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Monetary Policy: Definition, Objectives, Types, Tools Research Team | Posted On Monday, December 03,2018, 03:20 PM

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Monetary Policy: Definition, Objectives, Types, Tools



What is monetary policy? The Monetary Policy of India is set by the RBI. It is a macro-economic policy to manage money supply and interest which is the demand side economic policy. This is important for the Government to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. Inflation in India is measured by WPI (Wholesale Price Index) and CPI (Consumer Price Index). Retail inflation (CPI) was 3.77% in September 2018.

India’s monetary policy aims to manage money in the economy to meet the requirements of different sectors like pharma, IT, FMCG, Oil and gas, automobiles and so on, to increase growth in the economy.

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Monetary Policy: Definition, Objectives, Types, Tools

Let’s bring up an important question. Why is monetary policy so important? Monetary policy deals with repo rate (The rate at which RBI lends to commercial banks which is 6.5%), reverse repo (rate at which commercial banks lend to RBI and currently stands at 6.25%), cash reserve ratio (CRR is the amount of funds banks have to keep with RBI and currently stands at 4%) and Statutory Liquidity Ratio (SLR are required to be maintained in the form of cash, gold reserves, government approved securities before lending and currently stands at 19.5%). If RBI increases the repo rate, cost of borrowing for banks increase. Banks hike FD rates and loan rates go up. If you have availed home loan, you will find interest rates going up.

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Objectives of monetary policy:

High employment: Unemployment causes human misery, poverty, loss of self-respect and financial distress. It also means idle workers and idle resources. This means a lower GDP. Gross Domestic Product or GDP is the final value of all goods and services within India’s boundaries in a year. GDP shows the economic growth of India.

We measure GDP in 3 ways:

GDP by output method: GDP = Real GDP which is GDP at constant prices – Taxes + subsidies.

GDP by expenditure method: It measures the total expenditure incurred on goods and services within India.

GDP by expenditure method = Consumption Expenditure + Investment Expenditure + Government Spending + (Exports – Imports).

GDP by income method: This is total income earned by the factors of production like labor and capital.

GDP by income method = GDP (Factors of production) + Taxes – Subsidies.

India’s GDP for Q2 was 7.1% which is the fastest in the World.

1. Price Stability

Stable prices are very important for the growth in the economy. Rising prices (high inflation) causes distress in the economy. Financial planning and Investment Planning is very difficult in rising inflationary conditions.

2. Interest Rate Stability:

Maintaining interest rate stability is very important. Fluctuations in interest rate affect people purchasing houses, cars, consumer durables on loans.

3. Stability of financial markets:

It maintains the stability of financial markets. It prevents financial panic and failure of banks by being the lender of last resort. RBI is a major source of funds in the Money Market.

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4. Stability in Foreign Exchange Market

A rise in the value of the rupee (Rupee appreciates against the Dollar) makes exports non-competitive. The fall in rupee value (Rupee depreciates against the Dollar) increases inflation. Preventing extreme movements in the rupee vis-à-vis foreign exchange market is an important part of monetary policy.

5. Economic growth

Monetary policies promote economic growth by encouraging people to save, firms to invest and making money available for firms to invest.

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Tools of monetary policy:

1. Cash Reserve Ratio (CRR): Commercial Banks (Public Sector/Private Sector/ Foreign Banks/RRBs/Co-operative Banks have to maintain a portion of deposits with RBI called CRR. It currently stands at 4%.

Let’s have an example. If bank deposits increase by Rs 100 and CRR is 4%, Banks deposit Rs 4 with RBI and can use only Rs 96 for lending and investments.

2. Statutory Liquidity Ratio (SLR): The bank has to maintain at the close of business each day a minimum portion of NDTL (Net Demand and Time Liabilities) in cash, gold and approved Government securities. SLR currently stands at 19.5%. An increase in SLR affects banks ability to lend.

3. Repo Rate: Repo rate is the rate at which RBI lends to commercial banks for short periods against Government Securities like Treasury Notes and Treasury Bills.  RBI buys Government Bonds from banks with an agreement to sell them back at a fixed rate. Repo rate currently stands at 6.5%.

4. Reverse Repo Rate: Reverse Repo is the rate at which RBI borrows from commercial banks in the short-term. If banks have excess funds, they deposit with RBI to earn interest. If RBI wants to reduce liquidity it hikes the reverse repo rate sucking liquidity from the banking system. Banks prefer lending to RBI at a high rate because it’s safe.

5. Marginal Standing Facility (MSF): MSF is the rate at which banks borrow overnight funds from RBI against Government Securities. MSF is used by commercial banks in an emergency. MSF rate is 1% above repo rate. Banks can borrow up to 1% of NDTL. The minimum amount is Rs 1 Crores and in multiples thereof.

6. Open Market Operations: It is the purchase/sale of Government Securities by RBI from the market. Open market Operations (OPO) is done to control liquidity in the economy.  RBI sells Government Bonds to banks. Purchase of these bonds by banks means there’s less money to lend (retail and commercial lending) reducing surplus cash and sucking liquidity. If RBI purchases Government Bonds, money gets pumped into banks increasing liquidity and increasing banks ability to lend. If there’s excess liquidity, RBI sells securities and buys securities in case of liquidity crunch.

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