What is monetary policy? Monetary policy is the process by which RBI manages the money supply in the economy. The monetary policy includes inflation targeting, full employment and stable economic growth.
What affects money supply in the economy? The money supply is affected by the reserve ratios, (Cash Reserve Ratio, Statutory Liquidity Ratio among others), Open market operations and indirectly affected by key interest rates like the repo rate. This affects cost of credit (This has an effect on home loan rates, car loan rates and can stimulate/reduce demand in the economy).
An easy monetary policy means reducing key interest rates (Repo rates are reduced) which improves liquidity and promotes growth in the economy.
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One of the main goals of monetary policy is to maintain price stability. Price stability is very important for growth in the economy.
For price stability, inflation must be controlled. This is why Government has set an inflation target for 5 years. India has adopted inflation target of 4% for the next 5 years. The Government of India sets the inflation target in consultation with RBI. Consumer Price Index, CPI, inflation target for August 5th 2016 to March 31st 2021 is the upper limit of 6% and the lower limit of 2%.
An expansionary monetary policy promotes job growth, reducing unemployment by supplying more money into the economy. (Increases liquidity in the economy).
The RBI would cut repo rate and banks would reduce home loan rates and other interest rates go down. This facilitates borrowing and lending activity increases. Businesses grow and expand which means more jobs as demand for labor increases. Unemployment goes down in the economy.
The value of rupee against dollar depends on the market forces. (Supply and Demand). If the demand for dollar increases, then the rupee depreciates. Let’s say demand for import rises. We pay for imports in dollars. The rupee weakens against the dollar.
These are some of the factors which influence the value of the rupee:
RBI intervenes in the market to support the rupee. A weak rupee increases import bill. But, a weak rupee is good for exports and this is why export oriented nations keep currency weak.
RBI intervenes in the markets by buying and selling dollars. If RBI wants to prop up the rupee (make rupee strong against the dollar or make rupee appreciate), then it sells dollars. If RBI buys dollar then rupee depreciates against the dollar.
SEE ALSO: Why Monetary Policy is Important
The RBI can also use monetary policy to influence the value of the rupee. RBI can adjust repo rate to influence liquidity and also cash reserve ratio and statutory liquidity ratio, SLR (Where banks must invest in Government Bonds) to control the rupee.
Repo rate: RBI uses the repo rate to control inflation. This is the rate at which RBI lends to commercial banks if there is shortfall in funds. The repo rate is 6.25%.
If RBI increases the repo rate, this leads to a rise in interest rates, bond yields, return on debt papers which draws foreign investment into the economy. Higher repo rate leaves more money with the RBI which helps manage the currency demand-supply situation.
If RBI raises the repo rate to control inflation, banks would not borrow from the RBI as rates are high. This would reduce money supply in the economy and high interest rates mean people postpone borrowing, slowing down in the economy. This cuts down demand and curbs price rise in the economy.
What happens when RBI cuts repo rate? When RBI cuts repo rate, banks pay less on borrowings. They charge less on loans which increases money circulation and increases economic activity.
Reverse repo rate: This is the rate at which RBI borrows from commercial banks with collateral of eligible government securities. The reverse repo is 6%.
Liquidity Adjustment Facility, LAF: RBI manages the commercial needs of banks through the liquidity adjustment facility or LAF.
If there are liquidity shortages then RBI uses LAF to inject liquidity into the system. It also uses LAF to suck out excess liquidity in the system if the need arises. Liquidity injection is done through repo operations and liquidity absorption is done through reverse repo operations.
Banks which face liquidity shortages approach RBI and pledge Government Securities for loans. Banks resort to repo operations in times of liquidity shortage. When banks have excess liquidity, they park money with RBI to earn interest (Reverse Repo Operations).
Marginal Standing Facility, MSF: Before MSF let’s understand SLR or Statutory Liquidity Ratio. Each bank must have a minimum portion of NDTL (Net Demand and Time Liabilities), in the form of cash, gold and liquid assets on each day. NDTL is basically deposits of the public held by banks and also deposits held with other banks. SLR is the ratio of these liquid assets to the total demand and time liabilities. SLR is currently 19.5%. If RBI increases SLR, banks have less money to lend.
What does all this mean? If a bank has securities above the 19.5% limit, then the banks can pledge with the RBI for funds. Under MSF commercial banks can dip into the SLR portfolio up to a limit at a penal interest rate. This helps borrow an additional amount of money overnight from the RBI. Commercial Banks use MSF when there’s desperate need of funds.
SEE ALSO: How Does LAF Work
Open market operations are purchase/sale of government securities and treasury bills by RBI. OMO is the buying and selling of Government Securities in the open market with the purpose of expanding or contracting money supply in the banking system.
Contractionary Monetary Policy is a type of economy policy which is used to fight inflation. It involves decreasing the money supply in the economy to increase the cost of borrowing. This reduces GDP by dampening inflation.
Contractionary Monetary Policy is also called a tight monetary policy where interest rates are increased to reduce liquidity. This has a negative effect on production and consumption and consequently, economy growth.
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