What is Monetary Policy in India & its 2 Important Tools?

what is monetary policy
Table of content
What is Monetary Policy
Objectives of Monetary Policy
Role of RBI in Monetary Policy
Tools of Monetary Policy
Conclusion
FAQ

What is Monetary Policy is the number 1 question we all have in our mind when we think about our economy & how it affects our day to day activities.

How prices of certain goods go up & down overnight?

How our loans become cheaper & expensive in a flash?

How is it that we can spend more money than our parents & still see poverty around?

There are many questions regarding how money is managed & generated in the system, but the answer is one-Monetary Policy.

Right from cash flow to price stability which ultimately leads to economic development, is all been handled by the Monetary Policy of India.

As to understand the game, we must understand the rules of the game. 

Here the name of the game is Monetary Policy. And to understand it better & make an informed decision, we must understand the objectives & functions of the Monetary Policy.

What is Monetary Policy?

The Monetary Policy means, set of principles & rules to manage cash flow & price fluctuations in the economy.

It also implies that monetary Policy controls the supply of money in the economy and the rate of interest. In India, RBI manages monetary Policy.

It is one of the primary functions of the Reserve Bank Of India to control the cash flow in the economy and also ‘the cost of credit.’

In simple words, it means how much money is available for the industry or the economy and what is the interest that the economy has to pay to borrow that money. “Availability of money” denotes liquidity and the “cost of borrowing” rate of interest.

But how does it affects us?

Liquidity & rate of interest directly impacts inflation & growth in the economy.RBI uses specific tools like Cash Reserve Ratio(CRR), Statutory Liquidity Ratio(SLR), Repo Rate & Reverse Repo Rate to monitor & control both.

We will talk about these tools in detail later in the article; for now, let us conclude what is Monetary Policy?

So, the following points summarise Monetary Policy-

  1. RBI manages Monetary Policy in India as mandated under the Reserve Bank of India Act,1934.
  2. Monetary Policy aims at controlling inflation & boosting economic growth.
  3. Liquidity in the economy & the cost of borrowing directly impacts inflation & economic growth.
  4. For achieving the targeted inflation & growth, Monetary Policy uses specific tools such as Repo Rate , Reverse Repo rate ,Cash Reserve Ratio(CRR), Statutory Liquidity Ratio(SLR) etc. to monitor & control both.

In a nutshell, Monetary Policy is the set of measures adopted by the Reserve Bank of India for monetary management.

So now, when we are clear about what is Monetary Policy, let us dive in deeper, checking upon its objectives, functioning & instruments.

Objectives of Monetary Policy

It is evident from our discussion on what is monetary policy that its primary objective is to take care of the rate fluctuations for the ultimate goal of economic stability.

All the economic tools & policies reel towards controlling inflation, employment generation, currency rate stability ultimately leading to economic development.

Price stability is the pre requisite for economic development.Let us discuss some of the objectives of Monetary Policy of India

Employment generation-

Employment generation is not only the primary goal of monetary policy but of the government as well. Employment ensures good quality of life.

With employment comes constant money in the household, which in turn is used for expenses & thus creating money flow in the whole economic system.

From the economic point of view too, when there is a lot of unemployment, there is not only an abundance of idle human resources but also physical resources such as closed factories & unused equipment. This finally results in loss of output (lower GDP). So, it is an opportunity loss wherein the total output is always less than the potential output.

Zero unemployment is also not the ideal scenario,considering the fact that voluntary unemployment, which is also called fractional unemployment, is beneficial to the economy.

For example, when a worker voluntarily leaves his employment seeking better opportunity or for pursuing further studies or hobby or looking after the family, but when they decide to come back, they should get a job within a reasonable period of time.

Thus the ideal scenario is not a hundred per cent employment but to match the demand of labour to the demand of supply & this is what the monetary policy of India strives for.

2. Price Stability

Price stability needs to be monitored, manipulated & maintained in a developing country like India because a fluctuating price level (inflation) leads to uncertainty in the economy.

Fluctuation in price affects investment decisions. It also leads to increased income disparities(rich becoming richer & poor becoming poorer).

High inflation may create social conflicts & lead to political instability and economic downfall.Hence a decent inflation needs to be maintained.

3.To Regulate Money Supply in the Economy:

Money supply refers to the liquidity of cash in the market. Monetary policy is formulated to regulate the liquidity in the market by credit expansion (giving more loans) and by credit contraction (by giving fewer loans).

Credit expansion increases liquidity in the market & credit contraction decreases liquidity.

So monetary policy aims to manipulate the money supply so that it expands liquidity to meet the needs of economic growth and, at the same time, contract it to curb inflation.

4.To Control Business Cycles:

Through credit expansion & credit contraction, monetary policy controls the boom & slump of the business cycle.

During the period of boom, credit contraction is done to reduce liquidity and control inflation. During the slump period, credit expansion is applied to increase liquidity in the system, thus promoting demand.

5.Stable Foreign Currency Exchange:

Fluctuations in the exchange rate of a currency affect foreign trade & investment. So it is, therefore, the objective of the monetary policy to ensure external stability in prices. Fluctuations in foreign currency rates dampen the trade between nations. It also reduces the credibility of the domestic currency.

We can safely say all the tools & rules of monetary policy aim to promote economic growth in the end.

Role of RBI in Monetary Policy

Reserve Bank of India has the primary role to play in the formulation & implementation of the monetary policy of India.

Reserve Bank of India (RBI) Act, 1934 was amended in May 2016, and RBI was given a statutory basis for implementing the flexible inflation-targeting framework.

As per the act, the inflation target has to be finalized by the Government of India once every five years in consultation with the Reserve Bank of India.

RBI announces monetary policy every year in April. Three quarterly reviews follow it in July, October & January.

However, it has the discretion of announcing corrective measures at any time of the year.

The functions of RBI in the context of monetary policy are as under-.

  • Using the monetary policy tools, RBI can increase & decrease the liquidity in the system to maintain price stability & check too much inflation.
  • RBI makes efforts for the controlled expansion of Bank credit & helps commercial banks in credit creation. It also decides on credit allocation to priority & marginal sectors.

Tools of monetary policy-

RBI uses credit control to control the demand & supply of money (liquidity) in the economy. It administers control over the credit that the commercial bank grants.

RBI uses this method to bring economic development with stability. It means that Bank will control not only inflationary trends in the economy but also boost economic growth. It would to ultimately lead to an increase in real national income with stability.

The Reserve Bank of India uses two credit control measures-

1.Quantitative control, also known as indirect control, uses tools like Bank Rate, Repo Rate, Reverse Repo Rate, CRR, SLR & Open Market Operations.

2.Qualitative, also known as the direct control measures by using change in the margin money, direct action & moral suasion

Both methods affect aggregate demand through the supply of money, cost of funds, and credit availability.

The first category of the two types of instruments includes bank rate variations, open market operations, and changing reserve requirements (cash reserve ratio, statutory reserve ratio). Policy instruments are meant to regulate the overall level of credit in the economy through commercial banks.The selective credit controls aim at controlling specific types of credit. They include changing margin requirements and regulation of consumer credit.

Qualitative control

There are four qualitative control/direct control measures-

Margin Requirement-

It means how much securities are offered and how much is borrowed by the Banks

Credit Rationing-

Reserve Bank of India rations the credit that can be issued to the banks.

Moral Suasion-

Controlling credit through psychological means & playing on emotions.

Direct action-

direct action against banks who do not follow RBI directives in the form of fines & bans.

Quantitative Control-

There are four qualitative/indirect control measures.

Bank rate-

RBI is the banker of the banks & bank rate refers to the rate at which RBI lends banks money. Bank rates affect the rates of interest charged by the banks from the customers who lend money from Banks.

To curb liquidity, the RBI can resort to raising the Bank rate & vice versa.

Base Rate-

It is the minimum rate at which Banks can. Lend money to the customers. For example, if Base Rate is 5%, Banks cannot lend money to the customers under any scenario for less than 5%.

Base rate is decided to enhance transparency in the credit market & ensure that the Banks pass on the lower cost of funds to the customers.

Loan pricing will be done by adding a base rate and a suitable spread depending upon the credit risk premium.

Call money rate

Call money rate is when Banks lend & borrow short-term funds for a day in the money market.
Banks resort to these types of loans to fill the asset-liability mismatch, comply with the statutory CRR & SLR requirements, and meet the sudden demand of funds.
RBI, banks, primary dealers, etc. are the participant of the call money market
Demand & supply of liquidity affect the call money rate
A highly liquid market leads to a fall in call money rate & vice versa.

The Repo Rate

When the RBI lends money to the Banks for a short-term period, they lend it a benchmark rate. This rate is called the repo rate.
When the repo rate increases. the borrowing from the RBI becomes more expensive
If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate & if it wants to make it cheaper, it reduces the repo rate.
But how does it affects us as an individual?
If the loans become expensive for the Bank, it becomes expensive for us too & it contracts liquidity in the market & vice versa.

Reverse Repo Rate

The reverse repo rate is the short-term rate at which RBI borrows money from commercial banks.
RBI uses this tool when it sees too much money floating in the system & inflation is rising.
The high reverse repo rate will give banks a higher interest rate from RBI & they would deposit more of their money to RBI than lend them in the market.

Cash Reserve Ratio(CRR)

The Cash Reserve Ratio or CRR is the minimum amount of cash out of the total cash reserve of a Bank that needs to be deposited at RBI.

In India, Banks don’t hold much cash with themselves: they deposit excess cash with RBI, which is considered holding cash.
When this ratio is increased, Banks don’t have enough liquidity to pump cash into the market & vice versa.

Statutory Liquidity Ratio

All banks are required to maintain at the close of business every day a minimum proportion of their net demand and time liabilities as liquid assets in the form of cash, securities & gold.

The ratio of demand and time liabilities to liquid assets is known as the Statutory Liquidity Ratio(SLR)
RBI is empowered to increase this ratio upto forty percent.

Conclusion

RBI manages and manipulates monetary policy of India & helps strenghtening the Indian Economy & promotes growth.

FAQs

Who controls monetary policy in India?

RBI controls monetary policy of India as per RBI Act 1934 under supervision of the Indian Government.

How many times monetary policy reviewed in a year?

Monetary Policy is reviewed 3 times in a year

Who formulates the monetary policy in india

RBI formulates Monetary Policy in India

What do you mean by monetary policy

Monetary policy refers to the tools used by the RBI to manage inflation & expedite economic growth in the country.

How monetary policy control inflation

Whenever the system has excess cash RBI through monetary policy contracts liquidity from the system & vice versa leading to inflation control.


What are the tools of monetary policy?

1.Quantitative control, also known as indirect control, uses tools like Bank Rate, Repo Rate, Reverse Repo Rate, CRR, SLR & Open Market Operations.
2.Qualitative, also known as the direct control measures by using change in the margin money, direct action & moral suasion

Which monetary policy tool is most effective?

Both qualitative & quantitative tools are effective in combating inflation ensuring economic stability depending on the circumstances.

What are the effects of inflation?

Inflation leads to increased rate of basic commodities leading to cash crunch & poverty.

What is the difference between Monetary Policy & Fiscal Policy

Monetary policy is monitored by RBI whereas fiscal policy is done by central government


What is CRR and SLR?

CRR is the minimum ratio of cash that needs to be deposited at RBI by the Banks & The ratio of demand and time liabilities to liquid assets is known as the Statutory Liquidity Ratio(SLR)

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