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Monetary Policy of Reserve Bank of India

    Mr. Rahul Singh | Tuesday, January 06,2009, 04:31 AM
 

Like every country, India has its own central bank – RBI, which performs the following roles :

  • Conduct monetary policy
  • Monitor and regulate banks and financial institutions
  • Act as government’s bank

I will focus primarily on the first role in this article. Conducting monetary policy means that the central bank is in charge of making sure the country has the right amount of money by taking decision on how much money gets printed and how much get circulated into the economy.

Monetary Policy:

What do we mean by money?

By money we mean currency, coins, deposits, saving accounts, travelers’ checks and short term deposits (less than 90 days). Credit cards are NOT considered as money because money is an asset while transaction on credit card is a liability i.e. credit.

Right amount of money

So how much is the right amount of money in an economy? Economists say that the right amount is just "enough money" that allows aggregate demand (AD) to grow at a rate that will let the economy expand at an acceptable rate without inflation. In layman’s language, right amount of money is just enough money to enable growth of GDP at a healthy rate without inflation. It is for the central bank (RBI) and/or the government to decide how much is a healthy GDP growth rate and how much inflation is acceptable.

Monetary Policy of Reserve Bank of India:

Goals of RBI

The following quote comes from the RBI website and explains its goals :
\"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.\"

Tools and Policy

It is clear from RBI’s goal that its main role is to maintain low and stable inflation by regulating credit system of the country. To understand this we need to know what causes inflation in the economy. Inflation is an increase in the prices of goods and services in the economy. It is caused by excess demand of products and services by the population due to increased growth or income. Hence, an increase in aggregate demand (AD) causes inflation. To check inflation, RBI has to control growth in AD. The best way to influence AD is to influence interest rate because AD is interest rates sensitive.

Interest rates on home loans influence housing demand. Auto loan rates affect the plan of individuals to purchase automobiles such as cars, bikes and trucks. Banks loan affects the ability of corporate to borrow and hence, influence economic growth. Hence, if RBI or any other central bank has to control AD, it has to influence interest rates.

However, RBI does not decide interest rates directly i.e. it cannot decide the interest rates on home loans or auto loans or corporate borrowing. RBI simply does not have any direct control over them. It can only use its tools to influence key rates. Whatever these tools may be, always remember the common thing – Controlling the amount of money that flows into the economy.

  • By reducing the availability of money in the economy, RBI can reduce AD because lesser money will be there to buy things – decreasing demand
  • By increasing the availability of money in the economy, RBI can increase AD because individuals as well as corporate have more money to spend – increasing demand
  • To reduce AD, raise interest rates because people and corporate will borrow less money and hence spending will go down. This would in turn reduce the demand for goods and services.
  • To increase AD, just do the reverse i.e. lower the interest rates. Individuals and corporate would borrow more money at lower rates and consume more goods and services, increasing AD in the economy.

Changing the Cash Reserve Ratio (CRR)

Banks cannot loan out all their deposits because they may fail soon. RBI or central banks require banks to keep a small portion of their deposits as “banks reserves”, which the banks cannot lend out. The current value of CRR is .....

When RBI increases CRR, banks are required to keep a higher amount of money in their banks reserves. Hence, less money is available for individuals and corporate in the market. This causes AD to decrease (see point no 1 above) and thus reducing inflation. On the other hand when RBI decreases CRR, Banks have more funds to lend to people. To loan out these extra money, banks will reduce the interest rates and increase AD.

Changing the Bank Rate

This is the rate at which RBI lends money to other banks (or financial institutions). These loans are usually very short-term loans. The main idea is that if the central bank, RBI, has reduced this rate, it is a signal to banks that it is appropriate to borrow money from it in larger quantities. These banks then lend out this extra money to their customers. To loan out these money banks have to lower interest rates which in turn increase AD.

Changing the Reverse Repo Rate

The rate at which RBI borrows money from the banks (or banks lend money to the RBI) is termed the reverse repo rate. The RBI uses this tool when it feels there is too much money floating in the banking system.

If the reverse repo rate is increased, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with the RBI (which is absolutely risk free) instead of lending it out (this option comes with a certain amount of risk). Consequently, banks would have lesser funds to lend to their customers. This helps reduce the flow of excess money into the economy.

Open market operations

This is the primary and most frequent way by which RBI control monetary policy. Open market operations involve buying and selling of short term government securities. This method may be different from others but the end result is the same – controlling money supply in the economy.

When RBI buys government securities from commercial banks, it gives them money and keeps those securities with itself. Thus, banks have now more money to lend out (see point 2). To loan out this extra money, banks lower interest rates on their products. We know how lower interest rates influence AD.

Current Rates Figures

(as of Jan 6, 2009)

CRR = 5.0%
Repo Rate            = 5.5%
Reverse Repo Rate    = 4.0%

Final Few Words

Nobel Laureates Finn Kydland and Edward Prescott once wrote that policy makers should be time consistent i.e. stick to their good long-run policies and not have their attention diverted to short-term emergencies. Had our RBI and central government listened to his wise comments, they would not have made hasty short-term decisions to control liquidity to tame inflation even. They were aware of the fact that inflation was caused by supply side constraints and NOT demand side. Yet, short term decisions, which are more often politically motivated, affect long term growth of the country. The aggressive approach of RBI has now led to a severe credit crunch in our economy. Some may argue that it is caused by sub-prime crisis and not RBI’s policies. I partially agree to that. However, majority of liquidity issues were caused by increased CRR.

The IndianMoney.com team has taken the pledge to educate and add to the knowledge of our readers in micro- as well as macro-economy related theories. More articles on Indian economy to come soon.

Mr. Rahul Singh

Mr. Rahul Singh is a B.Tech (Electronics) fom IIT Roorkee. He did his MBA from Kelly School of Business, Indiana University in 2008. He worked as a developer and a project lead at Support Soft India (Aug 2004-June 2008), a small software firm, where he was instrumental in establishing a critical product vertical within the firm. He also spent two years at Infosys between 2002 and 2004. He also worked as a Business Strategy intern (May 2007-Aug 2007) at Wetpaint.com Inc. in Seattle and gained significant experience in managing strategy and operations at a start-up.

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