Monetary Policy

What are the main objec­tives of mon­e­tary pol­icy?#

Sim­ply put, the main objec­tive of mon­e­tary pol­icy is to main­tain price sta­bil­ity while keep­ing in mind the objec­tive of growth as price sta­bil­ity is a nec­es­sary pre­con­di­tion for sus­tain­able eco­nomic growth.

In India, the RBI con­trols infla­tion under a flex­i­ble infla­tion-tar­get­ing frame­work, with the tar­get set by the gov­ern­ment in con­sul­ta­tion with the RBI.

What role does the Mon­e­tary Pol­icy Com­mit­tee play?#

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to pro­vide for a statu­tory and insti­tu­tion­al­ized frame­work for a Mon­e­tary Pol­icy Com­mit­tee, for main­tain­ing price sta­bil­ity, while keep­ing in mind the objec­tive of growth. The Mon­e­tary Pol­icy Com­mit­tee is entrusted with the task of fix­ing the bench­mark pol­icy rate (repo rate) required to con­tain infla­tion within the spec­i­fied tar­get level.

The Gov­ern­ment of India, in con­sul­ta­tion with RBI, noti­fied the ‘Infla­tion Tar­get’ in the Gazette of India dated 5 August 2016 for the period begin­ning from the date of pub­li­ca­tion of the noti­fi­ca­tion and end­ing on March 31, 2021, as 4%. At the same time, lower and upper tol­er­ance lev­els were noti­fied as 2% and 6% respec­tively. In 2021 the same tar­get and band were retained for the five years to March 2026.

What are the instru­ments of mon­e­tary pol­icy?#

Some of the fol­low­ing instru­ments are used by RBI as a part of their mon­e­tary poli­cies.

• Open Mar­ket Oper­a­tions: An open mar­ket oper­a­tion (OMO) is an instru­ment which involves buy­ing/sell­ing of secu­ri­ties like gov­ern­ment bond from or to the pub­lic and banks. The RBI sells gov­ern­ment secu­ri­ties to con­trol the flow of credit and buys gov­ern­ment secu­ri­ties to increase credit flow.
• Cash Reserve Ratio (CRR): Cash Reserve Ratio is a spec­i­fied amount of bank deposits which banks are required to keep with the RBI in the form of reserves or bal­ances. The higher the CRR with the RBI, the lower will be the liq­uid­ity in the sys­tem and vice versa. The CRR was reduced from 15% in 1990 to 5 % in 2002. As of Feb­ru­ary 2024, the CRR was 4.5%.
• Statu­tory Liq­uid­ity Ratio (SLR): All finan­cial insti­tu­tions have to main­tain a cer­tain quan­tity of liq­uid assets with them­selves at any point in time of their total time and demand lia­bil­i­ties. This is known as the Statu­tory Liq­uid­ity Ratio. The assets can be held in forms such as cash, gold and approved gov­ern­ment secu­ri­ties. As of Feb­ru­ary 2024, the SLR was 18%.
• Bank Rate Pol­icy: Also known as the dis­count rate, bank rates are inter­est charged by the RBI for pro­vid­ing funds and loans to the bank­ing sys­tem. An increase in bank rate increases the cost of bor­row­ing by com­mer­cial banks which results in the reduc­tion in credit vol­ume to the banks and hence the sup­ply of money declines. An increase in the bank rate is the sym­bol of the tight­en­ing of the RBI mon­e­tary pol­icy. As of Feb­ru­ary 2024, the bank rate was 6.75%.
• Credit Ceil­ing: With this instru­ment, RBI issues prior infor­ma­tion or direc­tion that loans to the com­mer­cial bank will be given up to a cer­tain limit. In this case, a com­mer­cial bank will be tight in advanc­ing loans to the pub­lic. They will allo­cate loans to lim­ited sec­tors. A few exam­ples of credit ceil­ing are agri­cul­ture sec­tor advances and pri­or­ity sec­tor lend­ing.

Con­trac­tionary vs. expan­sion­ary mon­e­tary pol­icy#

Mon­e­tary poli­cies can be either con­trac­tionary or expan­sion­ary. Imple­ment­ing one type of pol­icy depends on the cur­rent eco­nomic cli­mate and the ulti­mate goals.

• Con­trac­tionary Mon­e­tary Pol­icy: Cen­tral banks will use con­trac­tionary mon­e­tary poli­cies when infla­tion becomes a con­cern as the econ­omy gets over­heated. In this case, prices rise as pur­chas­ing power drops.
• Expan­sion­ary Mon­e­tary Pol­icy: This type of mon­e­tary pol­icy is used to spur growth dur­ing a reces­sion or slow­down. It sup­ports growth by low­er­ing the cost of bor­row­ing and rais­ing asset prices, which makes invest­ment more attrac­tive and com­pa­nies more prof­itable.

Key terms#

Mon­e­tary pol­icy

Mon­e­tary pol­icy is a set of actions avail­able to a nation's cen­tral bank to achieve sus­tain­able eco­nomic growth by adjust­ing the money sup­ply.

Com­mon ques­tions#

What are the types of mon­e­tary pol­icy?#

Mon­e­tary poli­cies are seen as either expan­sion­ary or con­trac­tionary depend­ing on the level of growth or stag­na­tion within the econ­omy.

Con­trac­tionary: a con­trac­tionary pol­icy increases inter­est rates and lim­its the out­stand­ing money sup­ply to slow growth and decrease infla­tion, where the prices of goods and ser­vices in an econ­omy rise and reduce the pur­chas­ing power of money.

Expan­sion­ary: dur­ing times of slow­down or a reces­sion, an expan­sion­ary pol­icy grows eco­nomic activ­ity. By low­er­ing inter­est rates, sav­ing becomes less attrac­tive, and con­sumer spend­ing and bor­row­ing increase.