CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA

CHAPTER 3:MONETARY POLICY OF RESERVE BANK OF INDIA

Q.1: Define Monet !" Po#i$". Di%$&%% t'e o()e$ti*e% of RBI+% Monet !" ,o#i$". OR -!ite note on o()e$ti*e% of RBI+% Monet !" Po#i$". An%.A. MONETARY POLICY :/ Monetary policy is a regulatory policy by which the central bank or monetary authority of a country controls the supply of money, availability of bank credit and cost of money, that is, the rate of Interest. Monetary policy / monetary management is regarded as an important tool of economic management in India. RBI controls the supply of money and bank credit. The entral bank has the duty to see that legitimate credit re!uirements are met and at the same credit is not used for unproductive and speculative purposes. RBI rightly calls its credit policy as one of controlled e"pansion. B.OB0ECTIVES OF MONETARY POLICY OF INDIA :/ The main ob#ective of monetary policy in India is $growth with stability%. Monetary Management regulates availability, cost and use of money and credit. It also brings institutional changes in the financial sector of the economy. &ollowing are the main ob#ectives of monetary policy in India '( 1. 1!o2t' -it' St (i#it" :/ Traditionally, RBI%s monetary policy was focused on controlling inflation through contraction of money supply and credit. This resulted in poor growth performance. Thus, RBI have now adopted the policy of $)rowth with *tability%. This means sufficient credit will be available for growing needs of different sectors of economy and at the same time, inflation will be controlled with in a certain limit. 3. Re4&# tion5 S&,e!*i%ion An6 De*e#o,7ent Of Fin n$i # St (i#it" :/ &inancial stability means the ability of the economy to absorb shocks and maintain confidence in financial system. Threats to financial stability can come from internal and e"ternal shocks. *uch shocks can destabili+e the country%s financial system. Thus, greater importance is being given to RBI%s role in maintaining confidence in financial system through proper regulation and controls, without sacrificing the ob#ective of growth. Therefore, RBI is focusing on regulation, supervision and development of financial system. 3. P!o7otin4 P!io!it" Se$to! :/ ,riority sector includes agriculture, e"port and small scale enterprises and weaker section of population. RBI with the help of bank provides timely and ade!uately credit at affordable cost of weaker sections and low income groups. RBI, along with -.B.R/, is focusing on microfinance through the promotion of *elf 0elp groups and other institutions. 8. 1ene! tion Of E7,#o"7ent :/ Monetary policy helps in employment generation by influencing the rate of investment and allocation of investment among various economic activities of different labour Intensities. 9. E:te!n # St (i#it" :/

1ith the growth of imports and e"ports India%s linkages with global economy are getting stronger. 2arlier, RBI controlled foreign e"change market by determining ea"change rate. -ow, RBI has only indirect control over e"ternal stability through the mechanism of $managed &le"ibility%, where it influences e"change rate by buying and selling foreign currencies in open market. ;. En$o&! 4in4 S *in4% An6 In*e%t7ent% :/ RBI by offering attractive interest rates encourage savings in the economy. . high rate of saving promotes investment. Thus the monetary management by influencing rates of interest can influence saving mobili+ation in the country. <. Re6i%t!i(&tion Of in$o7e An6 -e #t' :/ By control of inflation and deployment of credit to weaker sectors of society the monetary policy may redistribute income and wealth favouring to weaker sections. =. Re4&# tion Of NBFI%:/ -on 3 Banking &inancial Institutions 4-B&Is5, like 6TI, I/BI, I& I plays an important role in deployment of credit and mobili+ation of savings. RBI does not have any direct control on the functioning of such institutions. 0owever it can indirectly affects the policies and functions of -B&Is through its monetary policy. Q.3:Di%$&%% > E:,# in t'e * !io&% f&n$tion% of RBI. An%. A.RESERVE BANK OF INDIA ?RBI. :/ The Reserve Bank of India is the central bank of India it was established as a shareholder%s bank on 7st .pril 789:. Its share capital was Rs. : crore, divided in to : lakhs fully paid up shares of Rs. 7;; each. <n 7st =anuary 78>8 it was nationali+ed. Its head!uarters is at Mumbai. RBI, like any other bank performs almost all traditional entral banking functions. /ue to country%s development it has also undertaken developmental and promotional functions. .. F@NCTIONS OF RBI :/ RBI performs many functions, some of them are'( 7. I%%&e Of C&!!en$" Note% :/ 6nder section ?? of RBI .ct, the bank has the sole right to issue currency notes of all denominations e"cept one rupee coins and notes. The one(rupee notes and coins and small coins are issued by entral )overnment and their distribution is undertaken by RBI as the agent of the government. The RBI has a separate issue department which is entrusted with the issue of currency notes. 3. B nAe! To T'e 1o*e!n7ent :/ The RBI acts as a banker agent and adviser to the government. It has obligation to transact the banking business of entral )overnment as well as *tate )overnments. 2.g.'( RBI receives and makes all payments on behalf of government, remits its funds, buys and sells foreign currencies for it and gives it advice on all banking matters. RBI helps the )overnment 3 both entral and state 3 to float new loans and manage public debt. The bank makes ways and meets advances of the government. <n behalf of central government it sells treasury bills and thereby provides short(term finance. 3. B nAe!+% ( nA An6 Len6e! Off L %t Re%o!t :/ RBI acts as a banker to other banks. It provides financial assistance to scheduled banks and state co(operative banks in form of rediscounting of eligible bills and loans and advances against approved securities.

RBI acts as a lender of last resort. It provides funds to bank when they fail to get it from other sources. It also acts as a clearing house. Through RBI, banks make interbanks payments. 8. Cont!o##e! Of C!e6it :/ RBI has power to control the volume of credit created by banks. The RBI through its various !uantitative and !ualitative techni!ues regulates total supply of money and bank credit in the interest of economy. RBI pumps in money during busy season and withdraws money during slack season. 9. E:$' n4e $ont!o# An6 C&%to6i n Of Fo!ei4n Re%e!*e :/ RBI has the responsibility of maintaining fi"ed e"change rates with all member countries of IM&. &or this, RBI has centrali+ed all foreign e"change reserves 4&<R2@5. RBI functions as custodian of nations foreign e"change reserves. It has to maintain e"ternal valu of Rupee. RBI achieves this aim through appropriate monetary fiscal and trade policies and e"change control. ;. Co##e$tion An6 P&(#i$ tion Of D t :/ The RBI collects and complies statistical information on banking and financial operations of the economy. The Reserve Bank <f India% Bulletian is a monthly publication. It not only provides information, but also results of important studies and investigations conducted by reserve bank are given. $The Report on currency and finance% is an annual publication. It provides review of various developments of economic and financial importance. A. Re4&# to!" An6 S&,e!*i%o!" F&n$tion% :/ The RBI has wide powers of supervision and control over commercial and co(operative banks, relating to licensing, establishment, branch e"pansion, li!uidity of .ssets, management and methods of working, amalgamation, re(construction and li!uidation. The supervisory functions of RBI have helped a great in improving the standard of banking in India to develop on sound lines and to improve the methods of their operation. =. C#e !in4 Ho&%e F&n$tion% :/ The RBI acts as a clearing house for all member banks. This avoids unnecessary transfer of funds between the various banks. B. De*e#o,7ent An6 P!o7otion # F&n$tion% :/ The RBI has helped in setting up Industrial &inance orporations of India 4I& I5, *tate &inancial orporations 4*& s5, /eposit Insurance orporation, .gricultural Refinance and /evelopment orporation 4.R/ 5, units Trust of India 46TI5 etc. these institutions were set up to mobili+e savings, promote saving habits and to provide industrial and agricultural finance. RBI has a special .gricultural redit /epartment 4. /5 which studies the problems of agricultural credit. &or this Regional Rural banks, o(operative, -.B.R/ etc. were established. The RBI has also taken measures to promote organi+ed bill market to create elasticity in Indian Money Market in order to satisfy seasonal credit needs. Thus RBI has contributed to economic growth by promoting rural credit, industrial financing, e"port trade etc. B.95' E:,# in t'e C& ntit ti*e n6 %e#e$ti*e methods of$!e6it $ont!o#&%e6 (" RBI.<R E:,# in t'e Monet !" Po#i$" of RBI Imeasures taken(" RBI to control credit. -!ite note on Q& ntit ti*e I Se#e$ti*e 7et'o6% of$!e6it $ont!o#. <R E:,# in Monet !" M n 4e7ent of RBI.

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An%. .5 M<-2T.RC ,<DI C <& RBI '( The Monetary ,olicy of RBI is not merely one of credit restriction, but it has also the duty to see that legitimate credit re!uirements are met and at the same time credit is not used for unproductive and speculative purposes RBI has various weapons of monetary control and by using them, it hopes to achieve its monetary policy. I. )eneral I Buantitative redit ontrol Methods '( In India, the legal framework of RBI%s control over the credit structure has been provided 6nder Reserve Bank of India .ct, 789> and the Banking Regulation.ct, 78>8. Buantitative credit controls are used to maintain proper !uantity of credit o money supply in market. *ome of the important general credit control methods are'( 1. Bank Rate ,olicy '( Bank rate is the rate at which the entral bank lends money to the commercial banks for their li!uidity re!uirements. Bank rate is also called discount rate. In other words bank rate is the rate at which the central bank rediscounts eligible papers 4like approved securities, bills of e"change, commercial papers etc5 held by commercial banks. Bank rate is important because its is the pace setter to other marketrates of interest. Bank rates have been changed several times by RBI to control inflation and recession. By ?;;9, the bank rate has been reduced to EF p.a. 3. <pen market operations '( It refers to buying and selling of government securities in open market in order to e"pand or contract the amount of money in the banking system.This techni!ue is superior to bank rate policy. ,urchases in#ect money into the banking system while sale of securities do the opposite. /uring last two decades the RBI has been undertaking switch operations. These involve the purchase of one loan against the sale of another or, vice(versa. This policy aims at preventing unrestricted increase in li!uidity. 9. ash Reserve Ratio 4 RR5 The )ash Reserve Ratio 4 RR5 is an effective instrument of credit control. 6nder the RBl .ct of, l89> every commercial bank has to keep certain minimum cash reserves with RBI. The RBI is empowered to vary the RR between 9F and 7:F. . high RR reduces the cash for lending and a low RR increases the cash for lending. The RR has been brought down from 7:F in 7887 to A.:F in May ?;;7. It further reduced to :.:F in /ecember ?;;7. It stood at :F on =anuary ?;;8. In =anuary ?;7;, RBI increased the RR from :F to :.A:F. It further increased in .pril ?;7; to EF as inflationary pressures had started building up in the economy. .s of March ?;77, RR is EF. 8. *tatutory Di!uidity Ratio 4*DR5 6nder *DR, the government has imposed an obligation on the banks to ,maintain a certain ratio to its total deposits with RBI in the form of li!uid assets like cash, gold and other securities. The RBI has power to fi" *DR in the range of ?:F and >;F between 788; and 788? *DR was as high as 9G.:F. -arasimham ommittee did not favour maintenance of high *DR. The *DR was lowered down to ?:F from 7;th<ctober 788A.It was further reduced to ?>F on -ovember ?;;G. .t present it is ?:F.

9. Repo .nd Reverse Repo Rates In determining interest rate trends, the repo and reverse repo rates are becoming important. Repo means *ale and Repurchase .greement. Repo is a swap deal involving the immediate *ale of *ecurities and simultaneous purchase of those securities at a future date, at a predetermined price. Repo rate helps commercial banks to ac!uire funds from RBI by selling securities and also agreeing to repurchase at a later date. Reverse repo rate is the rate that banks get from RBI for parking their short term e"cess funds with RBI. Repo and reverse repo operations are used by RBI in its Di!uidity .d#ustment &acility. RBI contracts credit by increasing the repo and reverse repo rates and by decreasing them it e"pands credit. Repo rate was E.A:F in March ?;77 and Reverse repo rate was :.A:F for the same period. <n May ?;77 RBI announced Monetary ,olicy for ?;77(7?. To reduce inflation it hiked repo rate to,A.?:F and Reverse repo to E.?:F *2D2 TIH2 / B6.DIT.TIH2 R2/IT <-TR<D M2T0</* '( 6nder *elective redit ontrol, credit is provided to selected borrowersfor selected purpose, depending upon the use to which the control try to regulate the !uality of credit ( the direction towards thecredit flows. The *elective ontrols are '( 1. eiling <n redit
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The eilingon level of credit restricts the lending capacity of a bank to grant advances against certain controlled securities. ?. MarginRe!uirements '( . loan is sanctioned against ollateral *ecurity. Margin means that proportion of the value of security against which loan is not given. Margin against a particular security is reduced or increased in order to encourageor to discourage the flow of credit to a particular sector. It varies from ?;F to G;F. &or agricultural commodities it is as high as A:F. 0igher the margin lesser will be the loan sanctioned. 9. /iscriminatory Interest Rate 4/IR5 Through /IR, RBI makes credit flow to certain priority or weaker sectors by charging concessional rates of interest. RBI issues supplementary instructions regarding granting of additional credit against sensitive commodities, issue of guarantees, making advances etc. . >. /irectives'( The RBI issues directives to banks regarding advances. /irectives are regarding the purpose for which loans may or may not be given. :. /irect .ction It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount bills or cancellation of license, if the bank has failed to comply with the directives of RBI. Moral *uasion

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6nder Moral *uasion, RBI issues periodical letters to bank to e"ercise control over credit in general or advances against particular commodities. ,eriodic discussions are held with authorities of commercial banks in this respect. B. > '2"amine the recent changes that have taken place in RBIs Monetary ,olicy. 4Mar. $775 .ns. .5R2 2-T 0.-)2* I- RBI%s M<-2T.RC ,<DI C '( *ince 7887 RBI%s monetary management has undergone some ma#or changes. Det us e"plain 75 Multiple Indicator .pproach '( 6pto late 788;s, 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 changes in growth of money supply. .fter 7887 reforms this approach became difficult to follow. *o RBI adopted Multiple indicator .pproach in which it looks at a variety of economic indicators and monitor their impact on inflation and economic growth. ?5 *elective Methods Being ,hased <ut '( 1ith rapid progress in financial markets, the selective methods of credit control are being slowly phased out. Buantitative methods are becoming more important. Reduction In Reserve Re!uirements '( In post(reform period the RR and *DR have been progressively lowered. This has been done as a part of financial sector reforms. .s a result, more bank funds have been released for lending. This has led to the growth of economy. /eregulation <f .dministered Interest Rate *ystem '( 2arlier lending rate of banks was determined by RBI. *ince 788;s this system has changed and lending rates are determined by commercial banks on the basis of market forces. :5 /elinking <f Monetary ,olicy &rom Budget /eficit '( In788> government phased out the use of adhoc treasury Bills.These bills were used by government to borrow from RBI to finance fiscal deficit. 1ith phasing out of Bills, RBI would no longer lend to government to meet fiscal deficit. E5 Di!uidity .d#ustment &acility 4D.&5'( D.& allows banks to borrow money through repurchase agreement D.& was introduced by RBI during =une, ?;;;, in phases. The funds under D.& are used by banks to meet day(to( day mismatches in li!uidity. A5 ,rovision <f Micro &inance By linking the banking system with *elf 0elp )roups, RBI has introduced the scheme of micro finance for rural poor. .long with -.B.R/, RBI is promoting various other microfinance institutions. G5 2"ternal *ector 1ith globalisation large amount of foreign capital is attracted. To provide stability in financial markets, RBI uses sterli+ation and D.& to absorb the e"cess li!uidity that comes in with huge inflow of foreign capital. >5 95

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2"pectation .s . hannel <f Monetary Transmission

Traditionally, there were four key channels of monetary policy transmission '(Interest rate, credit availability, asset prices and e"change rate channels. Interest rate is the most dominant transmission channel as any change in monetary policy has immediate effect on it. In recent years fifth channel, 2"pectation has been added. &uture e"pectations about asset prices, general price and Income levels influence the four traditional channels. B.:'/iscuss RBI%s short term Di!uidity Management. <R 1hy has short term Di!uidity Management gained importance in post reform IndiaI /iscuss measures taken by RBI for Management of short term Di!uidity. 4Mar. $775 .ns...RBI%* *0<RT T2RM DIB6I/ITC M.-.)2M2-T '( Di!uidity Management of entral bank means supplying to the market the amount of li!uidity that is consistent with a desired level of short(term interest rate. It is defined Jas the framework, set of instruments and the rules that the central bank follows in order to manage the amount of money supply to control short term interest rates with the ob#ective of price stabilityK. In RBI%s overall management short term li!uidity management occupies a very important place due to following factors'( 75 In financial sector, in 788;%s, many reforms were introduced. The important reforms are deregulation of interest rates and e"change rates. 2arlier these rates were determined by RBI, after reforms, they are determined by demand and supply. RBI in absence of direct intervention indirectly influences these rates by using multiple indicators approach. ?5 /ue to liberali+ation capital flows between countries have increased. &rom 6* L77G Million during 7887(8?, capital flows to. India rose to 6* L7: billions in ?;;>(;:. 95 &oreign capital flows have increased employment. It adds to the supply of foreign e"change and have resulted into appreciation of domestic currency.1ith this, thee"ports have become more e"pensive. >5 1hen capital inflows are converted into rupees, they get in#ected into the economy thereby, increasing the money supply. *o to maintain price stability RBI has to mange the e"change rate and Interest rate. B5 RBI%* M2.*6R2* &<R *0<RT T2RMDlB6I/ITC M.-.)2M2-T 1. Repo I Reverse Repo To improve short term li!uidity management, RBl. introduced repos in /ecember 788?. Repo is *ale and Repurchase .greement. It is a swap deal involving the immediate *ale of *ecurities and simultaneously purchase of those securities at a future date, at a predetermined price. *uch deals takes place between RBI and banks. /ue to lack of demand repos auctions were discontinued in March 788:, they were resumed again in 788A. Reverse repo rate is the rate that banks get from RBI for parking their short term e"cess funds with RBI. 3. Interim Di!uidity .d#ustment &acility 4ID.R5

To develop short term money market -arasimham ommittee 788G recommended D.&. .ccordingly in 7888 RBI introduced ID.&. It 4ID.&5 provided a mechanism for li!uidity management through a combination of repos, e"port credit refinance and collateralised lending facilities supported by <pen Market <perations. 3. Di!uidity .d#ustment &acility 4D.,5 V RBI introduced(full(fledged D.&. It has been revised further. 6nder D.&, Reverse repo auctions and Repo auctions are conducted on daily basis. In India, the emergence of D.& was a single biggest factor which helped RBI to manage short term li!uidity and maintain interest rate stability. In ?;;8(7;, li!uidity absorption through reverse repo reached its peak on >th *eptember ?;;8 at Rs. 7,EG,?7:crore. 8. *terli+ation '( *terli+ation means re(cycling of foreign capital inflows to prevent appreciation of domestic currency and to check the inflationary impact of such capital. *terli+ation is carried out through open market operations. But *terli+ation can also leads to some problems. Thus RBI also,uses a variety of other measures to manage interest rates. 9. Market *tabili+ation *cheme 4M**5'( Till ?;;9(;> the impact of large capital inflows was managed through day(to(day D.& and <M<. In the process, the government securities available with RBI declined, as they were being used for absorbing e"cess li!uidity. In order to handle these issues, RBI signed a Memorandum of 6nderstanding 4M<65 with )overnment for issuance of Treasury Bills and dated government securities under Market *tabili+ation *cheme 4M**5. These Bills and *ecurities are used to absorb e"cess li!uidity from market and' maintain stability in foreign e"change market. Q. ; :E* #& te RBI+% Monet !" Po#i$".OR. 1i*e n ,,! i% # ?A$'ie*e7ent% n6 F i#&!e%. of 7onet !" ,o#i$" of RBI. An%. A.2H.D6.TI<- <& M<-2T.RC ,<DI C '( The RBI aims at one time was controlled e"pansion. <n one hand it was taking steps to e"pand bank credit. <n other hand RBI uses !uantitative and !ualitative methods to control credit. These two contradictory ob#ectives limited the success of monetary policy. The performance of monetary policy can be seen from its achievements and failures, let us discuss. I. .chievements I ,ositive .spects <f Monetary ,olicy '( 7. *hort Term Di!uidity Management '( RBI has developed various methods to maintain stability in interest rate and e"change rate like D.&, <M< and M**. RBI has also managed its sterli+ation operations very well.

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&inancial *tability '( 1ith the help of controls, regulation and supervision mechanism, RBI has been successful in maintaining financial stability. /uring the period of global crisis it has also been able to maintain macro economic stability.

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&inancial Inclusion '( .long with -.B.R/, RBI has made a great impact in the growth of microfinance. RBI has supported *elf 0elp )roup Model and promoted other microfinance institutions. .daptability'( In India monetary policy is fle"ible, as it changes with time. RBI has developed new methods of credit control and shifted from monetary targeting to multiple indicator approach. Increase In )rowth'( To maintain the growth of economy RBI has used its instrumentsM effectively. .t present India has the second highest rate of )/, growth after hina. Thus monetary policy has played an important role. Increase In Bank /eposits'( The increase in bank deposits over the years indicates trust and confidence of people in banking sector. 2ffective supervision of RBI over banks and financial institutions is largely responsible for trust and confidence of public in banking sector.

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ompetition .mong Banks '( The monetary policy of RBI has resulted in healthy competition among banks in the country. The competition is due to deregulation of interest rates and other measures taken by RBI. -ow( a(days due to professionalism banks provide better service to customers.

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&.ID6R2* I DIMIT.TI<-* <& M<-2T.RC ,<DI C 7. 0uge Budgetary /eficits '( RBI makes every possible attempt to control inflation and to balance money supply in the market. 0owever entral )overnmentMs huge budgetary deficits have made monetary policy ineffective. 0uge budgetary deficits have resulted in e"cessive monetary growth.

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overage <f <nly ommercial Banks '( Instruments of monetary policy cover only commercial banks so inflationary pressures caused by banking finance can be controlled by RBI, but in India, inflation also results from deficit financing and scarcity of goods on which RBI may not have any control. ,roblem <f Management <f Banks .nd &inancial Institutions '( The monetary policy can succeed to control inflation and to bring overall development only when the management of banks and &inancial institutions are efficient and dedicated. Many officials of banks and financial institutions are corrupt and inefficient which leads to financial scams in this way overall economy is affected. 6norganised Money Market '( ,resence of unorganised sector of money market is one of the main obstacle in effective working of the monetary policy. .s RBI has no power over the unorganised sector of money

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market, its monetary policy becomes less effective. :. Dess .ccountability'( .t present time, the goals of monetary policy in India, are not set out in specific terms and there is insufficient freedom in the use of instruments. In such a setting, accountability tends to be weak as there is lack of clarity in the responsibility of governments and RBI. Black Money '( There is a growing presence of black money in the economy. Black money falls beyond the purview of banking control of RBI. It means large proposition of total money *upply in a country remains outside the purview of RBIMs monetary management. Increase Holatility '( The integration of domestic and foreign e"change markets could lead to increased volatility in the domestic market as the impact of e"ogenous factors could be transmitted to domestic market. The widening of foreign e"change market and development of rupee ( foreign e"change swap would reduce risks and volatility. Dack <f Transparency '( .ccording to *. *. Tarapore, the monetary policy formulation, in its present form in India, cannot be continued indefinitely. &or a more effective policy, it would be necessary to have greater

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transparency in the policy formulation and transmission process and the RBI would need to be clearly demarcated. B. <- D6*I<- '( Thus, from above we can say that despite several problems RBI has made a good effort for effective implementation of the monetary policy in India