI has lowered the difference between repo rate and MSF to 0.25%. The MSF rate and Bank rate are equal.

2. Qualitative Credit Control Methods

These are those tools through which the Central Bank not only controls the value of loans but also the purpose for which these loans are assigned by the commercial banks. Some of these are:

Moral Suasion: 

• Moral suasion means persuasion and request. To arrest inflationary situation Central Bank persuades and requests the commercial banks to refrain from giving loans for speculative and non-essential purposes. On the other hand, to counter defiation Central Bank persuades the commercial banks to extend credit for different purposes.
• Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in general or advances against particular commodities.
• Periodic discussions are held with authorities of commercial banks in this respect.
• In India, from 1949 onwards the Reserve Bank has been successful in using the method of moral suasion to bring the commercial banks to fall in line with its policies regarding credit.

Rationing of credit:  

• Rationing of credit is a method by which the Reserve Bank seeks to limit the maximum amount of loans and advances, and also in certain cases fix ceiling for specific categories of loans and advances. RBI also makes credit flow to certain priority or weaker sectors by charging concessional rates of interest. This is at times also referred to as Priority Sector Lending.

Regulation of Consumer Credit:

• Now-a-days, most of the consumer durables like Cars, Televisions, and Laptops, etc. are available on installment basis financed through bank credit. Such credit made available by commercial banks for the purchase of consumer durables is known as consumer credit.
• If there is excess demand for certain consumer durables leading to their high prices, Central Bank can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of installments of repayment of such credit.
• On the other hand, if there is deficient demand for certain specific commodities causing deflationary situation, Central Bank can increase consumer credit by (a) reducing down payment and (b) increasing the number of installments of repayment of such credit.

Direct action:

• This method is adopted when a commercial bank does not co-operate with the central bank in achieving its desirable objectives. Direct action may be as:
  • Central banks may charge a penal rate of interest over and above the bank rate upon the defaulting banks;
  • Central bank may refuse to rediscount the bills of those banks which are not following its directives;
  • Central bank may refuse to grant further accommodation to those banks whose borrowings are in excess of their capital and reserves.

Margin Requirements:

• Generally, commercial banks give loan against ‘stocks or ‘securities’. While giving loans against stocks or securities they keep margin. Margin is the difference between the market value of a security and its maximum loan value. Let us assume, a commercial bank grants a loan of Rs. 8000 against a security worth Rs. 10,000. Here, margin is Rs. 2000 or 20%.
• If central bank feels that prices of some goods are rising due to the speculative activities of businessmen and traders of such goods, it wants to discourage the flow of credit to such speculative activities. Therefore, it increases the margin requirement in case of borrowing for speculative business and thereby discourages borrowing. This leads to reduction is money supply for undertaking speculative activities and thus inflationary situation is arrested.

Limitations of Monetary Policy

The monetary policy of Reserve bank has played only a limited role in controlling the inflationary pressure. It has not succeeded in achieving the objective of growth with stability.

• The existence of black money in the economy limits the working of the monetary policy. Black money is not recorded since the borrowers and lenders keep their transactions secret.
• Informal money lenders on a large scale in countries like India but they are not under the control of the monetary authority. This factor limits the effectiveness of monetary policy in such countries.
• An important limitation of monetary policy arises from its conflicting objectives. To achieve the objective of economic development, the monetary policy is to be expansionary but contrary to it is to achieve the objective of price stability and curb on inflation. It can be realized by contracting the money supply. The monetary policy generally fails to achieve a proper coordination between these two objectives.
• Another limitation of monetary policy in India is underdeveloped money market. The weak money market limits the coverage, as also the effecient working of the monetary policy.

Monetary Policy Committee

• The Monetary Policy Committee (MPC) is a committee of the Central Bank in India (Reserve Bank of India), headed by its Governor, which is entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level.
• The MPC replaces the current system where the RBI governor, with the aid and advice of his internal team and a technical advisory committee, has complete control over monetary policy decisions.
• A Committee-based approach will add lot of value and transparency to monetary policy decisions.
• Prior to MPC, the RBI governor, with the aid and advice of his internal team and a technical advisory committee, had complete control over monetary policy decisions. This lacked clear objective, accountability and transparency in decision making.
• All the important committees of namely the Y. V. Reddy Committee (2002), Tarapore Committee (in 2006), Percy Mistry Committee (2007), Raghuram Rajan Committee (2009), Dr. Urjit R. Patel (URP) Committee (2013) (discussed below) recommended for a MPC to decide policy actions.
• They all opinioned that “Heightened public interest and scrutiny of monetary policy decisions and outcomes has propelled a worldwide movement towards a committee based approach to decision making with a view to bringing in greater transparency and accountability in India.
• Monetary Policy Committee (MPC) as a statutory committee of the Central Bank in India (Reserve Bank of India), headed by its Governor, which is entrusted with the task of fixing the benchmark policy interest rate (repo rate) to contain inflation within the specified target level. The MPC replaces the current system.
• The MPC will have six members; - the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three members would represent the Government of India. These Government of India nominees are appointed by the Central Government based on the recommendations of a search cum selection committee
• Government nominees of the MPC will hold office for a period of four years and will not be eligible for re-appointment. These three central government nominees in MPC are mandated to be persons of ability, integrity and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy.
• RBI Act prohibits appointing any Member of Parliament or Legislature or public servant, or any employee / Board / committee member of RBI or anyone with a conflict of interest with RBI or anybody above the age of 70 to the MPC.
• Central government also retains powers to remove any of its nominated members from MPC subject to certain conditions and if the situation warrants the same.

Financial Stability and Development Council

• Background: Since April 2009, India was a member of the international agency looking into the issue, namely, Financial Stability Board.
• High Level Coordination Committee on Financial Markets (HLCCFM), was the agency facilitating regulatory coordination, informally
• HLCCFM was the forum to deal with inter-regulatory issues arising in the financial and capital markets, as India follows a multi-regulatory regime for financial sector. It functioned under the Chairmanship of Governor (RBI), with Chairman (SEBI) Secretary (Economic Affairs, Ministry of Finance), Chairman (Insurance Regulatory and Development Authority) and Chairman (Pension Fund Regulatory Development Authority- PFRDA) as members.
• However, it was an informal body and had its own limitations despite being a good mechanism. In the absence of formal instruments, clear specifications as to its functions/powers and an empowered secretariat to nominate and follow up on the decisions of the HLCCFM, its effectiveness has been limited.
• The markets that are regulated by members of the HLCCFM have dramatically changed since 1992. Over time, markets have become more complex and converged and are becoming increasingly integrated. In such a scenario, if the regulators do not take an integrated and holistic view, it was felt that outcomes will be sub-optimal.
• Various Governmental Committees, as given below, have also recommended such an approach to regulation:
  • RBI’s Advisory Group on Securities Market Regulation (RBI-AGSMR 2001);
  • High Level Expert Committee on Making Mumbai an International Financial Centre (MIFC 2007);
  • Committee on Financial Sector Reforms (CFSR 2008);
  • Committee on Financial Sector Assessment (CFSA 2009).
• With a view to strengthen and institutionalize the mechanism for maintaining financial stability and enhancing inter-regulatory coordination, Indian Government setup an apex-level Financial Stability and Development Council (FSDC), in the Union Budget 2010–11.

Composition:

• The Chairman of the FSDC is the Finance Minister of India and its members include the heads of the financial sector regulatory authorities (i.e, SEBI, IRDA, RBI, PFRDA and FMC) , Finance Secretary and/or Secretary, Department of Economic Affairs (Ministry of Finance), Secretary, (Department of Financial Services, Ministry of Finance) and the Chief Economic Adviser.
• The commodities markets regulator, Forward Markets Commission (FMC) was added to the FSDC in December 2013 subsequent to shifting of administrative jurisdiction of commodities market regulation from Ministry of Consumer Affairs to Ministry of Finance.
• Mandate: The Council would monitor macro prudential supervision of the economy, including the functioning of large financial conglomerates. It will address inter-regulatory coordination issues and thus spur financial sector development. It will also focus on financial literacy and financial inclusion. What distinguishes FSDC from other such similarly situated organizations across the globe is the additional mandate given for development of financial sector.