MONETARY POLICY OF RBI

Introduction The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India. The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as: "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."

Financial Supervision: The Reserve Bank of India performs this function under the guidance of the Board for Financial Supervision (BFS). The Board was constituted in November 1994 as a committee of the Central Board of Directors of the Reserve Bank of India. Objective: Primary objective of BFS is to undertake consolidated supervision of the financial sector comprising commercial banks, financial institutions and non-banking finance companies. Constitution: The Board is constituted by co-opting four Directors from the Central Board as members for a term of two years and is chaired by the Governor. The Deputy Governors of the Reserve Bank are ex-officio members. One Deputy Governor, usually, the Deputy Governor in charge of banking regulation and supervision, is nominated as the Vice-Chairman of the Board. BFS meetings:

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The Board is required to meet normally once every month. It considers inspection reports and other supervisory issues placed before it by the supervisory departments. BFS through the Audit Sub-Committee also aims at upgrading the quality of the statutory audit and internal audit functions in banks and financial institutions. The audit sub-committee includes Deputy Governor as the chairman and two Directors of the Central Board as members. The BFS oversees the functioning of Department of Banking Supervision (DBS), Department of Non-Banking Supervision (DNBS) and Financial Institutions Division (FID) and gives directions on the regulatory and supervisory issues. Functions: Some of the initiatives taken by BFS include: i. ii. iii. iv. restructuring of the system of bank inspections introduction of off-site surveillance, strengthening of the role of statutory auditors and strengthening of the internal defences of supervised institutions.

The Audit Sub-committee of BFS has reviewed the current system of concurrent audit, norms of empanelment and appointment of statutory auditors, the quality and coverage of statutory audit reports, and the important issue of greater transparency and disclosure in the published accounts of supervised institutions. Current Focus :

supervision of financial institutions consolidated accounting legal issues in bank frauds divergence in assessments of non-performing assets and supervisory rating model for banks.

Main Functions: Monetary Authority:

Formulates, implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

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Regulator and supervisor of the financial system:

Prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

Manager of Foreign Exchange :

Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency:

Issues and exchanges or destroys currency and coins not fit for circulation. Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.

Developmental role :

Performs a wide range of promotional functions to support national objectives.

Related Functions :

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker. Banker to banks: maintains banking accounts of all scheduled banks.

Definition of Monetary Policy:

Monetary policy, is the policy statement through which the Reserve Bank of India seeks to regulate the money supply in the economy

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Monetary policy is that part of economic policy in which central bank controls the cost and supply of money and credit by applying different techniques. It is also main function of central bank. We all know, if supply and cost of money are not controlled. Then both are harmful for development of economy. In India RBI is sole institute who is taking steps to regulate money and credit by controlling its supply. Monetary policy regulates both volume and value of currency and credit. The Monetary and Credit Policy is the policy statement, traditionally announced twice a year and dealers in the foreign exchange (forex) market. rough which the Reserve Bank of India seeks to ensure price stability for the economy. These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy. Besides, the RBI also announces norms for the banking and financial sector and the institutions which are governed by it. These would be banks, financial institutions, non-banking financial institutions.

When is the Monetary Policy announced? Historically, the Monetary Policy is announced twice a year - a slack season policy (AprilSeptember) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy. However, with the share of credit to agriculture coming down and credit towards the industry being granted whole year around, the RBI since 1998-99 has moved in for just one policy in April-end. However a review of the policy does take place later in the year Monetary Policy and Fiscal Policy:
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Two important tools of macroeconomic policy are Monetary Policy and Fiscal Policy. The Monetary Policy regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. The Monetary Policy aims to maintain price stability, full employment and economic growth. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements. The Monetary Policy is different from Fiscal Policy as the former brings about a change in the economy by changing money supply and interest rate, whereas fiscal policy is a broader tool with the government. The Fiscal Policy can be used to overcome recession and control inflation. It may be defined as a deliberate change in government revenue and expenditure to influence the level of national output and prices. For instance, at the time of recession the government can increase expenditures or cut taxes in order to generate demand. On the other hand, the government can reduce its expenditures or raise taxes during inflationary times. Fiscal policy aims at changing aggregate demand by suitable changes in government spending and taxes. The annual Union Budget showcases the government's Fiscal Policy

Objective of Monetary Policy The objectives are to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy. Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through
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long and variable periods while the financial markets are also impacted through short-term implications.

There are four main 'channels' which the RBI looks at: Maintain price stability Adequate flow of credit to all sectors of the economy. Exchange Stability Norms for the banking and financial sector and the institutions which are governed by it. Ensure overall economic growth

All this is more linked to the banking sector. How does the Monetary Policy impact the individual? In recent years, the policy had gained in importance due to announcements in the interest rates. Earlier, depending on the rates announced by the RBI, the interest costs of banks would immediately either increase or decrease. A reduction in interest rates would force banks to lower their lending rates and borrowing rates. So if you want to place a deposit with a bank or take a loan, it would offer it at a lower rate of interest. On the other hand, if there were to be an increase in interest rates, banks would immediately increase their lending and borrowing rates. Since the rates of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very important to them also. But over the past 2-3 years, RBI Governor Bimal Jalan has preferred not to wait for the Monetary Policy to announce a revision in interest rates and these revisions have been when the situation arises. Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario. This means that banks are free to decide on interest rates on term deposits and loans. Being the central bank, however, the RBI would have a say and determine direction on interest rates as it is an important tool to control inflation. The bank rate is a tool used by RBI for this purpose as it refinances banks at the this rate. In other words, the bank rate is the rate at which banks borrow from the RBI.

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Scenario prior to recent liberalization:

Prior to recent liberalization, the RBI resorted to direct instruments like interest rates regulation, selective credit control and CRR (cash reserve ratio) as monetary instruments. One of the risks emerging in the past 5-7 years (through the capital flows and liberalisation of the financial sector) is that potential risk has increased for institutions. Thus, financial stability has become crucial and there are concerns relating to credit flows to the agricultural sector and small-scale industries.

Instruments or technique of credit control / monetary policy: Quantitative Measures :

1. 2. 3. 4. 5. 6. 7. 8. Bank Rate Open Market Operation Cash Reserve Ratio / Statutory minimum reserve Changes in Marginal Requirement of loan Moral Persuasion / Inspiration Rationing of Credit Regulation of consumer credit Repo

1. Bank Rate
Bank rate is that rate which is charged by Central bank for issue loan to the member banks. By changing it, central bank can control the credit. If Central bank increase this bank rate, all commercial banks will increase their interest rate by this loan become costly and flow of fund in the form of credit will decrease. If central bank wants to expand credit, then Central bank will decrease bank rate, after this commercial bank can get advance and loan at cheap rate and by this way, they also decrease their interest rate. After this flow of cash in the form of loan will increases.

2. Open Market Operation

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Open market operation is the all action which is done by central bank for purchase and sale of member banks' security in open market. If RBI wants to contract the credit, then RBI will sell the security of member bank and member bank's flow of cash will stop. If RBI wants to expand credit in recession, then RBI will start to buy the security of member banks and member banks get cash and they can now use it for providing more loans to customers.

3. Cash Reserve Ratio / Statutory minimum reserve:

Cash reserve ratio is the minimum percentage of the deposit to be kept as reserve by the banks with central bank. It can be used as the technique of monetary policy. By changing cash reserve ratio, RBI can contract or expand credit in Indian economy. If RBI wants to contract credit, and then RBI will increase this ratio. After this all banks have to keep more fund as reserve with RBI. So, they will decrease the amount of loan due to decrease the total fund available for enterprises. If RBI wants to expand credit, then RBI will decrease this ratio, after this all banks have to keep less fund as reserve with RBI. So, they will issue more credit to public.

4. Changes in Marginal Requirement of loan:

Marginal requirement is the difference between value of security and actual loan accepted by bank. Suppose a person wants to take loan of Rs. 80 , we has to give security of Rs. 100 then marginal requirement is Rs. 100 - Rs. 80 = Rs. 20 . If RBI wants to contract the credit , this rate will increase suppose , if RBI fixes it as 40 % , then customer can get loan of Rs. 60 after giving security of Rs. 100 . So , trend of getting loan will decrease . If RBI wants to expand the credit, this rate will decrease suppose, if RBI fixes it as 10% more people will take loan , if they get Rs. 90 in cash after giving security of Rs. 100 . So , by this way RBI controls credit .

5. Moral Persuasion / Inspiration

RBI as central bank of country can control credit with moral persuasion. Under this persuasion, RBI can call a meeting of all commercial bank and give advice in discussion that they should not give loan for speculative purposes.
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6. Rationing of Credit
RBI has right to create ration of credit under monetary policy. It can be done by following way:-

To fix the amount of loan for a particular bank. To fix Quota for all banks. To fix Quota for different traders.

7. Regulation of consumer credit

In case inflation, prices are increased. To control prices central bank contract c redit to reduce the total amount of installment for payment. In case of deflation, prices are decreased to control prices central bank expand credit to increase the amount of installment.

8. Repo
A repurchase agreement or ready forward deal is a secured short-term (usually 15 days) loan by one bank to another against government securities. Legally, the borrower sells the securities to the lending bank for cash, with the stipulation that at the end of the borrowing term, it will buy back the securities at a slightly higher price, the difference in price representing the interest.

Money Supply (M3)

This refers to the total volume of money circulating in the economy, and conventionally comprises currency with the public and demand deposits (current account + savings account) with the public.
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The RBI has adopted four concepts of measuring money supply. The first one is M1, which equals the sum of currency with the public, demand deposits with the public and other deposits with the public. Simply put M1 includes all coins and notes in circulation, and personal current accounts. The second, M2, is a measure of money, supply, including M1, plus personal deposit accounts plus government deposits and deposits in currencies other than rupee. The third concept M3 or the broad money concept, as it is also known, is quite popular. M3 includes net time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1

Expansionary Monetary Policy:

When the economy is faced with recession or involuntary cyclical unemployment, which comes about due to fall in aggregate demand, the central bank intervenes to cure such a situation. Central bank takes steps to expand the money supply in the economy and or lower the rate of interest with a view to increase the aggregate demand which will help in stimulating the economy. The following three monetary policy measures are adopted as a part of an expansionary monetary policy to cure recession and to establish the equilibrium of national income at full employment level of output. The central bank undertakes open market operations and buys securities in the open market. Buying of securities by the central bank chiefly from commercial banks will lead to the increase in reserves of the banks. With greater reserves, commercial banks can issue more credit to the investors and businessmen for undertaking more investment. More private investment will cause aggregate demand curve to shift upward. Thus buying of securities will have an expansionary effect. The central bank may lower rate. At a lower bank rate, the commercial banks will be induced to borrow more from the central bank and will be able to issue more credit at the lower rate of interest to businessmen and investors. This will not only make credit cheaper but also increase the availability of credit or money supply in the economy. The expansion in credit or money supply will increase the investment demand which will tend to raise aggregate output and income. The central bank may reduce the cash reserve ratio (CRR) to be kept by the commercial banks. This is a more effective and direct way of expanding credit and increasing money supply in the economy by the central bank. With lower reserve requirements, a large amount of funds is released for providing loans to businessmen and investors. As a result, credit expands and investment increases in the economy which has an expansionary effect on
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output and employment. Statutory liquidity ratio (SLR) changes the lending capacity and therefore credit availability in the economy. To increase the lendable resources of commercial banks, central bank can lower SLR. Thus, when central bank lowers SLR, the credit availability for the private sector will increase.

Restrictive or Tight Monetary Policy:

When the economy is faced with inflation, the central bank intervenes to cure such a situation. Central bank takes steps to reduce the money supply in the economy and or higher the rate of interest with a view to decrease the aggregate demand. The following four monetary policy measures are adopted as a part of an restrictive or tight monetary policy to cure inflation and to establish the equilibrium of national income at full employment level of output. The central bank sells the government securities to the banks, other depository institutions and the general public through open market operations. This action will reduce the reserves with the banks and liquid funds with the general public. With less reserve with the banks, their lending capacity will be reduced. Therefore, they will have to reduce their demand deposits by refraining from giving new loans as old loans are paid back. As a result, money supply in the economy will shrink. The bank rate may also be raised which will discourage the banks to take loans from the central banks. This will tend to reduce the availability of credit and also raise its cost. This will lend to the reduction in investment spending and help in reducing inflationary pressures. The most important anti-inflationary measure is the raising of statutory cash reserve ratio (CRR). To meet the new higher reserve requirements, banks will reduce their lending. This will have a direct effect on the contraction of money supply in the economy and help in controlling demand-pull inflation. Besides CRR, SLR can also be increased through which excess reserves of the banks are mopped up resulting in contraction in credit. An important anti-inflationary measure is the use of qualitative credit control, namely, raising of minimum margins for obtaining loans from banks against the stocks of sensitive commodities such as foodgrains, oilseeds, cotton, sugar, vegetable oil. As a result of this measure, businessmen themselves will have to finance to a greater extent the holding of inventories of goods and will be able to get less credit from banks.

Impact of cut in CRR on interest rates:

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From time to time, RBI prescribes a CRR or the minimum amount of cash that banks have to maintain with it. The CRR is fixed as a percentage of total deposits. As more money chases the same number of borrowers, interest rates come down.

Impact of SLR on interest rates:

SLR reduction is not so relevant in the present context for two reasons: First, as part of the reforms process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared to earlier for their statutory investments in government securities. Second, banks are still the main source of funds for the government. This means that despite a lower SLR requirement, banks' investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be high despite the RBI bringing down the minimum SLR to 25 per cent a couple of years ago. Therefore, for the purpose of determining the interest rates, it is not the SLR requirement that is important but the size of the government's borrowing programme. As government borrowing increases, interest rates, too, rise. Besides, gilts also provide another tool for the RBI to manage interest rates. The RBI conducts open market operations (OMO) by offering to buy or sell gilts. If it feels interest rates are too high, it may bring them down by offering to buy securities at a lower yield than what is available in the market.

Effect of Monetary Policy on domestic and exporters in particular:

Exporters look forward to the monetary policy since the central bank always makes an announcement on export refinance, or the rate at which the RBI will lend to banks which have advanced pre-shipment credit to exporters. A lowering of these rates would mean lower borrowing costs for the exporter.

Stock Market and Money:

Most people attribute the link between the amount of money in the economy and movements in stock markets to the amount of liquidity in the system. This is not entirely true.

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The factor connecting money and stocks is interest rates. People save to get returns on their savings. In true market conditions, this made bank deposits or bonds (whose returns are linked to interest rates) and stocks (whose returns are linked to capital gains), competitors for people's savings. A hike in interest rates would tend to suck money out of shares into bonds or deposits; a fall would have the opposite effect. This argument has survived econometric tests and practical experience.

Relation of money supply to jobs, wages and output :

At any point of time, the price level in the economy is determined by the amount of money floating around. An increase in the money supply - currency with the public, demand deposits and time deposits - increases prices all round because there is more currency moving towards the same goods and services. Typically, the RBI follows a least-inflation policy, which means that its money market operations as well as changes in the bank rate are generally designed to minimize the inflationary impact of money supply changes. Since most people can generally see through this strategy, it limits the impact of the RBI's monetary moves to affect jobs or production. The markets, however, move to the RBI's tune because of the link between interest rates and capital market yields. The RBI's policies have maximum impact on volatile foreign exchange and stock markets. Jobs, wages and output are affected over the long run, if the trends of high inflation or low liquidity persist for very long period. If wages move slower than other prices, higher inflation will drive real wages lower and encourage employers to hire more people. This in turn ramps up production and employment. This was the theoretical justification of a long-term trend that showed that higher inflation and employment went together; when inflation fell, unemployment increased.

Measures to regulate money supply:

The RBI uses the interest rate, OMO, changes in banks' CRR and primary placements of government debt to control the money supply. OMO, primary placements and changes in the CRR are the most popular instruments used.

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Under the OMO, the RBI buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system. The changes in CRR affect the amount of free cash that banks can use to lend - reducing the amount of money for lending cuts into overall liquidity, driving interest rates up, lowering inflation and sucking money out of markets.

Qualitative Measures:
This method is used to control the flow of credit to particular sectors of the economy. The direction of credit is regulated by the central bank. This method is used as a complementary to quantitative credit control discourage the flow of credit to unproductive sectors and speculative activities and also to attain price stability. The main instruments used for this purpose are:

1. 2. 3. 4. 5.

Rationing of credit Direct action Moral suasion Regulation of consumer credit Changes in margin requirements

1. Rationing of credit:
The amount of credit to be granted is fixed by the central bank. Credit is rationed by limiting the amount available to each commercial bank. The RBI can also restrict the discounting of bills. Credit can also be rationed by the fixation of ceiling for loans and advances.

2. Direct action:
It is an extreme step taken by the RBI. It involves refusal by RBI to extend credit facilities, denial of permission to open new branches etc. RBI also gives wide publicity about the erring banks to create awareness amongst the public.

3. Moral suasion:
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RBI uses persuasion to influence lending activities of banks. It sends letters to banks periodically, advising them to follow sound principles of banking. Discussions are held by the RBI with banks to control the flow of credit to the desired sectors.

4. Regulation of consumer's credit:

Apart from trade and industry a great amount of credit is given to the consumers for purchasing durable goods also. RBI seeks to control such credit in the following ways: a) by regulating the minimum down payments on specific goods. b) by fixing the coverage of selective consumers durable goods. c) by regulating the maximum maturities on all installment credit. d) by fixing exemption costs of installment purchase of specific goods.

5. Changes in margin requirements :

While lending commercial banks accept securities, deduct a certain margin from the market value of the security. This margin is fixed by the central bank and adjust according to the requirements. This method affect the demand for credit rather than the quantity and cost of credit. This method is very effective to control supply of credit for speculative dealing in the stock exchange market. It also helps for checking inflation when the margin is raised. If the margin is fixed as 30%, the commercial banks can lend up to 70% of the market value of security. This method has been used by RBI since 1956 with suitable modifications from time to time as per the demand and supply of commodities.

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