Monetary policy is made by the Reserve Bank to manage the supply of money and in return achieving specific goals. These goals include constraining inflation, maintaining an appropriate exchange rate, generating jobs and economic growth. Monetary policy includes fluctuating interest rates that are a direct or an indirect cause of open market operations, setting reserves requirements, or trading in foreign exchange markets.
- A monetary policy is the use of the central bank’s interest rate and other instruments that influence money supply in order to achieve certain set of goals those revolve around macroeconomic.
- Credit policy deals with how much and at what rate, credit is advanced by the banks and these are a part of monetary policy.
- Monetary policy can either be expansionary or contracting in nature.
- In Expansionary policy there is an increase of the total supply of money in the economy an example for this can be in 2008-9 all over the world there were policies made to curb the global recession and slowdown.
- Whereas in a contractionary policy the total money supply is decreased by tightening credit conditions.
- The Expansionary policy is generally used to combat unemployment in a recession that results due to lowering interest rate, on the other hand in contractionary policy the goal is to control inflation by raising the interest rates.
Objective of Monetary Policies
The objectives for monetary policy are as follows:
- Generating employment
- Exchange rate stabilisation
- Prices stability
- Accelerating growth of economy
- Balancing savings and investment
The Reserve Bank of India generally announces the monetary policy twice a year i.e. April to September and October to March as these are the slack season policy and the busy season policy respectively in accordance’s with agriculture cycle.
The Tools the central bank uses to achieve the Monetary Policy
These tools are as follows:
- Intervention in the forex market
- Bank rate
- Open market operation
- Moral suasion
- Bank rate
Repo and Reverse Repo Rates
- REPO is a transaction between two parties to sell and repurchase the same security.
- Under this agreement the seller sells a specified security with an agreement to repurchase the same on a mutually decided future date and price. Similarly, the buyer purchases the same securities with an agreement to resell the same to the seller on the agreed upon date in future at an already predetermined price.
- In India, RBI lends security on a short term basis to banks to the government bonds (repo). Banks undertake the responsibility to repurchase the security at a later date over, RBI charges a repo rate for the money it lends to the government.
- Reverse Repo rate is when RBI borrows from the market in order to absorb excess liquidity with the sale of securities and repurchase them after a short time period. The rate at which the RBI borrows is known as reverse repo rate.
- The repo or reverse repo transaction only takes place in Mumbai and securities as approved by RBI these securities includes treasury bills, central and state government securities.
- The central bank uses the repo and reverse repo as an instrument for liquidity adjustment in the market.
- Repo rate is also known as policy rate as it is used as a signal to the financial system and to adjust lending and borrowings operations.
- Bank rate is a rate at which RBI lend long term loan to commercial banks this is a tool that RBI uses for maintaining money supply.
- Any revision in bank rate is a signal for the banks to revise deposit rates as well as PLR i.e., Prime Lending Rate the rate at which bank lend money to its customers.
- Bank Rate is not used any more. The last time it was used in 2003 when the 6% Bank Rate was fixed. In 2011, the bank rate was replaced with Marginal standing facility.
- Bank rate is nowadays aligned with Marginal Standing Facility (MSF) rate which is linked to the Repo rate.
Marginal Standing Facilities
In 2011 RBI introduced the MSF as a window through which commercial banks can borrow from the Central Bank at a rate i.e. 1% more than the Repo Rate. It is a very short term borrowing scheme for commercial banks by this Banks borrow funds through the Reserve Bank during severe cash shortage or acute shortage of liquidity. These were introduced by the Reverse Bank of India to reduce volatility in the overnight lending rates and to enable smooth monetary transmission in the financial system.
Liquidity Adjustment Facilities
This is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. LAF are used to aid banks in resolving any short-term cash shortages during periods of economic instability. It is enabled through repo rate and reverse repo rate.
The reserve requirement is a bank regulation that sets the minimum reserves each bank must hold as a part of the deposits at any given time, these reserves are designed to satisfy various needs. Some of them include providing loans to the government (SLR) kept with themselves or cash that is kept with the RBI.
Statutory liquidity ratio (SLR)
Banks are required to invest a certain percentage of their deposits in specified financial securities that includes securities set forth by the Central Government or State Government. The deposited percentage is known as SLR i.e. Statutory Liquidity Rate. The money is invested in government approved securities (bonds).
Cash reserve ratio
There is a specified amount that is held to be held by the bank either in form of cash or cash equivalents, and can be stored in bank vaults or with the Reserve Bank of India. The aim of CRR is to ensure that banks do not run out of cash to meet the payment demands of their depositors it is also used for controlling money supply in an economy. Commercial banks have to hold only some specified part of the total deposits as reserve this is called Fractional Reserve Banking.
Open market operations of RBI
OMSs of the RBI is described as outright purchase sale of government securities in the open market i.e, banks and financial institutions by the RBI in order to influence the volume of money and credit in the economy. While Purchases of government securities result in the injection of money into the market and hence it leads to credit expansion.
Moral persuasion is a measure used by the Central bank to influence banks into adhering the said policy. The Measures taken by the RBI are as follows closed door meeting with bank directors, increased severity of inspections, discussions on appeals to community spirit etc.
Importance of Monetary Policy
- To control inflationary pressure
- To Achieve price stability
- To bridge balance of payment deficit
- Interest rate policy
- To create banking and financial institutions
- Debt Management
Frequently Asked Questions
What is RBI monetary policy?
Monetary policy is the policy laid down by the RBI and involves the Management of money supply and interest rates.
What are the Repo and Reverse Repo Rate?
The Repo rate is the rate at which RBI lens money to the commercial banks whereas the Reverse Repo Rate is the rate at which the Commercial Banks lark their money at the RBI.
What are the current rates?
Reserve Repo Rate
Marginal Standing Facility Rate
Cash Reserve Ratio
Statutory Liquidity Ratio
Edited by Shikhar Shrivastava
Approved & Published – Sakshi Raje