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Raising Output, Stabilizing Prices: The Role Of Monetary Policy

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Monetary Policy Of India

By: Tavaga Research

Monetary Policy of RBI

A broad agreement that governs the general economic discourse is the necessity of an economic policy that promotes high employment, stable prices, and rapid economic growth. These goals, however, are not entirely compatible, and if left unchecked, an imbalance between these could disrupt the financial stability, leading to huge economic costs.

To appreciate the importance of financial stability, it is essential to understand the potential implications of financial instability. For instance, when the economy is operating near the full employment level, the prices are elevated and unemployment is low. In such a situation, increasing the output further with fewer workers available to be hired, leads to a higher wage demand by those workers. The companies, in turn, pass on the higher wage bill to the customers, raising the general price level. The workers, in view of maintaining their real purchasing power; demand a further wage hike, and the situation spirals out of hand, resulting in hyperinflation. The opposite situation prevails when the economy is operating way below the full employment level.

Such situations do not necessarily auto-correct themselves; they often require intervention by an external force, such as the government or the central bank. These stabilizing external forces use the macroeconomic instruments, such as the fiscal and the monetary policy, to contain these imbalances and restore financial stability. Although both these tools are essential in macroeconomic management, this article focuses on the monetary policy of RBI 2020.

What is monetary policy?

Monetary Policy of RBI meaning

Monetary policy refers to the actions and communications of the Reserve Bank of India (RBI), the nation’s central bank that influences the amount of money and credit in the Indian economy. This, in turn, affects the interest rates and hence, indirectly stimulates (contracts) the economy by lowering (raising) the cost of credit.

In India, the RBI aims to manage the quantity of money in order to meet the requirement of various sectors and to increase the pace of economic growth. It uses a gamut of tools such as the open market operations (OMOs), bank rate, credit control, reserve system, etc., to achieve its objectives. Monetary policy can either be expansionary or contractionary. An increase in the supply of money eases the liquidity conditions, spurring economic growth, and vice versa.

What are the objectives of the monetary policy of RBI?

There are several objectives that the monetary policy aims to achieve. For the central banks, usually, this objective has precedence over the other important goals that it is mandated to achieve. The central objective of this goal is to enable an environment that promotes development while maintaining reasonable price stability.

  • Promoting fixed investment: Investments is an essential activity that, with consumption, forms the core of the well-known macroeconomic equation. To achieve economic prosperity, it is necessary to invest in capital creation that increases productivity and hence economic growth. RBI aims to do so by restricting the flow of capital to non-essential fixed investment.
  • Enabling high economic growth: The only way to economic prosperity is to achieve high economic growth, as measured by GDP, for a sustained period of time. The RBI, by keeping prices steady and maintaining overall financial stability, has the ability to promote high economic growth, leading to prosperity over time.
  • Managing the foreign exchange markets: Another major activity that forms the core of the macroeconomic equation is the net exports. Unless managed, a huge deficit could lead to a large debasement of the currency and vice versa. The RBI has to intervene to prevent extreme movements in the currency vis-à-vis the foreign exchange market, in order to protect investor’s interest in the long run.
  • Interest Rate Stability: This is an important objective because an unstable interest rate environment would hinder credit growth and in turn, curtail the ability of the economy to attain the full employment level. Therefore, it is essential for the central bank to be consistent and stable when setting policy rates.

What are the tools of monetary policy?

Tools of the monetary policy:

  • Open market operations (OMOs): Under OMOs, the central bank buys and sells government securities from the market. These are usually done to regulate liquidity in the economy. When the central bank purchases those securities, it eases the liquidity conditions in the economy and vice versa.
  • Cash Reserve Ratio (CRR): This mandates the commercial banks (Public Sector/ Private Sector/ Foreign Banks) to keep a portion of their deposits with the central bank as reserves. If the central bank plans to reduce the lending activity, it could ask those commercial banks to deposit an increased portion of their deposits with them and vice versa.
  • Statutory Liquidity Ratio (SLR): Banks, under this, are mandated to hold a certain portion of net demand and time liabilities (NDTL) in liquid assets such as cash, gold, and government securities, at the end of the day. Again, if the central bank is looking to curtail the economic activity, it could ask those banks to hold an increased share of deposits as SLR.
  • Repo Rates: These are the rates at which the central bank lends to commercial banks looking to raise money to meet their daily regulatory requirements, for a short period of time. They use government securities like Treasury Notes and Treasury bills as collateral against the loan. The commercial banks sell those securities with a promise to buy them back at a promised later date. If the central bank plans to stimulate the economy, it could disincentives commercial banks by lower the repo rates, nudging them to lend the surplus money for commercial purposes, where they could earn a higher return and vice versa.
Repo Rate In India
Source: Tavaga Research
  • Reverse Repo rates: These are the rates at which the central bank borrows from commercial banks for a short period of time. Banks with excess funds can earn interest on that surplus by lending the surplus to the central bank. The central bank looking to reduce liquidity in the system can hike the reverse repo rates, sucking that money out of the system. Banks prefer to lend to the central bank because they earn a high return and risk-free compared to commercial lending.
Reverse Repo Rate India
Source: Tavaga Research
  • Marginal Standing Facility: This facility allows banks a window to borrow from the central bank in an emergency situation when liquidity in the inter-bank market dries up. Banks, by pledging government securities, borrow from the central bank at a higher rate than the repo rates in the liquidity adjustment facility (LAC).

What are the types of monetary policy?

There are broadly two types of monetary policy, with a large spectrum of variations lying between them. These are:

Contractionary Monetary Policy: Central banks use contractionary monetary policy to bring inflation under control. They essentially reduce the supply of money in the system, by restricting the volume of money that the banks can lend. The banks charge higher interest on the loans, making them expensive for the borrowers. In turn, fewer businesses and individuals borrow, slowing growth.

Expansionary Monetary Policy: Central banks use expansionary monetary policy in the pursuit of lower unemployment and avoiding recession. They give the banks more money to lend by increasing the liquidity in the system. Banks lower the interest at which they lend, making loans cheaper. Businesses borrow more to hire workers, buy equipment, and expand their operations. Individuals borrow more to buy houses, cars, appliances, etc.

Important details about the monetary policy in India

Currently, the important monetary policy decisions are taken by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), headed by the governor of the Reserve Bank. They meet bi-monthly to set out the important policy rates and present their outlook for the economy going forward. The next MPC meet is scheduled for the 2nd of December.

What time is the RBI Monetary Policy?

RBI Monetary Policy 2020 dates

Dates of the meeting of the Monetary Policy Committee for 2020-21
June 3 to 5, 2020
August 4 to 6, 2020
September 29-30 & October 1, 2020
December 2-4, 2020
February 3 to 5, 2021

Monetary Policy of RBI how many times in a year?

As per the RBI Act, the monetary policy committee of the RBI is required to meet at least four times in one year.

Members of the monetary policy committee

The MPC is a committee comprising of 6 members. All the members of the committee have a term of 4 years or until further orders unless they are ex-officio members. The current members are:

  1. Shaktikanta Das
  2. Michael Debabrata Patra
  3. Mridul K Saggar
  4. Ashima Goyal
  5. Jayant R Varma
  6. Shashanka Bhide

The last three members in the list above recently replaced, the following three erstwhile members:

Recent changes in monetary policy committee of RBI 2020

  1. Chetan Ghate
  2. Pami Dua
  3. Ravindra Dholakia

Monetary policy of RBI – December 2020

The RBI in the latest (4th December) MPC meet left the key interest rates unchanged for the third time in a row, against the backdrop of inflation remaining elevated, above the tolerance band of 2-6 percent.

More importantly, it hinted at more easing ahead to support the economy if the need arises. All the members of the MPC voted unanimously in favor of maintaining a pause. This was the 26th MPC meeting since its inception in June 2016.

The Reserve Bank continued to maintain an accommodative stance and signaled that it will continue to do so at least for this financial year.

Key RBI monetary policy rates currently are:

Policy Rates
Repo Rate 4%
Reverse Repo Rate 3.35%
Marginal Standing Facility 4.25%
Bank Rate 4.25%

An accommodative stance implies that the central bank is willing to further cut the interest rates to support the economy if the need arises. The continuation of the accommodative stance underlines the importance that the central bank is placing on reviving growth at the current juncture.

RBI, also revised upwards its growth forecast for the current financial year, from a contraction of about 9.5 percent to a contraction of about 7.5 percent, with the expectation of an expansion of 0.1 percent and 0.7 percent in the Q3 of and Q4 of FY21, respectively.

The central bank also forecasted the inflation rate to be at 6.8 percent in the third quarter and 5.8 percent for the fourth quarter for this fiscal year. Further, it projected inflation to be at 4.6 percent in the next financial year.

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