Monetary Policy

The Economic Policy

Definition:

Monetary policy is the process by which the monetary authority of a country controls the supply of money , often targeting a rate of interest for the purpose of promoting economic growth and stability. It uses various tools to influence outcomes like the economic growth, inflation, exchange rates and unemployment.

Objectives Of Monetary Policy:

Growth with stabilitythe main objectives of monetary policy in India are (a) Price stability (b) provisions of adequate credit to productive sectors of the economy to support aggregate demand and ensure high GDP growth. These objectives can be together termed as growth with stability.

 Financial Stability:

Financial stability means the ability of the economy to absorb shocks and maintain confidence in the financial system. Threats to financial stability can come as internal and external shocks, e.g. collapse of major banks or a sudden rise in international oil price. Such shocks can destabilize the countrys financial system and cause volatile and unpredictable changes in the economy. Accordingly, RBI is focuses on regulation, supervision and development of the financial system

Promotion of financial inclusion:

Financial inclusion is the process by which financial services and timely and adequate credit at affordable cost are provided to the weaker sections and low income groups. It has been observed that financial inclusion has not been achieved in case of many sections of society. Therefore, RBI along with NABARD, is focusing on microfinance through the promotion of self help groups and other institutions. These efforts of RBI are expected to reduce income inequality.

Employment generation:

By allocating cheap credit to agriculture and small scale industries, the RBI seeks to generate employment, although maintaining price stability is considered the most important objective of monetary policy. Recent experiences in conducting monetary policy has called for an imperative need for strategic adjustment so as to enable the policy to respond effectively to market disturbances and external sector development, particularly in the context of Indian economy getting integrated with global financial market.

When is the Monetary Policy announced?

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

Instruments of RBI Policy can be classified as under:

(i) Quantitative measures which affect the total money supply and credit

(ii) Qualitative or the selective measures which affect the allocation of bank credit among competing uses and users

Quantitative credit control:

Bank rate: As the lender of the last resort, the RBI helps the commercial banks in temporary need of cash when other sources of raising cash are exhausted. The RBI provides credit to banks by rediscounting eligible bills of exchange and by making advances against eligible securities such as government securities.(6.0%)

Reserve requirements: Reserve requirements are used by RBI to control the credit creation capacity of banks. Every commercial bank needs to maintain a certain proportion of its assets in the form of reserves for fulfilling reserve requirements of the RBI. These reserves are in the form of: Cash Reserve Ratio (CRR)-6.0% Statutory Liquidity Ratio (SLR)-24.0%

Open Market Operations

The RBI can enter the money market for the purchase or sale of government securities on its own account. Every open market purchase of the RBI increase primary money by equal amount while every sale decreases it. Open market operations, consider very effective in developed countries, are not of much importance in India in view of captive nature of the market for government bonds

Repo And Reverse Repo Rates:

Repo at which banks borrow money from RBI (8.50%) Reverse repo rate at which, banks park surplus money with RBI is pegged at 7.50%. The RBI has introduced overnight repos as well as longer-term up to 14 day period.(7.50%)

Qualitative Methods:

Margin requirements:-A loan is sanctioned against a collateral security. Margin is that proportion of value of the security against which loan is not given higher the margin, lesser will be the loan sanctioned in India, bank loans are often used for speculative and unproductive purposes. Discriminatory rates of interest:-Under this method, different rates of interest are charged for different use of credit.

Ceiling on credit:- Under this scheme, the RBI imposes limits on the amount of credit to different sectors. Direct action:- RBI may use strict disciplinary actions against banks that fail to follow its directives. These may be in the form of cancellation of licenses, refusal of rediscounting facility and imposition of penalty.

Monetary Policy Tools:

Monetary base: This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. Reserve requirements: Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Discount window lending: Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.

Interest rates: The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. Currency board: to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives.

Key highlights of RBI's Q2 review of monetary policy FY12:

The Reserve Bank of India (RBI) raised the key policy rates by 0.25% or 25 basis points while keeping cash reserve ratio (CRR) rate unchanged at 6%.
The repo rate, at which banks borrow money from RBI, now stands at 8.50% while reverse repo rate at which, banks park surplus money with RBI is pegged at 7.50%.

The banking regulator revised down its growth forecast for FY12 to 7.6% from 8%, projected earlier.
RBI finally deregulated savings bank interest rates with immediate effect. Accordingly, each bank will offer uniform rate on savings bank up to Rs 1 lakh. Savings bank account rate will be linked with the policy rate at which the central bank lends short-term funds to commercial banks.

Limitations:

Existence of unorganized money market Weak channels of monetary transmissions Unable to control inflation Existence of black money Preference for cash transactions Phasing out of Selective Methods

Conclusion:

RBI has powers to supervise and control commercial and co-operative banks with a view to developing an adequate and a sound banking system in the country.
The RBI has powers to issue licenses to new banks and branches, prescribe minimum requirements regarding paid up capital and reserve, maintenance of cash and other reserves and inspect the working of banks in India and abroad.

The RBI has also powers to conduct ad-hoc investigations from time to time into complaints, irregularities and frauds in banks. The functions of RBI include issue of currency notes, banker to the government, bankers banks, and exchange control authority audit control and agriculture finance. The monetary policy of RBI is regulatory policy whereby the central bank maintains its control over the supply of money for the realization of general economic goals

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