Monetary policy refers to the set of actions and measures implemented by a country's central bank to regulate and control the money supply, credit availability, and interest rates in the economy. The primary goal of monetary policy is to achieve specific macroeconomic objectives, such as maintaining price stability, promoting economic growth, and ensuring financial stability. Interest rate changes and adjustments to bank reserve requirements are examples of monetary policy strategies. “Monetary Policy” is one of the important concepts in the UPSC/IAS 2023 Economy syllabus which is discussed in this article in detail.

What exactly is Monetary Policy?

• Monetary policy is a macroeconomic plan established by the central bank.
• It is a demand-side economic strategy used by a nation's government to achieve macroeconomic goals including inflation, consumption, growth, and liquidity.
• Monetary policy includes changing interest rates, either directly or indirectly, through open market operations, reserve requirements, or foreign exchange trading.
• Credit policy is a subset of monetary policy since it governs how much and at what interest rate banks extend credit.
• Central banks use various tools and strategies to influence the money supply and interest rates, which in turn impact economic activities and overall economic conditions.

Types of Monetary Policy

There are two types of monetary policy:

1) Expansionary Policy

• An expansionary policy boosts economic activity during slowdowns or recessions.
• Expansionary policy works by increasing the total money supply in the economy.
• The money supply in the economy is increased by lowering the general interest rates on loans and other forms of debt.
• When there are low interest rates, people tend to save less, and consumer spending and borrowing increase. Thus, it is used to stimulate economic growth.

2) Contractionary Policy

• Contractionary policy decreases the total supply of money in the economy by increasing the interest rates.
• It is used to reduce prices caused by an excess money supply.

Objectives of Monetary Policy

• Monetary policy is concerned with making money available to the market at reasonable rates and in sufficient quantities at the appropriate time in order to achieve:
  • Price stability
  • Accelerating the growth of economy
  • Exchange rate stabilization
  • Balancing savings and investment
  • Generating employment
  • Financial stability
• The primary goal of monetary policy is to maintain price stability while keeping growth in mind. Price stability is a prerequisite for long-term growth.
• In order to maintain price stability, inflation must be kept under control.
• Every five years, the Indian government sets an inflation target. The Reserve Bank of India (RBI) plays an important role in the consultation process for inflation targeting.
• The current inflation-targeting framework in India is flexible.

Monetary Policy in India

• In India, the monetary policy of the Reserve Bank of India aims to control the amount of money in circulation in order to meet the requirements of various economic sectors and quicken the rate of economic expansion.
• Historically, in India, monetary policy was announced twice a year, once during the slack season (April-September) and once during the busy season (October-March), in accordance with agricultural cycles.
• However, because monetary policy has become more dynamic, the Reserve Bank of India decided to issue a bi-monthly Monetary Policy.
• Statements—once every two months—beginning in 2014, as recommended by the Urjit Patel Committee.

How does the RBI get its Mandate to conduct Monetary Policy?

• The Reserve Bank of India (RBI) controls the monetary policy and this mandate is clearly mentioned in the Reserve Bank of India Act, 1934.
• The Monetary Policy Department of the RBI assists the Monetary Policy Committee (MPC) in formulating the monetary policy of the nation.
• For this, the RBI uses a variety of tools to carry out monetary policy, including open market operations, bank rate policy, reserve system, credit control policy, and moral persuasion.
• There have recently been many changes in the way India's monetary policy is formed, with the introduction of the Monetary Policy Framework (MPF), Monetary Policy Committee (MPC), and Monetary Policy Process (MPP).

Instruments of Monetary Policy

Monetary policy is implemented using a variety of direct and indirect instruments:

1. Repo Rate

• Repo Rate is the (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks in exchange for the government and other approved securities as collateral under the liquidity adjustment facility (LAF).

2. Reverse Repo Rate

• Reverse Repo Rate is the (fixed) interest rate at which the Reserve Bank absorbs liquidity from banks on an overnight basis in exchange for eligible government securities under the LAF.

3. Liquidity Adjustment Facility (LAF)

• Liquidity Adjustment Facility (LAF) is made up of both overnight and term repo auctions.
• The Reserve Bank has gradually increased the proportion of liquidity injected through fine-tuning variable rate repo auctions of various tenors.
• The goal of term repo is to help develop the inter-bank term money market, which in turn can set market-based benchmarks for loan and deposit pricing and thus improve monetary policy transmission.
• The Reserve Bank also conducts variable interest rate reverse repo auctions as market conditions dictate.

4. Marginal Standing Facility (MSF)

• Marginal Standing Facility (MSF) is the facility through which scheduled commercial banks can borrow an additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a certain limit at a penal rate of interest.
• This acts as a safety valve for the banking system in the event of unexpected liquidity shocks.

5. Corridor

• The corridor for the daily movement in the weighted average call money rate is determined by the MSF rate and the reverse repo rate.

6. Bank Rate

• Bank Rate is the rate at which the Reserve Bank is willing to purchase or rediscount bills of exchange or other commercial papers.
• Section 49 of the Reserve Bank of India Act, 1934 mandates the publication of the Bank Rate.
• This rate has been aligned with the MSF rate and, as a result, changes automatically when the MSF rate and the policy repo rate change.

7. Cash Reserve Ratio (CRR)

• Cash Reserve Ratio (CRR) is the average daily balance that a bank is required to maintain with the Reserve Bank as a share of such percentage of its Net Demand and Time Liabilities (NDTL) as specified by the Reserve Bank in the Gazette of India from time to time.

8. Statutory Liquidity Ratio (SLR)

• Statutory Liquidity Ratio (SLR) is the percentage of NDTL that a bank must keep in safe and liquid assets such as unencumbered government securities, cash, and gold.
• SLR changes frequently have an impact on the availability of resources in the banking system for lending to the private sector.

9. Open Market Operations (OMOs)

• Open Market Operations (OMOs) include the outright purchase and sale of government securities for the purpose of injecting and absorbing long-term liquidity, respectively.

10. Market Stabilisation Scheme (MSS)

• Market Stabilisation Scheme (MSS) is a monetary management tool that was introduced in 2004.
• Short-term government securities and treasury bills are sold to absorb longer-term surplus liquidity resulting from large capital inflows.
• The money raised in this manner is kept in a separate government account of the Reserve Bank.

Monetary Policy Framework (MPF)

• While the Government of India establishes the Flexible Inflation Targeting Framework in India, the Reserve Bank of India (RBI) is in charge of the country's Monetary Policy Framework.
• The amended RBI Act explicitly gives the Reserve Bank the legislative mandate to run the country's monetary policy framework.
• The framework aims to set the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation, as well as to modulate liquidity conditions in order to anchor money market rates at or near the repo rate.
• Changes in repo rates are transmitted through the money market to the entire financial system, influencing aggregate demand – a key determinant of inflation and growth.
• Once the repo rate is announced, the Reserve Bank's operating framework envisions day-to-day liquidity management through appropriate actions aimed at anchoring the operating target - the weighted average call rate (WACR) – around the repo rate.

Monetary Policy Committee (MPC)

• The Monetary Policy Committee (MPC) is the committee set up by the Union government to set the policy interest rates as a part of its monetary policy.
• It is headed by the Governor of the Reserve Bank of India (RBI).
• The Monetary Policy Committee's decisions will impact the money supply and liquidity in the economy.
• The MPC is a six-person committee appointed by the Central Government (Section 45ZB of the amended RBI Act, 1934).
• The MPC must meet at least four times per year. The MPC meeting requires a quorum of four members. Each MPC member has one vote, and in the event of a tie, the Governor has a second or casting vote.
• Following the conclusion of each MPC meeting, the resolution adopted by the MPC is published.

*To know more about the topic, click this link Monetary Policy Committee (MPC).

Conclusion

Monetary policy decisions are typically made by a central bank's monetary policy committee or board of governors. The effectiveness of monetary policy depends on a variety of factors, including the economic conditions, government fiscal policies, global economic trends, and financial market dynamics. Central banks often use a combination of these tools to achieve their policy objectives and maintain a stable and healthy economy.