Monetary Policy – Basics Simplified | Prelims Capsules 2021

Monetary Policy 

Monetary policy

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Introduction 

Let us take you back to a time when there is no concept of money as you see now. When people want to buy something, they simply exchange things with one another i.e., barter system exists. 

For example: if one needs to buy onion, then they exchange rice with them. Need is fulfilled. The person who wanted onion gets it by paying rice to another person.  

This system suffers from two main problems: 

1. A person will always be required to find someone who is willing to buy what he is selling and willing to sell what he wants to buy. For example: In the above case, the person with rice must find someone who wants to buy rice and also has onions to sell to him. This is called the double coincidence of wants. Both the parties involved must be wanting to buy and sell to each other certain specific things. 
2. No common measure of value: Now, suppose two such persons do meet who want to buy from and sell to each other. In this case, also, a new problem crops up. Regarding the amount of quantity that must be exchanged. For example: How much rice should one give in exchange for a certain number of onions? There is no common measure of value. 

There are many other problems too but these are the two major ones.
Thus, the concept of money was introduced to solve these problems of the Barter system. 
Now, we have money in our economy which leads us to the concept of money supply and a need to control it. 

What is the money supply? 

In simplest of terms, the money supply is the amount of money circulating in the economy i.e., money in circulation. 

Why we need to control the money supply? 

Money supply indirectly impacts economic growth and the rate of inflation in an economy. 

For example:  

Money supply and inflation 

• Assume that there is a big society building where hundreds of people live. This society has one particular shop outside its exit gate. This shop supplies everything that people may need on a daily basis. 
• Suppose, around 40 people from the society receive a pay raise from their employer.  
• This leads to an increase in the money supply in this small economy. 
• Now, people would want to buy things using this excess money. This will not only lead to an improvement in their living standards but also to some unintended consequences as discussed below. 

• Suppose, 25 amongst this group decide to buy a specific brand of AC. 
• This AC sold around 2 units a month earlier, but now there is a sudden demand for 25 ACs in the economy.

What do you think will happen in this case? 

• The company, which builds the ACs, sensing this high demand will increase the prices.  
• As people have excess money, they’ll also be willing to pay more. And, this entire scenario leads to an increase in prices of the AC as too much money is chasing too few (in this case 1 product) goods. 
• If this situation remains there for a period of time, then it will result in inflation. 
• Also, did you notice that although only 40 people had excess money, the price rise will be paid by all the people living in the society! 

This is a side-effect of excess money supply in the economy. Though people’s living standards improve, it also led to a price rise. Hence, the money supply needs to be controlled to a certain level to balance growth & inflation (price stability) 

Note: We have deliberately kept this example very simple so that it can help you understand the concept. In an actual case, there are many factors that can lead to a price rise.   

Money supply and economic growth 

• Banks lend money to businesses. These businesses invest their money further. It generates profits and jobs for people and increases economic growth. 
• If a country is witnessing a slower growth rate, then increasing money supply can lead to more banks’ lending to the businesses, leading to growth & employment.  

So, as you can see, in some cases we need to decrease the money supply (Case 1) while in some cases we need to increase the money supply (Case 2). This control of the money supply is done by the central bank of a country through its monetary policy.  

What are the tools which RBI uses to implement monetary policy? 

RBI has various tools at its disposal to implement monetary policy. They are categorized under two heads: 

1. Quantitative/General tools 
2. Qualitative/Selective tools 

Quantitative tools:

As the name suggests, these are related to the volume of the money supply. They are indirect in nature and influence the quantity of money supply in the economy. 

 Following are the types of Quantitative tools used by RBI:  

1. Reserve Ratio 
   • CRR 
   • SLR 
2. Open Market Operation (OMO) 
3. Rates 
   1. Bank rate 
   2. Liquidity Adjustment Facility (LAF) 
      • Repo Rate 
      • Reverse Repo Rate 
   3. Marginal Standing Facility (MSF) 
4. Market Stabilisation Scheme (MSS) 

Cash Reserve Ratio (CRR) 

It is the percentage of total deposits (NDTL) of banks that they are required to keep with RBI at any point in time. 

• Cash Deposit or CRR is either stored in the bank’s vault or is sent to the RBI.  
• Usually, banks do not receive any interest on CRR deposited with RBI.
• Example: Consider a bank that has total deposits of 100 Crore and CRR is 4%. Then it is liable to keep 4 Cr under CRR requirements.

Purpose of CRR: 

• Protect the interest of the depositors by keeping a certain amount safe with the RBI.  
• Check on inflation:  
  • In times of High inflation: During inflation (excess money supply) RBI increases CRR. This means that banks have to keep more money under CRR requirements, which means they have less money to lend out. This leads to decrease in money supply  
  • In times of slow growth: There are times when in an economy money supply is less. This leads to slower growth. In such cases, RBI pumps money into the system. It decreases CRR. This means banks can now lend more resulting in more money in the system. 

• Current CRR = 3.50% (No need to remember this. Just for your info) 

Note: NDTL (Net Demand and Time Liabilities): A bank takes deposits and gives out loans 

• Assets: Loans and advances given to anyone are assets for a bank because they generate interest. The asset is something that generates a cash flow in the future. 
• Liabilities: Deposits made in the bank are liabilities for the bank because they have to be paid back to the customer.  
• Demand liabilities (a): Deposits that customers can ask for any time like a savings account, current account, balances in overdue Fixed Deposits, etc. 
• Time Liabilities (b): Deposits that can be withdrawn only after a specific period of time like Fixed Deposits etc. A customer can withdraw his FD only after maturity or else he has to pay a penalty. 
• Other Time & Demand Liabilities (ODTL) (c): RBI has defined some other demand and time liabilities like Interests on deposits, gold borrowed by banks from abroad, etc. 
• Inter-bank liabilities (x): Banks transact with each other too. A bank’s liabilities with other banks are known as Inter-bank Liabilities.  
  • NDTL (Net Demand and Time Liabilities) = a + b + c – x 
  • In simple terms, NDTL shows a bank’s external liabilities. NDTL is calculated every 2 weeks.  

Statutory Liquidity Ratio (SLR) 

It is the percentage of total deposits that banks have to keep with themselves in the form of safe and liquid assets such as;

• • Government securities (G-sec) 
  • Gold 
  • Cash 

• Impact on inflation 

1. An increase in SLR shall lead to reduced lending capacity of banks, leading to the reduced money supply in the economy => decrease in inflation 
2. A decrease in SLR means more money to lend => increased money supply 

• Purpose of SLR 

1. The purchase of g-sec by banks enables the govt to borrow money for developmental projects. (If there is no G-sec requirement in SLR then banks would not prefer to buy them otherwise because the interest is low. Banks can loan out the same money and earn more. So, SLR is critical to the government borrowing) 
2. Controlling credit flow in the economy (When RBI increases SLR then the credit creation capacity of banks will decrease because banks will have less money to loan out). 

Note: Government needs money for its various developmental activities. Sometimes it arranges for this money via G-sec. These are issued by RBI.  

• They are nothing but a piece of paper in which govt guarantees that it shall repay the money it took after a specific period of time.  
• So, after buying a g-sec, you’ll get that piece of paper while the government gets the money for their project. 
• After maturity (just like a fixed deposit with a bank) government repays the amount it borrowed from you with some interest 

Note: CRR is a stricter requirement than SLR because on CRR banks get no interest. While in SLR they receive interest through G-secs.  

Note: SLR presently is at 18%. So, if a bank has total deposits of 100 Cr then it will have to keep 18 Cr as SLR.  

• If CRR is 4% then it will also have to keep 4 Cr as CRR too.  
• This means the bank has to keep a reserve of 18 + 4 = 22 Cr under SLR + CRR requirements.  
• So, the amount which it can rotate in loans, etc is 100 – 22 Cr = 78 Cr.

Open Market Operations (OMO) 

Buying and selling of G-secs in the open market by RBI is known as Open Market Operation (OMO). 

• When there is excess money supply then RBI sells G-secs. It means g-secs issued by RBI are bought by the market and RBI sucks excess money out of the market.  
• When there is a low money supply then RBI buys g-secs. It means it releases money in the market. 
• G-Secs are issued through auctions conducted by the RBI on the electronic platform called the E-Kuber, the Core Banking Solution (CBS) platform of RBI. 
• RBI carries out the OMO through commercial banks and does not directly deal with the public 

 Example: G-secs are always issued at discount.  

• Consider a G-sec with a face value of 100 Rs and it is sold to the buyers at a discounted price of, say 90 Rs. In this case, the discount is 10%. 
• Suppose G-sec will mature after 10 years. 
• Then after 10 years, the government shall repay 100 Rs to the holder, not 90 Rs.  

 Now, we shall discuss various types of interest rates as charged by RBI whenever it loans money to banks. 

• This interest rate is also a tool that is used by RBI to increase or decrease the money supply in the economy 

You can use the following diagram to understand the entire scenario. Whenever banks need money, they approach RBI, and in return, RBI charges a specific amount of interest rate from them. 

Bank rate 

In simplest of terms, the rate at which commercial banks can borrow from the RBI without providing any security. 

• Lending under bank rate is done for a long period of time 
• Bank rate is also sometimes used by RBI to penalize a bank for not following its guidelines. For example, the Bank rate currently is 4.25%. If RBI’s directions are not followed by a bank, say PNB, then RBI can charge a higher bank rate from it, like 5% or 6%. This will make things difficult for the bank as its borrowing cost will increase. This means it will have to charge a higher interest rate from its customers resulting in losses.

Liquidity Adjustment Facility (LAF)  

• This facility was introduced in 2000 
• Under this facility, banks are able to borrow money from RBI through repurchase options agreements (repos) or make loans to the RBI through reverse repo agreements. 

 Repo Rate (RR) 

It is the rate of interest at which a central bank lends to a bank for a short period of time (usually for 2 weeks or fortnight) against government securities (G-sec).

• Do you remember that under SLR a bank has to keep a certain percentage of its deposits in the form of g-sec also? This g-sec cannot be pledged against the money taken under Repo Rate.  
• Repurchase here simply means that a bank agrees to repurchase the securities (kept as collateral) later from the RBI at a predetermined rate and time.  
• If the bank defaults on its commitment, then RBI can sell the g-secs in the open market 
• Repo rate is also known as ‘policy rate’.  
• Monetary Policy Committee (MPC) decides Repo Rate 
• As no collateral (or security) is pledged by the bank when borrowing from RBI under bank rate so bank rate is always kept higher than Repo Rate. This way banks are encouraged to borrow under Repo rate 
• Banks also use Repo to fund their daily requirements, like CRR, SLR, etc.
• An increase in RR will decrease the money supply and vice-versa 
• Current Repo Rate = 4% 

Note: RBI has introduced Long Term Repo Operations (LTRO) in 2020 in wake of the COVID crisis to address liquidity problem i.e., banks were facing liquidity problem (liquidity is the ease with which an asset can be converted to cash. Hence, cash is the most liquid)  

• Under LTRO, RBI gives loans to banks for 1 to 3 years at prevailing Repo Rate 

How is this beneficial to banks?  

• We already know that money under Repo Rate is usually given for a shorter period of time. For a long period of time RBI charges a bank rate that is higher than the Repo Rate. 
• But now under LTRO banks can get money for a long period of time at the prevailing Repo Rate.

Note: If bank rate and repo rate are made equal, then which option shall banks choose to borrow money from RBI?  

• They’ll prefer Bank rate because banks will like to get money without pledging anything against it 

Reverse Repo Rate (RRR) 

The rate at which RBI borrows from the banks for a short period of time  

• Under reverse repo, RBI sells short-term g-secs to banks with an agreement to purchase them back at a predetermined rate and time (the exact opposite of RR).
• If reverse repo increases then money supply will decrease and vice-versa 
• Reverse Repo Rate is always less than Repo Rate because otherwise, banks will borrow money from RBI at lower interest rates and then deposit that money with RBI for a higher interest rate. 
• Current Reverse Repo Rate = 3.35% 

Note: The values of different rates mentioned in the article keeps on changing. You can find the exact value at any given point in time by visiting RBI’s website. 

 Controlling of money supply by RBI 

 Marginal Standing Facility (MSF) 

• Introduced in 2011 
• This is another method available with banks for borrowing money from RBI 
• Need for MSF: A natural question that arises at this point is that why did we need MSF when we already had other methods of borrowing, like Repo & Bank rate, etc? 
• Under Repo Rate banks have to pledge g-sec. 
• Under the Bank rate, the interest charged is higher. 
• Now, consider a case where a bank has no more g-sec left to keep as security with RBI. 
  • In this case, a bank will borrow from other banks and the inter-bank lending rate is high and can vary. For example: If SBI borrows from ICICI then ICICI can charge whatever interest rate it wants to from SBI. This can create volatility where no set limit is there and everyone is charging what they feel is right.  
• For such cases, MSF was introduced.  
• Under MSF, banks can borrow from RBI up to a certain percentage of their NDTL, on overnight basis 
• Banks still need to pledge g-sec against the borrowing but such g-sec do not affect the SLR requirements of the bank meaning the g-secs kept under SLR can be kept as collateral (गिरवी) 
• Purpose of MSF: 
  • To provide another route for borrowing money over & above the Repo Rate 
  • To curb volatility in the overnight inter-bank lending rate     
• Points to note: 
  • MSF is used as a last resort of borrowing by a bank after it has exhausted all of its borrowing options including Repo Rate.
  • The interest rate under MSF is always kept higher than Repo Rate so as to discourage banks from borrowing under this facility. It is a kind of penal rate. RBI doesn’t want banks to borrow under MSF.
  • Current MSF = 4.25% 

 Market Stabilisation Scheme (MSS) 

• Introduced in 2004 
• Used by RBI to address the problem of excess liquidity.
• When used for the first time in 2004, at that time there was a problem of excess liquidity due to huge inflow of foreign currency. How excess foreign inflow will cause excess liquidity? 
  • Suppose there is a foreign investor who wants to invest in India. 
  • Now, he can’t do so in dollars. He’ll have to convert his dollars to rupees. 
  • So, he goes to RBI and asks for rupees. Further, RBI takes his dollars and gives him rupees. 
  • Similarly, there would be other investors who will be lining up before RBI to get their dollars converted to rupees.  
  • This increases the demand for rupees, leading to its appreciation with respect to dollars (meaning, if before 1$ was worth 40 Rs then after the increased demand of rupees, 1$ may be worth 30 or 35$. Anything in demand will become costlier. Hence, rupee becomes costlier vis-à-vis dollars.) 
  • Now, RBI doesn’t like this because it likes to keep the exchange rates stable as an unstable exchange rate can cause multiple problems (like if rupees appreciates then it can make our export costlier, etc) 
  • Also, the money received by foreign investors was invested back in the economy resulting in excess liquidity. 
• So, how RBI checked this problem? It introduced Market Stabilisation bonds on behalf of the government. 

• • Through bonds an investor loans money to an entity (typically corporate or government) that borrows the funds for a defined period of time at a variable or fixed interest rate.  
  • Bonds are used by companies, municipalities, states, and sovereign governments to raise money to finance a variety of projects and activities.  
  • Owners of bonds are debtholders, or creditors, of the issuer. 
  • G-sec is also a type of bond.
• These bonds were sold in the market resulting in excess liquidity to be controlled. 
• As bonds were bought, money came back from the economy. 
• Do remember that although these bonds were issued on behalf of the government, the money that came back was kept with RBI.  
  • Government can use that money which it borrows via issuing of g-secs 
  • Market Stabilisation Bonds were different in the sense that they were meant for only one purpose: to suck excess liquidity out of the system. 

That’s a lot to take in if you are a complete beginner. 
Take a break. Re-read the above section, make your notes if you want and then proceed forward.
Now, let us discuss the second category of monetary policy tools. 

Qualitative tools:

These tools affect the usage of credit in various sectors like upper limits can be fixed by RBI wherein banks are not allowed to lend beyond a certain limit to certain specific sectors of the economy. The money supply is not affected. The allocation of money available is just given a direction.  

 Following tools are available to RBI under this category: 

• Credit rationing 
• Margin requirements 
• Other measures 
  • Moral suasion 
  • Direct Action 

Credit Rationing 

Under this method, RBI fixes a specific quota of credit that can be allocated for various sectors in the economy. Banks are told to adhere to these limits. For example, RBI can direct banks to give only 100 Cr of loans to the industrial sector, 500 Cr loans to the agriculture sector, etc.

Margin requirements 

It refers to the difference between the market value of a security (collateral) and the total amount of loan given by the bank against that security. For example: Suppose you want to open a restaurant and went to a bank for a loan. 

• Bank agrees to give you a loan. Obviously, the bank will only give you a loan against some security.
• Fortunately, you have some land that can be pledged as security. Suppose its present value is at around 1 Cr 
• Now, the bank will take that security and grant you a loan of 90 lakh rupees.  
  • You wanted a loan of 1 Cr against security of 1 Cr but you got a loan of 90 lakh rupees 
  • This difference between the loan granted and the value of the security is termed as Margin. (In this example, the margin requirement comes out to be 10%) 
  • Banks keep this margin in case the borrower, that is you, defaults or in case the market value of the security declines. 
• This margin requirement can be varied by RBI under this monetary policy tool. 
  • Let’s revisit the above example. You took a loan because you had to open a restaurant and for you, the margin requirement was 10%. 
  • Now, assume that your friend also needs a loan of 1 Cr. He wants it for his agricultural business. He also approaches the bank. Bank asks for security. Your friend also has some land which is valued at 1 Cr. 
  • But, in this case, the bank gives him 95 Lakh rupees as a loan. (Here the margin requirement comes out to be 5%) 
  • Why this difference? Your friend gets a higher loan against the similarly valued security because of the difference in margin requirements set by RBI.  
  • So, in the above example, RBI might have set a margin requirement of just 5% for loans given to the agriculture sector. 
• Thus, RBI can decide and direct towards which sector the liquidity flow would be higher or lower respectively. Like in our above example, the liquidity flow to the agriculture sector would be higher 

 Moral suasion 

• Suasion means persuasion as opposed to force or compulsion 
• Under this the central bank advises banks to follow certain guidelines via issuing letters, seminars, circulars, etc 
• Banks are not legally obligated to follow such advice.  

 Direct Action 

If banks still fail to follow RBI’s guidelines, then they can impose a penalty or sanctions on it. This is called direct action.

Monetary Policy

 Now, on the basis of what you’ve read above, you know that RBI uses monetary policy tools to either  

• Decrease the money supply (in times of inflation) 
• Increase the money supply (to push economic growth) 

 In both of the above situations, RBI is following a certain type of monetary policy. 

• In case 1, RBI is decreasing (contracting) the money supply => contractionary monetary policy 

• • It is also called the Dear money policy. Dear means highly valued or precious. The supply of money is decreased and borrowing it becomes dear. Hence, the name. 

• In case 2, RBI is increasing (expanding) the money supply => Expansionary monetary policy 

• • This policy is also called a cheap money policy because the money supply is increased in the economy and borrowing becomes cheaper. Hence, the name. 

Types of monetary policy 

There are two types of monetary policy 

• Contractionary/Dear money policy: It seeks to reduce the money supply in the economy. Under this policy  
  • These rates are increased: CRR, SLR, Bank Rate, Repo Rate, Reverse Repo Rate, MSF  
  • Under OMO, RBI will sell g-secs 
• Expansionary/Cheap money policy: It aims to increase the money supply in the economy. It is usually followed when RBI wants to push economic growth or counter recession. Under this policy, 
  • These rates are decreased: CRR, SLR, Bank Rate, Repo Rate, Reverse Repo Rate, MSF  
  • Under OMO, RBI shall purchase g-secs 

Who implements the monetary policy in India? 

In India, RBI is vested with the authority to conduct monetary policy in India. This responsibility has been explicitly mentioned under RBI Act 1934.  

What is the primary goal of a monetary policy? 

The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. This is known as flexible inflation targeting (keyword: flexible) wherein RBI has to pay prime attention to price stability but also keep in mind to promote economic growth.  

• In 2015, the central bank and the government agreed on a new monetary policy framework. Under which the primary objective is to ensure price stability while keeping in mind the objective of growth. 
• In India, flexible inflation targeting was officially adopted in 2016.  
  • In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting meaning flexible inflation targeting as a goal of monetary policy is now mentioned explicitly in the RBI Act 

Who sets the targets for inflation? 

The amended RBI Act states that the inflation target will be set by the Government of India, in consultation with the Reserve Bank, once every five years 

• Initial Target: 4+/-2% (From Aug 2016 to March 31st, 2021)  

• • This means that inflation has to be kept between 2% – 6%. It can’t be allowed to dip below 2% and go beyond 6%. 
  • If it dips below 2% then that means the economy is deficient in money supply which means less income in the hands of people. This leads to slower growth. This situation is the opposite of inflation i.e., deflation. This is equally dangerous.   
  • Flexible inflation targeting also means that a certain level of inflation between 2% to 6% is indeed desirable. 

• Current update: Government has retained this target band for the next five years i.e., till 2026 

• Also, as per the amendment to the RBI Act, Consumer Price Index (CPI) will be taken as the overall indicator of inflation in the economy.  

• • CPI is one of the ways to measure inflation. It is based on retail prices of selected goods & services.  
  • This indicator has been chosen because it tracks changes in the price movement of goods that people consume. Hence, it shows the impact of inflation on people 

• The MPC (Monetary Policy Committee) determines the policy interest rate (Repo Rate) required to achieve the inflation target. 

What is Monetary Policy Committee (MPC)? 

The Monetary Policy Committee (MPC) is constituted by the Central Government under Section 45ZB of the RBI Act 1934 

• The first such MPC was constituted in 2016 
• The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. 
• Situation before MPC: Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets, and public finance, used to advise the Reserve Bank on monetary policy. With the formation of MPC, the TAC on Monetary Policy ceased to exist. 
• Structure of MPC: 6 members  

• • Governor (Chairperson of MPC) 
  • Deputy Governor (in-charge of monetary policy) 
  • One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio 
  • 3 members to be nominated by the government (These members will hold office for a period of four years or until further orders, whichever is earlier) 

• Each member of the MPC has one vote, and in the event of an equality of votes, the Governor has a second or casting vote. 
• Under the flexible inflation targeting (FIT) framework, the “repo rate” is the policy rate. It is determined by the MPC based on the assessment of the macroeconomic condition and with the aim to keep CPI inflation near 4%+/-2%, as discussed above 
• Currently, MPC is only responsible for setting policy (repo) rate and performing the liquidity operations to operationalize the monetary policy lies with the RBI