Monetary Policy in India

Monetary Policy in India

• The Reserve Bank of India Act of 1934 explicitly mandates the Reserve Bank of India (RBI) with the responsibility of formulating the monetary policy for the country.
• The Finance Act of 2016 amended the RBI Act of 1934 to set up a Monetary Policy Committee (MPC).

Monetary Policy and Inflation in India – Flexible Inflation Target (FIT) Framework

• Launched in 2015 by RBI and the Centre.
• Objective: Ensuring price stability while keeping in mind the objective of growth.
• Major provisions:
  • The inflation target is set by the Centre, in consultation with the RBI, once every 5 years.
  • For the period 2021-25, the inflation is to be kept in the range of 4 (+/-2) percent.
  • The Headline Consumer Price Inflation has been chosen as a key indicator.

Monetary Policy Committee (MPC)

• The idea to set up MPC was mooted by an RBI-appointed Urjit Patel Committee.
• Origin: Under Section 45ZB of the amended (in 2016) RBI Act, 1934, the central government is empowered to constitute a six-member Monetary Policy Committee (MPC).
• Objective: The Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target”.
• Major provisions:
  • The Committee is to meet at least 4 times a year.
  • The Committee will have 6 members.
  • The members of MPC shall hold office for a period of 4 years and shall not be eligible for re-appointment.
  • The quorum for a meeting of the MPC is 4 members.
  • The RBI Governor will have a casting vote in case of a tie
• Composition:
  • RBI Governor – Chairperson
  • RBI Deputy Governor in charge of monetary policy
  • One official nominated by the RBI Board
  • 3 members are appointed by the Central Government.

Monetary Policy Tools in India

• It is classified into two-

Quantitative Tools

• Quantitative tools of monetary policy are aimed at controlling the cost and quantity of credit. They are –

  • Bank Rate or Discount Rate:

    • Bank Rate or Discount Rate is the rate at which the RBI is ready to buy or rediscount Bills of Exchange or other Commercial Papers from the Scheduled Commercial Banks (SCBs).
    • An increase in the Bank Rate results in a tightening of money supply and vice versa.

  • Cash Reserve Ratio (CRR):

    • Cash Reserve Ratio (CRR) is the share of a bank’s total deposit that is mandated by the Reserve Bank of India (RBI) to be maintained with the latter as reserves in the form of liquid cash.
    • The bank cannot use this amount for lending and investment purposes and does not get any interest from the RBI.
    • CRR applies to scheduled commercial banks, while the regional rural banks and NBFCs are excluded.
    • If the RBI increases the CRR, the commercial banks have to deposit more money with the RBI and are left with less money to lend to customers. Thus, the effect is reduced money supply in the economy.
    • If the RBI decreases the CRR, the commercial banks have to deposit less money with the RBI and are left with more money to lend to customers. Thus, the effect is increased money supply in the economy.

  • Statutory Liquidity Ratio (SLR):

    • SLR is a minimum percentage of deposits that a commercial bank has to maintain in the form of liquid cash, gold or other securities. 
    • It is basically the reserve requirement that banks are expected to keep before offering credit to customers.
    • However, these deposits are maintained by the banks themselves and not with the RBI.
    • The SLR is fixed by the RBI.

  • Liquidity Adjustment Facility:

    • A LAF is a monetary policy tool used in India by the RBI through which it injects or absorbs liquidity into or from the banking system.
    • It was introduced as a part of the outcome of the Narasimham Committee on Banking Sector Reforms of 1998.
    • LAF has two components – repo (repurchase agreement) and reverse repo.
      • Repo Rate – Repo Rate is the rate of interest at which the RBI provides short-term loans to SCBs against approved securities.
      • Reverse Repo Rate is the rate of interest at which the RBI borrows funds from the SCBs.

  • Marginal Standing Facility (MSF):

    • Marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter-bank liquidity dries up completely.
    • Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short.
    • The MSF rate is pegged 100 basis points or a percentage point above the repo rate.
    • Under MSF, banks can borrow funds up to one percentage of their net demand and time liabilities (NDTL).

  • Open Market Operations (OMOs):

    • Open Market Operations (OMOs) refer to the buying and selling of government securities by RBI to regulate the short-term money supply.
    • If RBI wants to induce liquidity or more funds in the system, it will buy government securities and inject funds into the system.

  • Market Stabilization Scheme (MSS):

    • Market Stabilization Scheme (MSS) refers to intervention by the RBI to withdraw excess liquidity by selling government securities in the economy.

Qualitative Credit Control

• Margins Requirements: Margin refers to the difference between the value of securities offered for loans and the value of loans actually granted.
• Consumer Credit Regulation: Credit made available by commercial banks (installments) for the purchase of consumer durables is known as consumer credit.
• Moral Suasion: Moral Suasion means persuasion and request. RBI makes the banks adhere to the policy and directives through persuasion or pressure in order to maintain a certain level of money supply in the economy.
• Direct Action: The RBI takes direct action such as refusing to rediscount the bills or charging penal interest rates, etc when a commercial bank does not co-operate with the central bank in achieving its desirable objectives.
• Rationing of Credit or Credit Ceiling: Under this, the RBI fixes a ceiling on the amount of loans that can be granted by SCBs. As a result, SCBs tighten in advancing loans to the public.