Monetary Policy of the Country are formulated and controlled by Central Bank. Monetary policy refers to use the Monetary Instruments to regulate the Financial Markets by way of regulating Interest Rates, Money Supply and availability of Credit in the economy to achieve the objective under the Economic policies of the Country.
Monetary Policy is macroeconomic policy which involves management of money circulation, demand and supply and rate of interest with an objective to control inflation, consumption, growth and liquidity in the market.
In India Reserve Bank of India (RBI) formulate and control the Monetary policy by way and use of monetary instruments to achieve the specified economic goals. The roles and responsibilities explicitly mandated under the Reserve Bank of India Act 1934, which are amended from time to time.
The RBI implement the monetary policy by way of open market operations, bank rate policy, reserve systems, credit control policy, moral persuasion and other instruments. With these instruments RBI lead to changes in money supply and interest rates. When money supply is increased and interest rates are reduced this is known as Expansionary monetary policy and on other side when money supply is reduced and rates are increased this is known as Contractionary monetary policy.
The purpose of Monetary Policy:
The basic purpose of RBI monetary policy is:
- To maintain price stability to maintain suitable growth.
- Implementing flexible inflation targeting framework with an upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.
- To control money supply to achieve microeconomic goals.
- Monetary policy can be broadly classified as either expansionary or contractionary.
- Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations.
- To maintain liquidity is RBI purchase bonds through open market operations, introduces money in the system and reduces the interest rates and vice versa.
The process of Monetary Policy formulation:
The process of Monetary Policy formulation is followed as per the RBI Act, 1934 and is as follows:
1. It empowers six-member Monetary Policy Committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. Which includes,
- Governor of the Reserve Bank of India – Chairperson, ex officio;
- Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex officio;
- One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio;
- Three more members are selected by Government.
2. The MPC determines the policy interest rate required to achieve the inflation target.
3. The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy.
4. The Financial Markets Operations Department (FMOD) operationalises 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 the weighted average call money rate (WACR).
5. 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. With the formation of MPC, the TAC on Monetary Policy ceased to exist.
Instruments of Monetary Policy:
RBI uses various direct and indirect monetary instruments that are used to implement, regulate or change monetary policy from time to time. These are:
- Repo Rate: This is the rate at which RBI lend money to Banks to meet the short term requirement of funds. This the fixed interest rate at which the RBI provides overnight liquidity to banks against the government approved collateral or securities under the liquidity adjustment facility (LAF). This is used to control the inflation.
- Reverse Repo Rate: This is the rate at which RBI borrows money from the Banks in short term. This is the fixed interest rate at which the RBI absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF. This is used to control the money supply in the system.
- Liquidity Adjustment Facility (LAF): This is the tool used in monetary policy that allows banks to borrow money on repurchase agreement (repos) basis or the banks lend to RBI through reverse repo agreement basis. The LAF consists of overnight as well as term repo auctions. The RBI also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.
- Marginal Standing Facility (MSF): This is new window created by RBI in its credit policy of May 2011. MSF is the rate at which the banks are able to borrow overnight funds from RBI against the approved government securities. It is a facility under which banks can borrow additional amount for short term requirement by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This helps in providing a safety valve against unanticipated liquidity shocks to the banking system.
- Corridor: The Corridor in the monetary policy refers to the area between reverse repo rate, which is lowest rate and the MSF rate, which is higher rate. Therefore the MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
- Bank Rate: This is the rate at which the RBI is ready to buy or rediscount bills of exchange or other commercial papers. This rate is aligned to the MSF rate, therefore, it changes automatically with the change in MSF rate.
- Cash Reserve Ratio (CRR): The CRR is an specified minimum fraction of the total deposits of customers which banks needs to hold as reserves in cash or deposits with RBI. The average daily balance that banks need to maintain with RBI as certain percent of its Net demand and time liabilities (NDTL) that are modified by RBI and notify from time to time in the Gazette of India.
- Statutory Liquidity Ratio (SLR): The SLR is the minimum percentage of deposit which banks needs to maintain with RBI in form of cash, gold or other securities. The SLR is the share of Net Demand and Time Liabilities. Changes in SLR often influence the availability of liquidity in the banking system for lending further.
- Open Market Operations (OMOs): The open market operations include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.
- Market Stabilisation Scheme (MSS): The MSS is a monetary policy intervention by RBI to withdrew excess liquidity in the system by selling government securities or bonds. This surplus liquidity of more enduring nature arising from large capital inflows is absorbed through sale of short term government securities and treasury bills.
Open and Transparent Monetary Policy Making:
As per the amended RBI Act, the monetary policy making process is as follows:
1. The MPC meeting needs to be organized at least 4 times a year.
2. At least 4 members of MPC is should be present in the meeting.
3. Each MPC member have one vote, and in case equal votes, the Governor has a casting vote.
4. After the MPC meeting the conclusion and resolution needs to be published with the provision of Chapter 3 F of RBI Act.
5. The minutes of the MPC meeting needs to be published on or before the 14th day and must include:
- The outcome and resolution passed by the MPC.
- The vote of each member on the resolution, describing each part.
- The statement of each member on conclusion and resolution adopted.
In every six months RBI needs to publish the report on Monetary Policy to explain:
- The sources of inflation.
- The forecast of inflation for 6-18 months ahead.
RBI plays an vital role in formulation, controlling and implementing monetary policy for the country and they keen an eye on inflation in the country, liquidity flows, shortage of funds and requirement of monetary instruments or measures to be taken from time to time.