UNIVERSITY OF MUMBAI A PROJECT ON RBI AND ITS MONETARY POLICIES

MASTER OF COMMERCE (BANKING AND FINANCE) SUBJECT: COMMERCIAL BANK MANAGEMENT SEMESTER II 2012-13

In Partial Fulfillment of the Requirement under Semester Based Credit and Grading System for post graduate (PG) Program under Faculty of Commerce

SUBMITTED BY ANITA SESMA Roll no: 102

PROJECT GUIDE Dr.T.B.Gadhave

Sydenham College of Commerce & economics, churchgate, B-Road, Mumbai

CERTIFICATE
This is to certify that Miss. Anita sesma of M.Com. Banking and Finance Semester 2 (2012-2013) has successfully completed the Project on RBI and its monetary policies under the guidance of Dr.T.B.Gadhave.

Project Guide

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Course Coordinator

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Internal Examiner

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External Examiner

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Principal

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Date: Place: Mumbai

DECLARATION

I ANITA SESMA ,a student of M.Com (Banking and Finance) 2nd semester (20122013), hereby declare that I have complete the project on RBI and its monetary policies. The information submitted is true and original to the best of my knowledge.

ANITA SESMA (Signature)

ACKNOWLEDGEMENT
I wish to express my sincere gratitude to Professor as well as our project guide Dr. Dr.T.B.Gadhave, Sydenham college of commerce and economics, Mumbai for providing me an opportunity to present a project on RBI and its monetary policies. This project has not only developed my skills as academics are concerned but also to a further extent help to know the topic in a much better way. I would also love to express my gratitude to our librarians who co-operate in completion of my project.

I am also thankful to my parents and friends who have helped me in my completion of my project.

Table of Contents NO. 1. 2. 3. 4. 5. Introduction of RBI Monetary policy Monetary policy objectives Monetary policy functions Operations of Monetary policy Quantitative credit control Selective or qualitative methods 6. Operating procedures of Monetary policy Liquidity adjustment facility (LAF) Market stabilization scheme 7. 8. 9. 10. 11. 12. 13. 14. Monetary policy tools Recent changes in Monetary policy Evaluation of Monetary policy First quarter review of monetary policy (2010-11) Mid quarter review of monetary policy (2010-11) Limitations Conclusion Bibliography Particulars

INTRODUCTION OF RBI

The central bank of the country is the Reserve Bank of India (RBI). It was established in April 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission Reserve Bank of India was nationalized in the year 1949. The general superintendence and direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors, one Government official from the Ministry of Finance, ten nominated Directors by the Government to give representation to important elements in the economic life of the country, and four nominated Directors by the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi. Local Boards consist of five members each Central Government appointed for a term of four years to represent territorial and economic interests and the interests of co-operative and indigenous banks.

The Reserve Bank of India Act, 1934 was commenced on April 1, 1935. The Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank.

Objectives and Reasons for the Establishment of R.B.I: The main objectives for establishment of RBI as the Central Bank of India Were as follows: To manage the monetary and credit system of the country To stabilizes internal and external value of rupee. For balanced and systematic development of banking in the country. For the development of organized money market in the country. For proper arrangement of agriculture finance. For proper arrangement of industrial finance
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For proper management of public debts.To establish monetary relations with other countries of the world andinternational financial institutions.

For centralization of cash reserves of commercial banks. To maintain balance between the demand and supply of currency.

According to the Reserve Bank of India Act, the aim of RBI is, to regulate the issue of bank notes and keeping of reserve with a view to secure system of the country to its advantage.

Monetary Policy

India is the management of a nation's money supply to achieve economic goals by a central bank or currency board. Monetary policy objectives can include control of inflation, control of exchange rates, or even simply economic stability. Monetary policy is contrasted with fiscal policy, which aims to achieve economic goals through taxation and government expenditure. The Federal Reserve, or Fed, handles monetary policy in the United States. The Fed controls the money supply through open market operations, and also sets interest rates between banks and reserve requirements. Tight monetary policy, also called contractionary monetary policy, tends to curb inflation by contracting the money supply. Easy monetary policy, also called expansionary monetary policy, tends to encourage growth by expanding the money supply. These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy. Besides, the RBI also announces norms for the banking and financial sector and the institutions which are governed by it. These would be banks, financial institutions, non-banking financial institutions, Nidhis and primary dealers (money markets) and dealers in the foreign exchange (forex) market.

When is the Monetary Policy announced? Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy

Monetary regulations
The main function of the Reserve Bank of India, as of all the central banks, is to formulate and administer monetary policy. Monetary policy refers to the use of instruments with the purview of the central bank to influence the level of aggregate demand for goods and services. Monetary policy is the twin objective of price and growth. As part of the monetary policy, money supply is sought to be influenced because it will have effect on output and prices. With the economic and the financial liberalisation and deregulation measures initiated since early 1990s, the framework of the monetary policy formulation and implementation has been undergoing significant changes, indirect tools gaining prominence over direct instruments along with a series of steps for the development and integrity of financial markets. The Reserve Bank of India thus seeks to influence the level of money through a continuation of measures that include interest rates as well as open market operations and other measures that alter the Bank reserves

Monetary policy objectives

In India, the main objective of monetary policy is growth with stability. But of late, financial stability is also becoming an important objective in view of the increasing openness of the Indian economy. Besides, the RBI also uses its power to direct credit flows to the priority sector to meet certain social objectives. The following are the main objective of RBIs monetary policy:-

1) Growth with stability :the main objective s of monetary policy in India are (a) price stability and (b) provisions of adequate credit to productive sectors of the economy to support aggregate demand and ensure high GDP growth. These objectives can be together termed as growth with stability. Traditionally, RBIs monetary policy was focused on controlling inflation through contraction of money supply and credit. But this resulted in poor growth performance of the economy. Therefore, RBI has now adopted the policy of growth with stability or controlled expansion of credit. this means, the monetary policy will be such that sufficient credit will be made available for the growing needs of different sectors of the economy, and at the same time, inflation will be controlled within a certain limit.

2) Financial stability:Financial stability means the ability of the economy to absorb shocks and maintain confidence in the financial system. Threats to financial stability can come internal and external shocks, e.g. collapse of major banks or a sudden rise in international oil price. Such shocks can destabilize the countrys
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financial system and cause volatile and unpredictable changes in the economy. The Indian economy is now open to external influences and can be affected by such shocks. Therefore, greater emphasis is being given to RBIs role in maintaining confidence in the financial system through proper regulations and controls, without sacrificing the objective of growth. Accordingly, RBI is focusing on regulation, supervision and development of the financial system.

3) Promotion of financial inclusion:Financial inclusion is the process by which financial services and timely and adequate credit at affordable cost are provided to the weaker sections and low income groups. Since nationalization of commercial banks in 1969, RBI has been promoting priority sector lending by banks. Priority sector includes agriculture, export and the small scale enterprises and the weaker section of the population. Of late, it has been observed that financial inclusion has not been achieved in case of many sections of society. Therefore, RBI< along with NABARD, is focusing on microfinance through the promotion of self help groups and other institutions. These efforts of RBI are expected to reduce income inequality.

4) Employment generation :Monetary policy promotes growth and therefore indirectly promotes employment generation. Selective measures of credit control indirectly help in employment generation. By allocating cheap credit to agriculture and small scale industries, the RBI seeks to generate employment.al though maintaining price stability is considered the most
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important objective of monetary policy, recent experiences in conducting monetary policy has called for an imperative need for strategic adjustment so as to enable the policy to respond effectively to market disturbances and external sector development, particularly in the context of Indian economy getting integrated with global financial market.

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Monetary policy functions

Monetary policy functions form the core of central banking functions and constitute the key functions of almost all the central banks. Of these functions, currency management and maintenance of external value of currency were the predominant concerns of central banks in the early years of central banking .the explicit concern for price stability is of relatively later origin. 1) Currency issue and management : Currency management is one of the most Important traditional functions of the central banks in most countries. Until the evolution of central banks, private banks issued their own currency and there were often numerous currencies with varying degrees of acceptability. The task of currency issue was entrusted to the central bank so as to bring uniformity in note issue across the country and facilitate exchange. Central bank s have continued to perform this functions for number of years. Currency issue was nationalized in almost all the countries. This function grew in scope and the present task of currency management includes functions such as estimating the demand for currency, currency design, printing, shortage, distribution and disposal of unit notes. The monopoly power to issue currency is delegated to a central bank in full or sometimes in part. The practice regarding the currency issue is governed more by convention than by any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange. The primitive currency note was in reality a promissory note to pay back to its bearer the original precious metals. With greater acceptability
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of these promissory notes, these began to move across the country and the banks that began to issue the promissory notes soon learnt that they could issue more receipts than the gold reserves. Even after the emergence of central banks, the concerned governments continued to decide asset backing for issue of coins and notes. The asset backing took various forms including gold coins, bullion, foreign exchange reserves and foreign securities. 2) Maintaining internal value of the currency Instituting a medium of exchange is one of the oldest functions assigned to central banks. Arising from the core function is the monetary policy function of keeping inflation low in order to maintain the value of the medium of exchange over time. This function is still very relevant to modern central banks as can be seen from the widespread adoption of inflation targeting framework. Domestic policy objectives have been centered on price stability goals for years and even today have remained the main pre-occupation of central banks. There have been often a conflict between functions of central bank; for instance, maintaining the value of currency conflicted with its functions of being a banker to the government, especially in developing country. These central banks have to manage a very level of public debts and often used inflation tax that undermined their price stability objective. There is increasing realizing that printing more money does not help in raising growth rates. In fact, a stable price level has become a prerequisite of growth and trade. Accordingly, the maintenance of price stability through the conduct of monetary policy has become the prime objective of central bank. In a market economy, the central may have the
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option of using market-based instruments for conduct of monetary policy. It may choose intermediate targets such as interest rates, exchange rates and monetary aggregates. 3) Maintaining external value of the currency Central banks in many economies consider exchange rate management as a crucial function. Exchange rate management was the core concern of the traditional central banks even in the 17th century. During the gold standards, the exchange rate was determined more or less automatically by the mechanism of specie flow. It ensured that the value of the currency rose with an increase in gold reserves and decreased with a decrease in the reserves. The role of central bank in managing the exchange rate cannot be underplayed. The rationale underlying the management of the exchange rate by the central bank has varied over time. There are various patterns to the management of the exchange rate. Some central banks keep exchange rates depressed while others target it a particular point or within a range.

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Operations of monetary policy

Instruments
The RBI has multiple instruments at its command such as repo and reverse repo rates, cash reserve ratio (CRR), statutory liquidity ratio, open market operations, including the market stabilization schemes (MSS) and the liquidity adjustment facility (LAF), special market operations, and sector- specific liquidity facilities. In addition, the RBI also uses other operational tools to modulate flow of credit to certain sectors consistent with financial stability. The availability of multiple instruments and flexible use of these instruments in the implementation of monetary policy has enabled the RBI to modulate the liquidity and interest rate conditions admit uncertain global macroeconomics conditions. The important function of RBI is to control money and credit in the country. The instruments of monetary policy operated by the RBI may be classified into two categories (i) (ii) Quantitative measures which affect the total money supply and credit Qualitative or the selective measures which affect the allocation of bank credit among competing uses and users

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Quantitative credit control

1) Bank rate: As the lender of the last resort, the RBI helps the commercial banks in temporary need of cash when other sources of raising cash are exhausted. The RBI provides credit to banks by rediscounting eligible bills of exchange and by making advances against eligible securities such as government securities. The lending rate for these advances by the RBI is called the BANK RATE which is a traditional weapon to control money supply. An increase in the bank rate would discourage commercial banks to borrow from the RBI and a corresponding increase in the lending rate of commercial banks to general public would decrease public borrowings from the bank.

2) Reserve requirements: Reserve requirements are used by RBI to control the credit creation capacity of banks. Every commercial bank needs to maintain a certain proportion of its assets in the form of reserves dash reserve ratio (CRR) and statutory liquidity ratio (SLR) are the two reserve requirements imposed by the RBI. When the TBI changes the reserve requirements, its influences that capacity of banks to lend and create credit. During inflation the reserve requirements are raised and during recession they are lowered.

a) CASH RESERVE RATIO (CRR):Scheduled banks in India are required to hold cash reserves, called cash reserve ratio (CRR), with the RBI. Increase/decrease in CRR is used by the RBI as an instrument of monetary control, particularly to
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mop up excess increase in the supply of money this power was given to RBI in 1956.

b) STATUTORY LIQUIDITY RATIO: Apart from the CRR, the banks in India are also subject to statutory liquidity requirement. Under this requirement, commercial banks along with other financial institutions are required under law to invest prescribed minimum proportions of their total assets/liabilities in government securities and other approved securities. The underlying philosophy of this provision is to allocate total bank credit between the government and the rest of the economy. The assurance of a certain minimum share of bank credit to the government affects the borrowings of the government from the RBI and hence serves as a tool of quantitative monetary control. The SLR provisions have created a captive market for government securities which increases automatically with the growth in the liabilities of the banks. Moreover, it has kept the cost of the debt to the government low in view of the generally low rate of interest on government securities.

3) OPEN MARKET OPERATIONS: The RBI can enter the money market for the purpose or sale of government securities on its own account. Every open market purchase of the RBI increase primary money by equal amount while every sale decreases it. As regards their advantages, open market operations are highly flexible. Easily reversible in time, their effect on money supply is
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immediate, and they do not carry announcement effect as in the case of changes in the bank rate. Open market operations, consider very effective in developed countries, are not of much importance in India in view of captive nature of the market for government bonds. For example, the treasure bill market is limited largely to the RBI itself and scheduled commercial banks which are required under law to invest minimum proportion of their total liabilities in government securities. The private dealers In government securities are few and far between.

4) Repo And Reverse Repo Rates:

The bank rate as a credit control policy instrument is losing its importance in recent years. At present, the repo and the reverse repo rates are becoming important in determining interest rate trends. Repo (sale and repurchase agreement) is a swap deal involving the immediate sale of securities and simultaneous purchase of those securities at a future date, at a predetermined price. Such swap deals take place between the RBI on one hand, and banks and other financial institutions, on the other. The repo rate helps commercial banks, to acquire funds from the RBI by selling securities and at the same time agreeing to repurchase them at a later date. Reverse repo rate that banks get from RBI for parking their short term excess funds with the RBI. The RBI has introduced overnigh repos as well as longer-term up to 14 day period. Repo and reverse repo operations are used by RBI in its liquidity adjustment facility which is used to manage dayto-day liquidity position in the market.
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b) selective or qualitative methods

The RBI has the power to direct banks to meet their obligation through selective methods of credit control. These methods affect particular sections of the economy as the influence distribution and direction of credit. The following are some of the selective methods followed by RBI:1) Margin requirements: A loan is sanctioned against a collateral security. Margin is that proportion of value of the security against which loan is not given higher the margin, lesser will be the loan sanctioned in India, bank loans are often used for speculative and unproductive purposes. To prevent this, the RBI has relied on the method of minimum requirements.

2) Discriminatory rates of interest:Under this method, different rates of interest are charged for different use of credit. RBI has relied on this method to direct resources to priority sector, export promotion and prevent speculative use of bank finance. This method has been used along with margin requirements in to prevent hoarding essential agricultural commodities. 3) Ceiling on credit:- Under this scheme, the RBI imposes limits on the amount of credit to different sectors. 4) Direct action:- RBI may use strict disciplinary actions against banks that fail to follow its directives. These may be in the form of cancellation of licenses , refusal of rediscounting facility and imposition of penalty. These methods are very harsh and are therefore rarely carried out by RBI.
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MORAL SUASION:- though moral suasion (discussions, suggestions and advise), the RBI can influence the investment and credit policies of the commercial banks. For example, it can ask the commercial banks to invest a larger proportion, than required, of their assets in government securities. Similarly, it canadvice them regarding the allocation of credit to the private sector.

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Operating Procedures of Monetary Policy

The conduct of contemporary monetary policy in the Indian economy is based on a carefully strategy. The strategy aims to balance the linkage between monetary policy, credit policy and the regulatory regime in a dynamics environment of structural transformation. Monetary policy now simultaneous pursues the objectives of price stability, provision of appropriate credit for growth and increasingly, financial stability. While there are complementarities between the objectives, especially in the long run, it cannot be denied that there are certain tradeoffs, especially in the short-run. The RBI has always had to address the monetary policy dilemma of providing adequate credit to the government and the commercial sector, without fuelling inflationary pressure. With the deregulation of the interest rates, as added dimensions is to balance the interest cost of public debt with the price of the commercial credit. In the late 1990s, in view of ongoing financial openness and increasing evidence of changes in underlying transmission mechanism with interest rates and exchange rates gaining in importance vis--vis quantity variables, it was felt that monetary policy exclusively based on the demand function for money could lack precision. The Reserve Bank, therefore, formally adopted a multiple indicator approach in April 1998 whereby interest rates or rates of return in different financial markets along with data on currency, credit, trade, capital flows, fiscal position, inflation, exchange rate, etc., are juxtaposed with the output data for drawing policy perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform period since the early 1990s. The switchover to a multiple indicator approach provided necessary flexibility to respond to changes in
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domestic and international economic environment and financial market conditions more effectively. The operating procedures of monetary policy in India have undergone a significant shift. In particularly, short-term interest rates have emerged as instruments to signal the stance of monetary policy. In order to stabilize short-term interest rates, the RBI now modulates market liquidity to steer monetary conditions to the desired trajectory this is achieved by the mix of policy instruments including changes in the reserve requirements an standing facilities and open market operations which affect the quantum of marginal liquidity and changes in the policy rates, such as bank rate and reverse repo/repo rates, which impact the price of liquidity. Now two new initiatives are one structural and the other on policy review and communication.

(i)

Liquidity adjustment facility(LAF):LAF, introduced in June 2000, allows the RBI to manage market liquidity on a daily basis and also transmit interest rate signals to the market. The LAF, initially recommended by the committee on banking sector reforms, was introduced in the stages in consonance with the level of market development and technological advances in payment and settlement systems. The first challenge was to combine the various sources of liquidity available from the RBI into a single comprehensive window, with a common price. An interim liquidity adjustment facility (ILAF), introduced in April 1999 as a mechanism for liquidity management through a repo operation, export credit refinance facilities and collateralized lending facilities support by
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open market operations at set rates of interest, was upgraded into a full- fledge LAF. Most of the alternative provision of primary liquidity has been gradually phased out and even though export credit refinance is still available, it is linked to the repo rate since March 2004. Accordingly, the LAF has now emerged as the principal operating instrument of monetary policy. The LAF has emerged as an effective instrument for maintaining orderly conditions in the financial markets in the face of sudden capital outflows to ward off the possibility of speculative attacks in the foreign exchange market. By funding the Government through private placements and mopping up the liquidity by aggressive reverse repo operation at attractive rates, the LAF helps to minimize the impact of market volatility on the cost of public debt. The LAF accords the Reserve Bank the operational flexibility to alter the liquidity in the system (by rejecting bids) as well as adjusting the structure of interest rates.

(ii)

Market stabilization scheme:

Pursuant to the recommendations of the Internal Working Group on LAF as well as the Internal Working Group on Instruments for Sterilisation, a market Stabilisation Scheme (MSS) was introduced in April 2004. The issurance of securities under the MSS enables the Reserve Bank to improve liquidity management in the system\, to maintain stability in the foreign exchange market and to conduct monetary policy in accordance with the stated objectives. The Indian experience underscores the need for constant innovation in terms of instruments and operating procedures for effective monetary
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management. Apart from introduction of innovative instrument such as the MSS, the policy framework has evolved in response to the changing environment. Illustratively, the interest rates in the LAF auctions were initially allowed to emerge from the bids, with the RBI holding occasional fixed rate auctions to transmit interest rate signals. As market players began to bid at the prices signalled by the RBI, the de jure market-determined LAF rates began to turn into de facto fixed rates. It is in this context that the Reserve Bank switched to a fixed auction format in March 2004. Second, while the reverse repo rate, acted as the floor, the practice of supplying liquidity at multiple rates, e.g., the and the repo rate, implied that there was no unique ceiling. It is in this context that the RBI has increasingly been resorting to pricing its liquidity at the repo rate, in recent years. Apart from Ways and Means Advances (WMA) which are still at the Bank Rate, all other forms of liquidity support are at the repo rate.

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Monetary policy tools

Monetary base Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base. Reserve requirements The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier. Discount window lending Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.
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 Interest rates The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply. Currency board A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the

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local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold: 1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation; 3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).

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Recent changes in RBIS monetary policy

RBIs monetary management has undergone some major changes since 1991. Before 1991, the RBIs monetary policy was closely linked with the financing of fiscal deficit. Now, the focus is more on promoting economic growth and maintaining price stability. 1) Multiple indicator approach: In 1980s and up to 1990s, the RBI used the monetary targeting approach to its monetary policy. Monetary targeting refers to a monetary policy strategy aimed at maintaining price stability by focusing on the changes in growth of money supply (M3). It was believed that a continuous rise in money supply caused inflation. After reforms in 1991, this approach became difficult to follow. Financial liberalization brought more innovative financial products. Earlier, RBI could monitor money supply as banks were the only financial intermediaries. As non-banking sources of finance grew, monitoring money supply and controlling inflation became difficult. Hence, RBI adopted the Multiple Indicators Approach in which it looks at a variety of economic indicators and monitors their impact on inflation and economic growth. This approach was formally adopted in April 1998. As a part of this approach, variables such as money, credit, output, trade, capital flows and fiscal position, as well as rates of return in different markets, inflation rate and exchange rate, are analyzed.

2) Expectation as a channel of monetary transmission: Monetary policy transmission refers to the channel through which a change in monetary policy affects the economy. Traditionally, four key channels of monetary policy transmission are identified, interest rate, credit
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availability, asset prices and exchange rate channels. The interest rate channel is the most dominant has an immediate impact on interest rate and through it on prices, demand, consumption and growth. In the recent period, a fifth channel, expectations, has also emerged. Future expectations about asset prices, general price and income level influence the four traditional channels and is therefore, taken into consideration by RBI in evaluating monetary policy transmission.

3) Introduction of liquidity adjustment facility (LAF): LAF is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. LAF was introduced by RBI during June 2000, in phases. The funds under LAF are used by the banks to meet their day-to-day mismatches in liquidity. Under the scheme, reverse repo auctions (for absorption of liquidity) and repo auctions (for injection of liquidity) are conducted. LAF has emerged as the most important factor in RBIs short term monetary management.

4) Selective methods being phased out: With greater market orientation of monetary policy and rapid progress taking place in the financial markets, the selective methods of credit control are being slowly phased out. The quantitative methods are becoming more and more significant.

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5) Delinking monetary policy from budget deficit: In 1994, an agreement has been reached between the central government and the RBI to phase out the use of ad hoc treasury bills. These bills were being used by the government to borrow form to finance fiscal deficit. With the phasing out the bills, RBI would no longer lend to the government to meet fiscal deficit.

6) Deregulation of administered interest rate system: The lending rates of banks used to be determined by the RBI earlier. Since 1990s this system has been changed and the lending rates are no longer regulated by the RBI but are determined by commercial banks on the basis of market forces.

7) Reduction in reserve requirements: CRR and SLR have been progressively lowered during the postreform period. This has done as a part of financial sector reforms on the recommendations of the narasimham committee report. As a result, more bank funds have been released for lending purpose. This promoted growth of the economy and improved profitability of banks.

8) Provision of micro finance: The RBI has introduced the scheme of micro finance for the rural poor by linking the banking system with Self Help Groups.RBI, along with NABARD, has been promoting various other microfinance institutions.

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9) External sector: The monetary policy is now oriented towards the process of globalization of Indias financial markets. It has become sensitive to changes in the rest of the world as India is increasingly attracting large amount of foreign capital. RBI uses sterilization and LAF to absorb the excess liquidity that comes in with huge inflow of foreign capital. This is done to provide stability in the financial markets.

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Evaluation of monetary policy

Achievements: 1) Financial stability: RBI has been successful in maintaining financial stability during the global financial crisis because of its controls, regulation and supervision mechanism. It has also been able to maintain macroeconomic stability to a large extent during the global crisis period.

2) Short term liquidity management: The RBI has succeeded in managing short term liquidity in order to maintain stability in interest rate and exchange rate. It has developed various methods to do this through LAF, OMO and MSS. In spite of large inflows of foreign capital, the RBI has managed its sterilization operations very well.

3) Adaptability: RBI has adapted its monetary policy approach with changing times. It has developed new methods of credit control and has shifted from monetary targeting to multiple indicator approach. This has made the monetary system in India flexible, helping it to move with the times.

4) Financial inclusion: RBI, along with Narbada, has made a great impact in the growth of microfinance. It has supported the Self Help Group model and promoted other microfinance institution. However, there is a lot more that needs to be done in this area
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5) Promotion of Growth: RBI has used its instruments effectively to maintain the growth of the economy even during the current phase of global slowdown. India at present has the second highest rate of GDP growth after china. Monetary policy has played a major role in this.

Limitations:
1. Existence of unorganized money market: Despite all that has been achieved by the banking sector through branch expansion, a large unorganized sector continues to exist, especially in the rural areas. RBIs monetary policy does not affect the functioning of this sector. It is comprised of indigenous bankers, money lenders, agents etc. who continue to provide credit to a large number of people at high rate of interest. 2. Weak channels of monetary transmissions: Recently, RBI has admitted that the traditional channels of monetary transmission, interest rate, credit availability, asset prices and exchange rate channels are weak. That is, the RBIs monetary policy dose not get properly transmitted to the economy through these channels, this is because of underdeveloped securities market, unorganized money market and speculative assets markets. 3. Unable to control inflation: India experienced high of inflation in the 1960s, 1970s and 1980s due to rapid growth in money supply and shortages in the availability of goods. To control inflation , RBI raised bank rate, CRR and SLR to very high levels. This proved to be ineffective as money supply continued to rise due to deficit financing and shortages continued to exist to excessive government
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control. The monetary policy followed by RBI the restricted growth of the economy. Only after 1990s this situation has changed and today CRR, SLR and bank rate are lower and inflation too is under control. Currently India is facing high rate of food inflation. Since it is largely due to supply side factors, RBIs monetary policy is not very effective in controlling such inflation. 4. Existence of black money: Due to high rate of taxation in the past, India has had high incidence of tax evasion. This has generated huge amount of black money. Black economy gives rise to inflation and speculative activities. The impact of such money cannot be controlled by RBIs monetary policy. 5. Preference for cash transactions: A large part of the country is still non-monetizes and transaction are preferred to be done in cash rather than through the banking system. Such cash transactions do not come under the purview of the RBIs monetary policy. However, with rapid growth of the economy, preference for cash transactions is also reducing. 6. Phasing out of Selective Methods: It is being argued that the RBI should revive the use of selective measures of credit control to directly attack sector specific inflation, since the general methods are ineffective in case of such inflation. Methods like credit rationing and discriminatory interest rates can be used in this case.

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First Quarter Review of Monetary Policy 2010-11

The Reserve Bank released the First Quarter Review of Monetary Policy for 2010-11 at a meeting of the chief executives of major banks. Given below are comments made by Dr. D. Subbarao, Governor of the Reserve Bank of India. 1) The important decisions contained in the review were to raise the repo rate from 5.5 per cent to 5.75 per cent and the reverse repo rate from 4 per cent to 4.50 per cent. This asymmetric raise in rates narrows the LAF corridor from 150 basis points to 125 basis points. Balance of Policy Stance 2) The dominant concern that has shaped the monetary policy stance in this review is high inflation. Even as food price inflation and, more generally, consumer price inflation, have shown some moderation, they are still in double digits. Non-food inflation has risen, and demand side pressures are clearly evident. With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations. Global Outlook 3) Since our last policy review in April, the macroeconomic environment has changed significantly. In the aftermath of the Greek sovereign debt crisis and other visible soft spots in Europe and the US, there is renewed uncertainty about the sustainability of the recovery. In contrast, EMEs are witnessing strong growth, driven by rising domestic demand, restocking of inventories and, thus far, recovering global trade. The relatively rapid
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recovery in EMEs has also been accompanied by higher inflation. Overall, though, there is widespread expectation of a slowdown of the global economy in the second half of 2010.

Indian Economy
Growth 4) The macroeconomic developments in India are contrarian to the global trend. We have recovered faster, but our inflation rate has also been higher. The recovery process has consolidated and become more broad-based since April 2010. A big known unknown in April 2010 was the outlook on monsoon. That has since become a known known in the sense that rainfall so far has been better than during last year, and the crop-wise area sown and the distribution of rainfall offer scope for cautious optimism on the agricultural front. 5) Better farm sector prospects should lead to a pick-up in rural demand. This should give further momentum to the performance of the industrial sector which has been growing firmly. The strength of the recovery is also reflected in the sales and profitability growth of the corporate sector with more investment intentions being translated into action across a range of sectors. While domestic drivers of growth are robust, any slowdown in the global recovery will affect all EMEs, including India. 6) Taking into account the above factors, the projection for real GDP growth for 2010-11 is revised to 8.5 per cent, up from our April policy projection of 8.0 per cent with an upside bias. This upward revision is primarily based on better industrial production and its favourable impact on the services sector while giving due consideration to the global scenario.

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Inflation 7) The developments on the inflation front are, however, worrisome. Let me explain. WPI inflation has been in double digits since February 2010. Primary food articles inflation, despite some moderation, continues to be in double digits. Between November 2009 and June 2010, non-food inflation rose from zero to 10.6 per cent and non-food manufactured inflation from zero to 7.3 per cent. Significantly, non-food items contributed over 70 per cent to WPI inflation in June 2010, suggesting that inflation is now very much generalised. Inflation in terms of all four consumer price indices remains in double digits notwithstanding some decline in recent months. 8) Going forward, the outlook on inflation will be shaped by: (i) the monsoon performance for the remaining period; (ii) movements in global energy and commodity prices, which have been showing distinct signs of softening over the past few weeks; and (iii) potential build-up in demandside pressures with the strengthening of domestic growth drivers. 9) Taking into account the emerging domestic and external scenario, the baseline projection for WPI inflation for March 2011 has been raised to 6.0 per cent from our April policy projection of 5.5 per cent. Monetary Aggregates 10) It is expected that even with the higher growth projection, monetary

aggregates will evolve along the projected trajectory indicated in the April policy statement. Accordingly, for policy purposes, we have retained the earlier projections of money supply (M3) at 17 per cent and of non-food bank credit growth at 20 per cent.

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Risk Factors 11) Let me indicate some important risks to the growth and inflation The first risk factor is that if the global recovery falters, the performance of EMEs is likely to be adversely affected, and a widespread slowdown in global trade will have an impact on the Indian manufacturing and service sectors too. The second risk factor is that an uncertain global situation will significantly reduce the flow of capital into EMEs. Such a slowdown in capital inflows will constrain domestic investment which is critical to achieving and sustaining high growth rates. This could potentially be a problem in India too since our rapid recovery has resulted in a widening of the current account deficit. It must be recognized though that the risk of capital flows runs both ways. It is quite possible that EMEs, including India, will receive more flows than they need because of accommodative monetary policies of advanced country central banks for an extended period. Large capital inflows above the absorptive capacity of our economy will pose a challenge for monetary and exchange rate management, and also have implications for asset prices. In this scenario, a widening current account deficit will help absorb a larger proportion of the inflows. The third risk factor is on the inflation front. Softening of inflation in the months ahead is contingent on moderation of food prices which

outlook.

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in turn will depend on a balanced spatial andtemporal distribution of rainfall in the remaining period of this monsoon season. While on risk factors, we must note one important upside. If global growth does not pick up, commodity and energy prices will remain subdued. Furthermore, unutilised global capacity in several sectors will soften the prices of imports and put downward pressure on import substitutes.

Monetary Policy Stance 12. The Reserve Bank began the reversal of its expansionary monetary policy in October 2009 and has calibrated the exit to Indias specific growth-inflation dynamics. Todays policy action in particular has been informed by three major considerations: domestic economic recovery is firmly in place and is strengthening; there is a need to contain the demand-side inflationary pressures which are clearly evident; and despite the increase in the policy rates by 75 basis points cumulatively, it is imperative that we continue in the direction of normalising our policy instruments to a level consistent with the evolving growth and inflation scenario, while taking care not to disrupt the recovery. 13) Our monetary policy actions are expected to: Moderate inflation by reining in demand pressures and inflationary expectations. Maintain financial conditions conducive to sustaining growth.

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 Generate

liquidity

conditions

consistent

with

more

effective

transmission of policy actions. Restrict the volatility of short-term rates to a narrower corridor. Operating Procedures of Monetary Policy 14) The two new initiatives are one structural and the other on policy review and communication. 15) The Reserve Banks LAF operates in such a manner that as systemic liquidity alternates between surplus and deficit, even at the margin, the overnight call money rate alternates between the reverse repo rate and the repo rate. As the systemic liquidity transits from a uni-directional surplus mode to a bi-directional mode, it will have implications for the effectiveness of monetary transmission. In the context of the changing liquidity dynamics, the operation of the LAF needs to be studied. Accordingly, it is proposed to set up a Working Group to review the current operating procedure of monetary policy of the Reserve Bank, including the LAF.

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Mid-Quarter Review of Monetary Policy 2010-11

1) The second new initiative relates to a more frequent policy review. While our

scheduled policy announcements are quarterly, in recent years, there have been several occasions, including March and July 2010, when we had to take off-cycle monetary policy actions. One significant advantage of the quarterly schedule is that it allows us to bring the full range of inputs into the decision-making process. Nevertheless, in a rapidly evolving macroeconomic situation, we need to combine the rigour and comprehensiveness of the quarterly process with the responsiveness and flexibility of more frequent reviews. 2) Accordingly, the Reserve Bank will now undertake mid-quarter reviews

roughly at the interval of about one and half months after each quarterly review. As per schedule, mid-quarter reviews will be in June, September, December and March. They will be by way of a press release and will communicate our assessment of economic conditions more frequently, and will provide a rationale for either policy action or maintenance of the status quo. However, the Reserve Bank will have the flexibility, as always, to take swift and pre-emptive policy action, as and when warranted by the evolving macroeconomic developments.

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Limitations
As the study of specific area is restricted, and time allotted is much limed for making project. If time permits then there would be a wide scope of study on specified topic. Study/ project on a specific topic have page constraints. The information which is provided is not enough for in-depth study of the topic. Lack of experience of using because the systems which are electronically settled are not developed is used generally in every bank or banks. If there is experience of using payment system, there would be different explanation for their working mechanism. Due to lack of practical knowledge or work experience it is different to compare topic with international scenario.

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Conclusion
RBI has powers to supervise and control commercial and co-operative banks with a view to developing an adequate and a sound banking system in the country. The RBI has powers to issue licenses to new banks and branches, prescribe minimum requirements regarding paid up capital and reserve, maintenance of cash and other reserves and inspect the working of banks in India and abroad. The RBI has also powers to conduct ad-hoc investigations from time to time into complaints, irregularities and frauds in banks. The functions of RBI include issue of currency notes, banker to the government, bankers banks, and exchange control authority audit control and agriculture finance. The monetary policy of RBI is regulatory policy whereby the central bank maintains its control over the supply of money for the realization of general economic goals.

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Bibliography Books
Monetary, banking and financial development in India -Nitin basin. RBI functions and working - shri m Jesudasan. RBI volume 3. Business economics. Net
www.google.com www.scribd.com www.wikipedia.org www.brupt.com www.rbi.com

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