18 Aug Monetary Policy
This article covers “Daily Current Affairs” and the topic details “Monetary Policy”. The topic “Monetary Policy” has relevance in the “Indian Economy” section of the UPSC CSE exam.
For Prelims:
What is Monetary Policy?
What are various tools of Monetary Policy?
For Mains:
GS3: Indian Economy
Why in the news?
As anticipated, the Reserve Bank of India (RBI) has maintained the repo rate at 6.5% for the third consecutive instance, citing apprehensions regarding an increase in inflation.
What is Monetary Policy?
- Monetary policy constitutes the macroeconomic strategy formulated by a nation’s central bank.
- This demand side economic policy employs specific tools and targeting mechanisms to accomplish macroeconomic goals, including maintaining price stability, revitalizing consumption, promoting growth, and ensuring sufficient liquidity.
- Consequently, monetary policy entails the utilization of monetary instruments within the central bank’s jurisdiction to regulate factors like interest rates, money supply, and credit availability.
- These measures are employed with the aim of achieving specific objectives in alignment with broader economic policies.
- The Reserve Bank of India (RBI) is entrusted with the responsibility of executing monetary policy, a mandate explicitly established by the Reserve Bank of India Act, 1934.
Classification of Monetary Policy:
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- There are two main types of monetary policies: expansionary and contractionary.
- Expansionary Monetary Policy:
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- Also known as a loose monetary policy, this approach aims to boost economic growth by increasing the availability of money and credit. During tough economic times, a central bank might use this policy to lower unemployment and stimulate investment.
- The goal is to encourage spending and borrowing. This is achieved by reducing interest rates, making loans cheaper and more accessible.
- When people and businesses have more money to spend at a lower cost, they tend to buy more goods and services, which helps the economy grow.
- Contractionary Monetary Policy:
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- This policy is used to prevent the economy from overheating and experiencing high inflation due to rapid growth.
- It involves reducing the money supply and increasing interest rates to discourage borrowing.
- This leads to decreased business investment because borrowing becomes less attractive for companies.
- Higher interest rates also discourage consumers from borrowing for big purchases like homes and cars.
Rule- based vs. Discretionary Monetary Policy
- There’s an ongoing debate about whether central banks should follow fixed rules or have more flexibility (discretion) in their monetary policies. Some argue that a fixed rule is reliable because it ensures a consistent plan of action that can’t be changed later.
- On the other hand, discretionary policies allow central bankers to react to economic indicators as they see fit, which can sometimes lead to overreactions.
- While a rules-based approach might seem inflexible, it offers market certainty that the central bank won’t prioritize short-term gains over long-term stability.
What is the Monetary Policy Committee (MPC)?
- The introduction of the Monetary Policy Committee (MPC) stems from an amendment made in the Reserve Bank of India (RBI) Act, 1934 through the Finance Act of 2016.
- Its purpose is to establish a body responsible for determining the benchmark interest rate in India, thereby enhancing transparency and accountability in the formulation of the country’s monetary policy.
- Composition:
- A total of six members, the committee is composed of three officials from the RBI and an equal number of external members selected by the Government of India (GoI).
- RBI Governor serves as the chairperson
- The present objective assigned to this committee is to uphold an annual consumer price index-based inflation (CPI) rate of 4%, allowing for a permissible deviation of +/- 2%.
- If the inflation rate goes above the set limit for three quarters in a row, the committee has to explain to the government the reasons behind the same.
Instruments of Monetary Policy
The Reserve Bank of India employs both Quantitative and Qualitative Instruments of monetary policy to attain economic objectives.
| Quantitative Instruments | Description |
| Bank Rate | The rate at which the Reserve Bank purchases or rediscounts bills of exchange or commercial papers. |
| Cash Reserve Ratio (CRR) | The average daily balance a bank must maintain with the Reserve Bank as a percentage of its liabilities. |
| Statutory Liquidity Ratio | The portion of a bank’s liabilities to be held in liquid assets like government securities, cash, gold. |
| Open Market Operations | The purchase and sale of government securities to inject or absorb durable liquidity in the economy. |
| Marginal Standing Facility (MSF) | Allows banks to borrow additional overnight money from the Reserve Bank as a safety measure. |
| Repo Rate | The rate at which the Reserve Bank provides short-term liquidity to banks by accepting collateral and lending funds overnight. |
| Reverse Repo Rate | The interest rate at which the Reserve Bank absorbs overnight liquidity from banks against collateral. |
| Standing Deposit Facility (SDF) | An additional tool for absorbing liquidity without any collateral. |
| Liquidity Adjustment Facility (LAF) | Allows temporary liquidity adjustments using repo and reverse repo rates. |
| LAF Corridor | The range between the MSF rate and SDF rate influencing the daily call money rate. |
| Market Stabilisation Scheme (MSS) | Involves sale of short-term government securities to manage enduring liquidity from capital inflows. |
| Qualitative Instruments | Description |
| Rationing of Credit | RBI sets credit limits for commercial banks, curbing their lending amounts for specific purposes. |
| Regulation of Consumer Credit | Consumer credit, like installment sales and hire purchases, is controlled with preset terms to manage inflation. |
| Change in Marginal Requirement | Adjusting the proportion of loan financed by banks’ margins to encourage lending to certain sectors. |
| Moral Suasion | RBI suggests, guides, and influences banks to restrain credit during inflationary periods without strict actions. |
More about the news
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- The Monetary Policy Committee (MPC) has chosen to maintain the policy repo rate at 6.5%, while the current Cash Reserve Ratio (CRR) stands at 4.5%, unaltered.
- For managing excess liquidity in the banking system, the RBI has directed banks to uphold an incremental cash reserve ratio (I-CRR) of 10%. This move aims to withdraw more than Rs 1 lakh crore of surplus liquidity from the banking realm.
- The RBI’s focus remains on its strategy of ‘withdrawal of accommodation’ until all inflation-related risks are mitigated.
- The RBI is preparing to introduce “conversational payments” on UPI (Unified Payments Interface), allowing users to interact with an AI-powered system to initiate and finalize transactions. This feature will debut in Hindi and English languages.
- In a bid to facilitate transactions in low-connectivity situations, the RBI is planning to enable offline transactions using Near Field Communication technology.
Sources:
Eye on inflation, RBI keeps repo rate unchanged | Mumbai News – The Indian Express
Q1. With reference to Monetary Policy Committee, consider the following statements:
- The purpose of the MPC is to create a body responsible for determining the benchmark interest rate in India, aiming to increase transparency and accountability in the formulation of the country’s monetary policy.
- The current objective of the committee is to maintain an annual consumer price index-based inflation (CPI) rate of 3%.
- If the inflation rate surpasses the set limit for two quarters consecutively, the committee is required to explain the reasons to the government.
Which of the statements given above is/are correct?
(a) 1 and 2 only
(b) 2 and 3 only
(c) 3 only
(d) None
Answer: (b)
Q2. Consider the following :
| 1. Marginal Standing Facility (MSF) | The interest rate at which the Reserve Bank lends overnight liquidity to banks against collateral. |
| 2. Repo Rate | Allows banks to borrow additional overnight money from the Reserve Bank as a safety measure. |
| 3. Reverse Repo Rate | The interest rate at which the Reserve Bank absorbs overnight liquidity from banks without any collateral. |
| 4. Standing Deposit Facility (SDF) | A tool for absorbing liquidity with collateral. |
How many of the abovementioned pairs are correctly matched ?
(a) Only one
(b) Only two
(c) Only three
(d) None
Answer: (d)
Q3. Discuss the role and objectives of a Monetary Policy Committee (MPC) in shaping a country’s economic landscape. Elaborate on the goals pursued by an MPC and explain their significance in the context of a nation’s financial well-being.
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