Monetary Policy Of India

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Monetary Policy Of India

The use by the Central Bank of interest rate and other instruments to influence money supply to achieve certain macro economic goals is known as monetary policy. Credit policy is a part of monetary policy as it deals only with how much and at what rate credit is advanced by the banks. Objectives of monetary policy are: accelerating growth of economy, maintaining price stability, stabilization of exchange rate, balancing savings and investment and generating  employment.

Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of  money  in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy  has the goal of raising interest rates to combat inflation.

The Reserve Bank of India announces the Monetary and Credit Policy twice a year- October and April. October policy is called busy season as it is the harvesting time for the kharif season which used to account for the  major part of India’s agricultural operations This policy determines the supply of money in the economy and the rate of interest charged by banks. The policy also contains an economic overview  and  presents  future forecasts.

The instruments of monetary policy are bank rate, SLR, CRR and open market operations by the RBI on the basis of repo and reverse repo rates  (buying  and  selling  of   Government securities in the open market to regulate money supply). Monetary policy works through influencing the cost and availability of credit and  money.

Tools  of  Monetary Policy

Primary category is two 1. Qunatitative toots 2. Quantitative tools

The tools available for the central bank to achieve the above ends are: Bank rate, Reserve ratios, Open market operations, Intervention in the  forex  market  and  Moral suasion.

Bank rate

Bank Rate is the rate at which RBI lends to commercial banks. Bank Rate is a tool  which RBI uses for managing money supply and credit. Any revision in Bank Rate by RBI is a signal to banks to revise deposit rates as well as Prime Lending Rate. It stands at 6% presently.

Reserve Requirements

In economics, fractional-reserve banking is the near-universal practice of banks in which banks keep a fraction of the total deposits managed by a bank as reserves and are not be lent. The reserve ratios are periodically changed by the RBI. The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold as  a part of the deposits. These reserves are designed to satisfy various needs like  providing  loans  to the Government (SLR) and inflation management (CRR). They are in the form of RBI approved securities (SLR) kept with themselves or cash that  is  kept  with  the  RBI (CRR).

Statutory  liquidity  Ratio (SLR)

It  is  the  portion  of  time  and   demand liabilities of banks that they should keep in the form of designated liquid assets like government and other RBI-approved securities like public sector bonds; current account balances with other banks and gold. SLR is aimed at ensuring that the need for government funds  is  partly but surely met by the banks. The commitment  of the Government to reduce fiscal deficit means that it will borrow less and so the SLR was progressively brought down from 38.5% in 1991 to  25%  today.

The Reserves Bank of India Act, 1934 and  the Banking Regulation Act, 1949 fixed the floor and cap on SLR at 25% and 40% respectively. But the amendment made in these statutes removed the limits-lower and upper: RBI has,   as a result, the freedom to fix the SLR at any rate depending on the macro economic conditions. The amendment was an enabling one.

Cash  Reserve  Ratio (CRR)

CRR is a monetary tool to regulate money supply. It is the portion of the bank deposits  that a bank should keep with the RBI in cash form.  CRR  deposits  earn  no interest

The Reserve Bank of India Act,  1934  and the Banking Regulation Act, 1949 fixed the floor and cap on CRR at 3% and 20% respectively.  But the amendment made in these statutes removed the limits-lower and upper. RBI has,   as a result, the freedom to fix the CRR at any rate depending on the macro economic conditions. The amendment was an enabling one.

CRR is adjusted to manage liquidity and inflation the more the CRR, the less the money available for lending by the banks to players in the economy. CRR was 15% in 1991 and today  it is 8.75%. If inflation is high, money supply needs to be taken out and so CRR is generally increased. But in a regime of moderate inflation, low  CRR  is  in place.

  • RBI increases CRR to tighten credit for example, CRR today  (July  2008)  stands  at %-high because inflation is also at 13-year high at 1.89% on WPI (July 2008). It needed to  be controlled by a variety of means one of which was  hike  in

CRR as a tool of monetary policy is used when there is a tremendous need to reduce inflation and tighten credit as in 2008. Otherwise, normally, RBI relies on open market operations  for  liquidity management.

Open  Market  Operations  (OMOs)  of RBI

OMOs of the RBI can be described as: Purchases and sales of government and certain other securities in the open market (banks and financial institutions) by the RBI in order to influence the volume of money and  credit  in the economy: Purchases of government securities injects money. Into the market and thus expands money and credit; sales have the opposite  effect  –  absorb excess

Liquidity and shrink credit. Open market operations are RBI’s most important and flexible monetary policy tool. Open market operations do not change the total stock of government securities but change the proportion held  by  the  RBI,  commercial  and  cooperative banks.

Ready  Forward  Contracts (Repos)

It is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same  to the seller on an agreed date in future at a predetermined  price.

In India, RBI lends on a short term basis to banks on the security of the government paper (repo). Banks undertake to repurchase the security at a later date-over night or few days. RBI charges a repo rate for the money it lends.   It  is  8.5%  presently  (2008 July)

Reverse repo is when RBI borrows from the market (absorbs excess liquidity) with the    sale of securities and repurchases them the next day or after a few days. The rate at which it borrows is called reverse repo rate as it is the reverse of the repo operation. Reverse repo rate presently is  6%  (July 2008)

The repo rate and reverse repo rate are 6% and  8.5%  respectively  today  (July 2008)

The Repo / Reverse Repo transaction can only be done at Mumbai and in securities as approved by RBI (Treasury Bills, Central / State Govt securities). RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system.

Selective  Credit Controls

Certain businesses can be given more and certain others may get less  credit  from  banks on the orders of the RBI. Thus, selective credit controls can be imposed for meeting various goals like discouraging hoarding and black- marketing of certain essential commodities by traders etc. Either credit can be rationed or interest rate can be hiked by RBI as a part of SCCs. In SCCs, the total quantum of credit does not change, but the amount lent and the cost     of credit may be changed for specific sector or sectors.

Moral suasion

A persuasion measure used by central bank to influence and pressure, but not force, banks into adhering to policy. Measures used are closed-door meetings with bank directors, increased severity of inspections discussion, appeals  to  community  spirit etc.

Recently the RBI Governor appealed to banks not to raise rates even though the central bank was following a tight money  policy.

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