Monetary policy has been making headlines lately, raising questions for many. This refers to the strategies employed by the central bank, the Reserve Bank of India (RBI), to influence the economy using specific financial tools.
These tools aim to achieve the goals established by the government, as outlined in the Reserve Bank of India Act of 1934. In simpler terms, the RBI uses its toolbox of financial instruments to steer the economy in the desired direction.
Who Decides Monetary Policy in India?
The decision-making body for monetary policy in India is the Monetary Policy Committee (MPC).
The current members of the MPC, as of October 5, 2020:
- Governor of the Reserve Bank of India (RBI): Chairperson (ex-officio)
- Deputy Governor of the RBI in charge of Monetary Policy: Member (ex-officio)
- One RBI officer nominated by the Central Board: Member (ex-officio)
- Independent Experts:
- Prof. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research
- Prof. Jayanth R. Varma, Professor, Indian Institute of Management, Ahmedabad
- Dr. Shashanka Bhide, Senior Advisor, National Council of Applied Economic Research, Delhi
This diverse composition ensures that monetary policy decisions are informed by a range of perspectives, balancing the RBI’s expertise with the insights of independent economists.
The Goals of Monetary Policy in India
Monetary policy in India aims to achieve two primary goals:
- Price Stability: This is the main objective and refers to keeping inflation under control. High inflation erodes the purchasing power of money, hurts savings, and disrupts economic stability. Maintaining stable prices fosters an environment conducive to long-term economic growth.
- Economic Growth: While price stability is crucial, promoting sustainable economic growth is also essential. The RBI balances these two sometimes conflicting goals to create a healthy and growing economy.
To achieve these goals, the Reserve Bank of India Act, 1934 established a flexible inflation targeting framework. This framework sets a specific target inflation rate with an upper and lower tolerance band. Currently, the target inflation is 4% with a tolerance band of 2% and 6%. If inflation falls outside this range for three consecutive quarters, it indicates a need for the RBI to adjust its monetary policy tools to bring inflation back within the target range.
This framework helps the RBI maintain a clear and transparent approach to monetary policy, ensuring both price stability and fostering an environment conducive to economic growth.
The Toolbox of Monetary Policy in India
The Reserve Bank of India (RBI) utilizes various tools, like a toolbox, to influence the Indian economy and achieve its monetary policy goals. Here’s a breakdown of some key instruments:
Interest Rates:
- Repo Rate: The interest rate at which the RBI lends overnight liquidity to banks. A higher rate discourages borrowing, reducing money in circulation and potentially curbing inflation. Conversely, a lower rate encourages borrowing, increasing money supply and potentially boosting economic activity.
- Reverse Repo Rate: The interest rate at which the RBI absorbs excess liquidity from banks. This helps manage inflation by taking money out of the system.
Liquidity Management Tools:
- Liquidity Adjustment Facility (LAF): This allows banks to borrow short-term funds from the RBI through repo auctions or lend their surplus funds to the RBI through reverse repo auctions, influencing overall liquidity in the banking system.
- Marginal Standing Facility (MSF): Acts as a safety net for banks, allowing them to borrow additional overnight funds from the RBI at a penalty rate in unforeseen situations.
Reserve Requirements:
- Cash Reserve Ratio (CRR): The portion of deposits that banks must hold with the RBI. Increasing CRR reduces the amount of money available for lending by banks, potentially slowing economic growth.
- Statutory Liquidity Ratio (SLR): The portion of deposits that banks must invest in government securities. Raising SLR also reduces credit availability, potentially impacting growth.
Open Market Operations (OMOs): Buying and selling government securities by the RBI to inject (buying) or absorb (selling) liquidity from the system, influencing interest rates and overall money supply.
Market Stabilization Scheme (MSS): A tool used to manage excess liquidity specifically arising from large capital inflows by selling government securities.
Understanding how these tools interact is crucial. For example, increasing the repo rate might also influence the corridor for call money rates, impacting short-term borrowing costs for banks.
By adjusting these tools strategically, the RBI strives to maintain price stability while fostering balanced economic growth in India.
Conclusion
In conclusion, understanding monetary policy in India involves recognizing the Reserve Bank of India (RBI) as the central authority with the responsibility to manage the economy through various financial instruments. The Monetary Policy Committee (MPC) guides the RBI in this mission, aiming to achieve the dual goals of price stability and sustainable economic growth. By effectively utilizing a toolbox of tools encompassing interest rates, liquidity management, reserve requirements, and open market operations, the RBI strives to guide the Indian economy towards a stable and prosperous future.