Economy is an important part of the UPSC syllabus and terms like monetary policy, fiscal policy, etc. are extremely important for the IAS exam. These have a big impact on the economy and are also frequently seen in the news. In this article, you can read about the changing dimensions of India’s monetary policy.
Monetary Policy in India
What is Monetary policy? Monetary policy refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit.
What are the goals?
- Price Stability along with growth
- The agreement on Monetary Policy Framework between the Government and the Reserve Bank of India in 2015 defines the price stability objective explicitly in terms of the target for i.e.,
(a) below 6 per cent by January 2016 (b) 4 per cent (+/-) 2 per cent for the financial year 2016-17 and all subsequent years.
Instruments Cash Reserve Ratio (CRR) The share of net demand and time liabilities (deposits) that banks must maintain as cash balance with the Reserve Bank.
Statutory Liquidity Ratio (SLR) The share of net demand and time liabilities (deposits) that banks must maintain in safe and liquid assets, such as, government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
Refinance facilities Sector-specific refinance facilities aim at achieving sector specific objectives through provision of liquidity at a cost linked to the policy repo rate. The Reserve Bank has, however, been progressively de-emphasising sector specific policies as they interfere with the transmission mechanism.
Liquidity Adjustment Facility (LAF) Consists of overnight and term repo/reverse repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected in the LAF through term-repos.
Term Repos Since October 2013, the Reserve Bank has introduced term repos, to inject liquidity over a period that is longer than overnight. The aim of term repo is to help develop inter-bank money market, which in turn can set market based benchmarks for pricing of loans and deposits, and through that improve transmission of monetary policy.
Marginal Standing Facility (MSF) A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their SLR portfolio up to a limit (currently two per cent of their net demand and time liabilities deposits) at a penal rate of interest (currently 100 basis points above the repo rate). This provides a safety valve against unanticipated liquidity shocks to the banking system. MSF rate and reverse repo rate determine the corridor for the daily movement in short term money market interest rates.
Open Market Operations (OMOs) These include both, outright purchase/sale of government securities (for injection/absorption of liquidity)
Bank Rate It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
Market Stabilisation Scheme (MSS) This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The mobilised cash is held in a separate government account with the Reserve Bank. The instrument thus has features of both, SLR and CRR.
|Note: Recent in news Since the start of the year 2015, the Reserve Bank of India has progressively reduced the repo rate by 150 basis points. As against this, commercial banks have reduced their base rates only by 50–60 basis points till March this year. Reasons why banks have not been able to do this monetary transmission is due to their average cost of borrowing still remaining high because of older fixed deposits. To make sure that the reduced policy rates are passed on to borrowers by banks, RBI introduced the Marginal Cost of Funds based Lending Rate (MCLR) methodology as an alternative to the earlier base rate system. MCLR is calculated on the basis of four major components – marginal cost of funds, operating cost, tenor premium and negative carry on account of cash reserve ratio (CRR) MCLR is the cost of obtaining funds for banks that has now been closely linked to the repo rate. Any changes in deposit rate or repo rate impacts the lending rates of the bank and MCLR’s monthly reporting would mean banks would now be compelled to pass on benefits of rate cuts to borrowers (Source: financial express)|
What is new?
Monetary Policy Committee
A new monetary policy committee has been established that will decide on the interest rates. What happened till now – The Reserve Bank’s Monetary Policy Department (MPD) used to assist the Governor in formulating the monetary policy What has changed –Now, the Monetary Policy Committee will be the authority responsible to:
- fix the benchmark interest rate of the RBI
- set the inflation targets
Proposed Composition It will be a six-member panel, which will include three nominees of the government and three members of the Reserve Bank including the Governor Each member shall have one vote and in case of a tie, the Governor shall have a casting vote. Please note that the governor does not have a veto. Tenure
Members of the MPC will be appointed for a period of four years and shall not be eligible for reappointment. RBI will every six months publish Monetary Policy Report explaining the sources of inflation and the forecasts of inflation for the period between six to 18 months. If RBI fails to meet the inflation target, it shall in the report give reasons for failure, remedial actions as well as estimated time within which the inflation target shall be achieved. With the introduction of the monetary policy committee, the RBI will follow a system similar to the one followed by most global central banks.
Inflation targeting is a central banking policy that aims to meet the preset targets for the annual rate of inflation What were Urijit Patel committee’s recommendations? The Reserve Bank of India (RBI) had constituted an Expert Committee to Revise and Strengthen the Monetary Policy Framework under the Chairmanship of Dr. UrjitR.Patel. The committee submitted its report in January 2014.
Important recommendations made were:
- Inflation should be the nominal anchor for the monetary policy framework. This nominal anchor should be set by the Reserve Bank as its predominant objective of monetary policy in its policy statements
- The RBI should adopt the new CPI (combined) as the measure of the nominal anchor for policy communication
- the target for inflation should be set at 4 per cent with a band of +/- 2 per cent around it
- In view of the elevated level of current CPI inflation and hardened inflation expectations, supply constraints and weak output performance, the transition path to the target zone should be graduated to bringing down inflation from the current level of 10 per cent to 8 per cent over a period not exceeding the next 12 months and to 6 per cent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent
- timely monetary policy response to shocks to food and fuel since they account for more than 57 per cent of the CPI
- Monetary policy decision-making should be vested in a monetary policy committee
- The MPC will be accountable for failure to achieve the inflation target of 4 per cent (+/- 2 per cent) for three successive quarters
- dependence on market stabilisation scheme (MSS) and cash management bills (CMBs) may be phased out
Advantages of Inflation Targeting
- Inflation targeting facilitates in predicting inflation
- It brings in an element of transparency
- It has the ability to maintain price stability and prevent one-time shocks to inflation
- It brings in element of accountability
- According to International Monetary Fund, in emerging markets, “Inflation Targeting appears to have been associated with lower inflation, lower inflation expectations and lower inflation volatility relative to countries that have not adopted it
Criticism for Inflation Targeting Inflation target reduces “flexibility” As Donald Kohn, noted American economist stated “Placing any number on an inflation objective – however much it would be surrounded with caveats – has the potential to constrain policy in some circumstances in which it would not be desirable to do so.”
Forward and Backward Linkages
Along with the above developments, it is imperative that our human wealth must be empowered with the knowledge and the tools required for them to derive the need of being a part of the system. This can be achieved through financial inclusion and a sound fiscal policy.
- Financial Inclusion
Nachiket Mor Committee has made recommendations in this regard which can be looked upon:
- provide each Indian resident above the age of 18 with an individual, full-service electronic bank account
- set up widely distributed Electronic Payment Access Points offering deposit and withdrawal facilities at reasonable cost
- provide each low-income household convenient access to formally regulated providers that can provide suitable: (a) credit products, (b) investment and deposit products, and (c) insurance and risk management products at a reasonable price
- to provide every customer the legally protected right to be offered suitable financial services
- every resident receive a Universal Electronic Bank Account at the time of registering for an Aadhaar card
- setting up of Payments Banks whose primary purpose will be to provide payments services and deposit products to small businesses and low-income households
- It also recommended that the Priority Sector Lending target be revised from 40% to 50% of credit provided
Financial inclusion will enable many of our growth objectives to be fulfilled without an extra push. Equitable Growth will then be a simultaneous process, which , the country ultimately aims to achieve.
Why monetary policy depends on the degree of “financial inclusion,”?
The greater degree of financial inclusion empowers the monetary policy to extend its reach to the needy and support policymakers to make better predictions for likely situations like inflation. The Reserve Bank of India has recently announced guidelines for ‘Priority Sector Lending Certificates’ that aim to enable banks to achieve the priority sector lending targets by the purchase of these instruments in the event of shortfall and at the same time incentivize the surplus banks; thereby enhancing lending to the categories under priority sector, giving support to the financial inclusion goal, thereby facilitating the aims of India’s Monetary Policy. Fiscal Policy involves changing government spending and taxation. It involves a shift in the government’s budget position. e.g. Expansionary fiscal policy involves tax cuts, higher government spending and a bigger budget deficit.
- Fiscal Policy
Fiscal Policy components of government spending and taxation. For example, for a contractionary fiscal policy, it is important to increase taxation or reduce government spending. This will reduce the aggregate demand in the economy, in turn reducing inflation. This is also the ultimate aim of monetary policy. Thus, monetary policy needs the support of other tools to effectively achieve its goal.
How to approach for civil services exam:
GS1: Society – The changing pattern of choices for India’s urbanized youth
GS2: Governance – Policies of the government
GS3: Economy – Monetary Policy, Fiscal Policy
Practice Question: Looking at the current developments, throw light on the effect of changing interest rates for the common citizen of the country. Discuss the role of commercial banking sector and the government in strengthening the monetary policy framework.