Monetary Policy – Significance & Challenges – Explained Pointwise

What is monetary policy?

• Monetary policy refers to the actions and strategies used by a central bank (RBI) to manage money supply, interest rates, and credit in the economy, ensuring price stability, supporting economic growth, and ensuring financial stability.
• The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.

Types of monetary policy:

There are two types of monetary policy:

1. 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.
2. 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.

Objectives of monetary policy:

1. Price Stability: Target headline inflation at 4% (±2%) to maintain stable prices for goods and services.
2. Growth and Employment: Support conditions for sustainable economic growth and job creation by adjusting interest rates, money supply, and credit flows.
3. Financial Stability: Prevent excessive volatility in financial markets and banking system. Manage liquidity, supervise banks, and avoid asset bubbles.
4. Exchange Rate Stability: Manage the external value of the rupee through intervention in the foreign exchange market, mitigating excessive volatility, and ensuring competitive export/import sectors.
5. Interest Rate Stability: Curb undue fluctuations in interest rates, ensuring certainty for businesses and consumers in planning investments and purchases.
6. Support Priority Sector: Ensure affordable credit to agriculture, small industries, housing, and other priority sectors to promote inclusive growth and poverty reduction.

Monetary Policy Tools:

Monetary Policy Committee:

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

Significance of monetary policy:

1. Price Stability & Inflation Control: By targeting inflation and managing money supply through rates, the RBI preserves the purchasing power of citizens and prevents economic disruptions.
2. Supports Sustainable Economic Growth: The RBI ensures adequate credit availability for productive sectors, enabling investment, entrepreneurship, and employment generation, which drive India’s development.
3. Financial System Stability: Monetary policy helps prevent financial crises, liquidity shortages, and systemic risks by actively overseeing and regulating banks, NBFCs, and financial institutions.
4. Exchange Rate Stability: The RBI manages the value of the rupee to avoid wild fluctuations, supporting international trade, controlling import/export costs, and maintaining investor confidence.
5. Interest Rate & Credit Flow Management: By influencing lending rates and credit conditions, the RBI supports business planning, housing markets, consumption, and investment.

Challenges or limitations of monetary policy:

1. Monetary Policy Transmission: Reductions or hikes in the RBI’s policy rates (e.g., repo rate) do not always reflect quickly or fully in the lending rates offered by banks due to inflexible deposit costs, high small savings interest rates, and administered pricing.
2. Inflation Targeting Constraints: Monetary policy is effective mainly for demand-driven inflation, but much of India’s inflation is supply-side (especially food and fuel), which the RBI cannot address directly.
3. Incoherence between Fiscal & Monetary Policy:
   • High fiscal deficit and government borrowing can crowd out private investment and reduce the effectiveness of monetary policy.
   • Price controls, subsidies, and MSP (Minimum Support Price) interventions can conflict with policy aims, limiting the RBI’s independence and flexibility.
4. Policy Rate Rigidity & Administered Rates: Administered rates on small-savings greatly influence household deposit decisions, causing banks to hold their deposit and lending rates steady even when RBI signals rate changes.
5. Structural Rigidities & Market Constraints:
   • India’s financial markets are still evolving. Limited integration, underdeveloped bond markets, and preference for cash transactions reduce the impact of policy tools.
   • The large informal sector, which operates outside formal banking, means monetary policy changes might not reach a significant portion of the economy.
6. External Factors: Factors such as capital flows, global recession, US monetary policy, and geopolitical risks can impact India’s currency, capital markets, and inflation, often beyond RBI’s control.
7. Conflicting Objectives: The need to simultaneously control inflation and promote growth can create trade-offs. Expansionary policies boost growth but risk inflation, while contractionary policies fight inflation but slow growth.

Way Forward:

1. Strengthen Monetary Policy Transmission:
   • Improve the transmission mechanism so changes in the RBI’s policy rates reflect promptly and effectively into bank lending and deposit rates.
   • Encourage banking sector reforms to reduce NPAs, improve competition, and lower fixed costs so banks can adjust rates dynamically.
2. Enhance Coordination between Fiscal & Monetary Policies:
   • Improve synchronization between RBI and government budgetary policies to reduce fiscal dominance and its adverse effects on inflation and interest rates.
   • Rationalize subsidies and move towards better-targeted support to limit distortions in price signals.
3. Target Broader Inflation Measure Responsibly:
   • Balance headline and core inflation targeting, ensuring policymakers do not overlook essential goods impacting the poor.
   • Build public understanding and set expectations for acceptable inflation bands tailored to India’s developmental context.
4. Strengthen Regulatory Framework & Digital Infrastructure:
   • Expand digital payments infrastructure to improve monetary policy transmission through formal financial channels.
   • Strengthen regulation and oversight of NBFCs and microfinance institutions to ensure credit flow and financial stability.
5. Enhance Global Risk Management: Develop frameworks to better manage capital flow volatility, exchange rate fluctuations, and external shocks through a mix of monetary, fiscal, and macroprudential tools.
6. Foster Transparency & Communication:
   • Improve RBI’s communication strategies to build market confidence and effectively anchor inflation expectations.
   • Publish detailed monetary policy reports, market surveys, and data releases for greater accountability.

Conclusion:
Monetary policy in India thus aims to maintain stable price levels, promote growth, and support broad-based, inclusive financial sector development, ensuring that its benefits reach every section of society.