MONETARY POLICY

I.INTRODUCTION
Monetary policy is the macroeconomic policy laid down by the central bank of
an economy. The policy involves an operational framework which uses certain
instruments and targeting mechanisms to achieve macroeconomic objectives
like price stability, reviving consumption, growth and liquidity. The Reserve Bank
of India (RBI) is vested with the responsibility of conducting monetary policy. This
responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.
Monetary policy thus involves the use of monetary instruments under the
control of the central bank to regulate magnitudes such as interest rates, money
supply and availability of credit with a view to achieve certain objectives of
economic policy.

II.EXPANSIONARY MONETARY POLICY VERSUS CONTRACTIONARY MONETARY

POLICY
The monetary policy response depends on the economic state of affairs of the
economy. Based on which, the monetary policy may be categorized in one of two
ways: expansionary monetary policy or contractionary monetary policy.
a) Expansionary Monetary Policy: This is known as loose monetary policy,
expansionary policy increases the supply of money and credit to generate
economic growth. A central bank may deploy an expansionist monetary policy
to reduce unemployment and boost growth and investment during hard
economic times.
The overall goal of any expansionary policy is to encourage spending and
borrowing. This is done by reducing the interest rate, subsequently providing
easier and cheaper loans to the borrowers. According to economic theory, more
money available to individuals and businesses at lower cost will result in the
increased purchase of goods and services, thus stimulating growth.
b) Contractionary Monetary Policy: Tight or contractionary monetary policy is
used to prevent inflation due to economy growing too fast (over-heating). It aims
at reducing the money supply, raising the interest rates and therefore,
discouraging borrowing in the economy. Business investment will decline
because it is less attractive for firms to borrow money. In addition, higher interest
rates will also discourage consumer borrowing for big-ticket items like houses
and cars. Figure 2 gives a schematic representation of how the above two
policies change the output and price level in an economy:

Figure 2 Change in Monetary policy and its influence on output and price level

Note- M- Money supply, r- rate of interest, I – Investment, C- Consumption

demand, P – Prices.
III.INSTRUMENTS OF MONETARY POLICY There are several direct and indirect
instruments that are used for implementing monetary policy.
1. Bank Rate: It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers.
2. Cash Reserve Ratio (CRR): The average daily balance that a bank is required
to maintain with the Reserve Bank as a share of such per cent of its Net demand
and time liabilities (NDTL).The Reserve Bank may notify CRR from time to time in
the Gazette of India.
3. Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to
maintain in safe and liquid assets, such as, government securities, cash and gold.
Changes in SLR often influence the availability of resources in the banking system
for lending to the private sector.
4. Open Market Operations (OMOs): These include both, outright purchase and
sale of government securities, for injection and absorption of durable liquidity,
respectively.
5. Repo Rate: The (fixed) interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government and other
approved securities under the liquidity adjustment facility (LAF).
6. Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank
absorbs liquidity, on an overnight basis, from banks against the collateral of
eligible government securities under the LAF.
7. Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as
term repo auctions. It is used to make temporary and swift adjustments in
liquidity within the banking system mainly using the repo and reverse repo rates.
8. Marginal Standing Facility (MSF): A facility under which scheduled
commercial banks can borrow additional amount of overnight money from the
Reserve Bank. This provides a safety valve against unanticipated liquidity shocks
to the banking system.
9. Corridor: The MSF rate and reverse repo rate determine the corridor for the
daily movement in the weighted average call money rate.
10. Market Stabilisation Scheme (MSS): This instrument for monetary
management was introduced in 2004. Surplus liquidity of a more enduring
nature arising from large capital inflows is absorbed through sale of shortdated
government securities and treasury bills.
IV. Qualitative Instruments or Measures:
RBI also makes use of certain qualitative or selective instruments to control and
regulate the flow of credit into particular industries or sector of the economy
(Encouraging productive and socially desirable sectors and discouraging
unproductive and socially undesirable sector). The important instruments of
qualitative instruments are:
1.Fixation of Margin: The bank gives loan on the basis of tangible security or
collateral security. The RBI fixes the minimum marginal requirements on loan for
purchasing or carrying securities. Market value of the security and the amount
lent by the bank against security is called Margin requirement. If the Central bank
fixes a margin of 20% then, on a security of 10,000, the bank will lend rs 8,000
only. If the central bank is to restrict credit to socially undesirable sector, it may
raise the margin to25%. In that case bank will be able to lend rs 7,500 only. In
case the central bank desires to expand credit to socially desirable channels it
may lower margin to 10%.
2) Regulation of Consumer Credit: Regulation of Consumer Credit aims at
regulating the demand for consumer durables like Refrigerator, TV set, Laptop,
Computer, etc. (Or in order to facilitate their demand-either minimum down
payment is raised or maximum period of repayment is lowered in order to curb
their demand for these goods, reverse measures are taken.
3) Direct Action: Direct action refers more or less, a corrective measure against
those commercial banks who fails to toe the line of the central bank monetary
policy. It may refuse to rediscount their bills of exchange or grant them other
financial accommodation, or come to their rescue in their crisis hour. However
commercial banks can ill-afford to earn the wealth of the central bank and be its
defaulter.

4) Moral Persuasion and Publicity: As a leader of commercial banks, the central

bank persuades them to follow a particular monetary policy in the face of
prevailing situation of the economy. In view of the vast statutory powers of the
central bank, the commercial banks due heard to what the former says. Another
way of moral pressure is the use of publicity medium. It influences the credit
policies of the commercial banks to sensitize the people regarding the economic
and monetary condition of the country. It publishes weekly or monthly or
quarterly statements of the assets and liabilities of the commercial banks as well
as reviews of credit and business conditions, reports on its own activities, money
market and banking conditions etc for the benefit of general public.
5) Control through Directives: Banks are directed by the central bank to be
liberal in granting credit to the priority sectors, like agriculture, power,
infrastructure, housing education, etc rather than less priority sectors.
6) Rationing of Credit: Rationing of Credit is practiced to check credit flow to
speculative activities by allotting credit quota for diverse business activities. The
banks are not allowed to exceed quota limits at the time of granting loans. These
various tools can be used for formulating a proper monetary policy to influence
levels of aggregate output, employment and prices in the economy.

V. GOALS OF MONETARY POLICY

Goals refer to the final policy objectives of the monetary policy.
In any monetary policy framework, a key ingredient is the enunciation of its
objectives as its actions are guided foremost by the objectives. These may
include: price stability, economic growth and financial stability.
1. Price Stability: The primary objective of monetary policy is to maintain price
stability while keeping in mind the objective of growth. Price stability is a
necessary precondition to sustainable growth.In May 2016, the Reserve Bank of
India (RBI) Act, 1934 was amended to provide a statutory basis for the
implementation of the flexible inflation targeting framework.
2. Economic Growth: One of the most important objectives of monetary policy
in recent years has been the rapid economic growth of an economy. The RBI, by
keeping the prices steady and maintaining overall financial stability, has the
ability to promote economic growth, leading to prosperity over time.
3. Financial Stability: Financial system stability means the effective functioning
of the financial system (financial institutions and markets) and the absence of
banking, currency, balance of payments and exchange rate crisis. By forestalling
or mitigating the consequences of financial instability for the economy, the
central banks help alleviate liquidity pressures and boost public confidence.
Formulating appropriate financial regulations, implementing effective bank
supervision, and operating or overseeing efficient payment systems are few ways
through which central banks help to offset the risks of financial instability.
4.Stability in Foreign Exchange Rates: Exchange rate stability was the traditional
methods of monetary policy. To achieve equilibrium in the balance of payments
monetary policy controls the flow of credit. Exchange stability means there is not
much rise or fall in the rate of interest. If there is deficit in balance of payments
the total supply of money is reduced and the domestic rate of interest is lowered
it brings down the price level and thereof encourages exports and discourages
import however whenever there is surplus in the balance of payments, the
supply of money can is increased and rate of interest on foreign loans.
5.Full employment: Full employment can be achieved in an economy by
following an expansionary monetary policy. Monetary policy aims to achieve full
employment level through infusing the flow of credit by keeping interest rates
low in order to boost production activities. By providing concessional to
productive sectors monetary policy promotes employment.
VI. Role of Monetary Policy in Economic Development and Growth
Economic development and growth is main objective of the economic policies of
developing countries in the world. Monetary policy does not confine to provide
solution to boom and depression but also to the development
The role of monetary policy in economic development and growth may be stated
below:

• Price stability: Maintenance of stability in the domestic price level is an

important condition for economic condition for economic development and
growth. In under-developed countries inflation is most susceptible. It generally
occurs when there is an abnormal increase in the effective demand due to
government expenditure. The monetary authority should keep a constant watch
on the movement of prices by regulating the supply of money and credit so that
inflation can be controlled.

• Appropriate Adjustment between Demand for and Supply of money: In the

underdeveloped countries economic fluctuation occurs because of lack of
proper adjustment between demand for and supply of money. Economic
development results in rising demand for money because of the increase in the
volume of production and transaction. The regularly rising demand for money
makes it imperative for the monetary authority to increase the supply of money
at a rate that is roughly equal to the rate of increase in real income.

• Strengthen Financial Institutions: Monetary policy can speed up the process of

economic development by improving the currency and credit system of the
country. To achieve the purpose more banks and financial institutions need to
be established for larger credit facilities and to mobilize savings for productive
purposes. The expansion of banks and other non banking financial institutions
can help both in generating banking habits among the public and transform
savings into capital formation

• Suitable Interest Rate Structure: Monetary policy can help in developing

countries to adopt most appropriate interest rate structure which can stop
fluctuations in the money market as well as investment activities. If economy
wants to establish equilibrium between saving and investment then appropriate
interest structure should be followed.

• Monetary Policy and Investment: Monetary policy has an important role to play
in boosting up the level of investment by making available saving or resources
mobilized by banks for the purpose of investment and production. The banks
fulfill this task by offering bank credit for investment to business and industry.

• Promotion: Economic development in developing economy needs economic

planning and monetary policy is a tool for economic planning. Monetary policy
can promote capital formation by encouraging saving in the economy. Monetary
policy by adopting suitable rate of interest and expanding banking facilities can
attract the private investors to invest funds. So, monetary policy can play a
crucial role in the economic development and growth in the developing
countries.
VII. Limitation of Monetary Policies
The importance of monetary policy is realized in the fact it tries to promote
economic development by supervising inflationary and deflationary gaps,
disequilibrium in balance of Payments, stability in exchange rate, infusion of
capital formation yet monetary policy faces certain barriers which are
highlighted as under:
1. Money market is not organized: There is a huge size of money market in our
country which is unorganized such as indigenous bankers like money lenders etc.
they do not come under the control of the RBI. Thus any tool of the Monetary
Policy does not affect the unorganized money market making Monetary Policy
less effective.

2. Large Non-monetized Sector: Large non-monetized sector which hinders the

success of monetary policy since all the transactions conducted therein are mere
barter exchanges. People do not deposit money with banks rather than use them
for conspicuous consumption, etc. Such activities encourage inflationary
pressures because they lie outside the control of the monetary authority.
3. Large Number of NBFLs: Coverage area of Monetary Policy is limited since
Monetary Policy covers only commercial banking sector. Other non-banking
institutions remain untouched. NBFI which do not come under the purview of
monetary policy greatly hampers to achieve the objectives of monetary policy in
the less developed country.
4. Existence of Parallel Economy: The existence of parallel economy limits the
working of the monetary policy. The black money is not recorded since the
borrowers and lenders keep their transactions secret and hidden. Consequently
the supply and demand of money gap arises and also doesn’t remain as desired
by the monetary policy.
5. Deficit Financing: A monitory authority wants to check the supply of money
while deficit financing helps to increase the supply. In today’s scenario deficit
financing is the main source of financing development activities and thereof with
deficit financing objectives of monetary policy becomes inoperative.
6. Only a Persuasive Policy: In underdeveloped economies monetary policy is
soft, persuasive and lenient which sometimes leave a scope of tax evasion,
antisocial elements, black money etc. in the economy which limits the
effectiveness of monetary policy

7. Time lag: Monetary Policy works judiously only after series of time lags. The
time gap between the formulation of the plan and implementation of it is known
as time lag.

VIII.RBI has an important role in the consultation process regarding inflation

targeting. The current inflation targeting framework in India is flexible in
nature.
Flexible Inflation Targeting Framework (FITF)
• Flexible Inflation Targeting Framework: Now there is a flexible inflation
targeting framework in India (after the 2016 amendment to the Reserve Bank of
India (RBI) Act, 1934).
• Who sets the inflation target in India: The amended RBI Act provides for the
inflation target to be set by the Government of India, in consultation with the
Reserve Bank, once every five years.
• Current Inflation Target: The Central Government has notified 4 percent
Consumer Price Index (CPI) inflation as the target for the period from August 5,
2016, to March 31, 2021, with the upper tolerance limit of 6 percent and the
lower tolerance limit of 2 percent.
• Factors that constitute a failure to achieve the inflation target:
(1) the average inflation is more than the upper tolerance level of the inflation
target for any three consecutive quarters, OR
(2) the average inflation is less than the lower tolerance level for any three
consecutive quarters.

IX. The Monetary Policy Framework (MPF):

While the Government of India sets the Flexible Inflation Targeting Framework
in India, it is the Reserve Bank of India (RBI) which operates the Monetary Policy
Framework of the country.
• The amended RBI Act explicitly provides the legislative mandate to the Reserve
Bank to operate the monetary policy framework of the country.
• The framework aims at setting the policy (repo) rate based on an assessment
of the current and evolving macroeconomic situation, and modulation of
liquidity conditions to anchor money market rates at or around the repo rate.
• Note: Repo rate changes transmit through the money market to the entire
financial system, which, in turn, influences aggregate demand – a key
determinant of inflation and growth.
• Once the repo rate is announced, the operating framework designed by the
Reserve Bank envisages liquidity management on a day-to-day basis through
appropriate actions, which aim at anchoring the operating target – the weighted
average call rate (WACR) – around the repo rate.
X. Monetary Policy Committee (MPC)
Now in India, the policy interest rate required to achieve the inflation target is
decided by the Monetary Policy Committee (MPC).
MPC is a six-member committee constituted by the Central Government
(Section 45ZB of the amended RBI Act, 1934).
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.
The resolution adopted by the MPC is published after the conclusion of every
meeting of the MPC.
Once in every six months, the Reserve Bank is required to publish a document
called the Monetary Policy Report to explain:
(1) the sources of inflation and

(2) the forecast of inflation for 6-18 months ahead.

The present Monetary Policy Committee (MPC) The Central Government in
September 2016 constituted the present MPC as under:
1. Governor of the Reserve Bank of India – Chairperson, ex officio
2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy
– Member, ex officio
3. One officer of the Reserve Bank of India to be nominated by the Central Board
– Member, ex officio
4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member

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

6. Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management,
Ahmedabad – Member.(Members referred to at 4 to 6 above, will hold office for
a period of four years or until further orders, whichever is earlier.
XI.The Monetary Policy Process (MPP)
The Monetary Policy Committee (MPC) determines the policy interest rate
required to achieve the inflation target. 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 of arriving at the decision on the policy repo rate.
The Financial Markets Operations Department (FMOD) operationalises the
monetary policy, mainly through day-to-day liquidity management operations.
The Financial Market 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. This
parameter is also known as the weighted average call money rate (WACR).