A PROJECT ON:

“MONETARY POLICY OF RESERVE BANK OF INDIA”

BACHELOR OF COMMERCE BANKING & INSURANCE

SEMESTER – V

ACADEMIC YEAR: 2013-2014

SUBMITTED BY:

NANDRE HARJAS KAUR

ROLL NO: 26

N.E.S RATNAM COLLEGE OPF ARTS, SCIENCE & COMMERCE,

BHANDUP (W), MUMBAI- 400078

 N.E.S RATNAM COLLEGE OF ARTS, SCIENCE & COMMERCE,

BHANDUP (W), MUMBAI- 400078

CERTIFICATE

CORSE CO-ORDINATOR: Principal:

Mrs. Riya Rupani Mrs. Rina Saha

PROJECT GUIDE / INTERNAL EXAMINER

Mrs. Riya Rupani

EXTERNAL EXAMINER
 DECLARATION

I Miss.Nandre Harjas kaur student of B.Com (B&I) Semester V (2012-

2013) hereby declare that I have completed the project on MONETARY
POLICY ON THE RESERVE BANK OF INDIA.

The information submitted is true & original to the best of my

knowledge.

Signature of student

Harjas kaur

Roll no: 26
 Acknowledgement

I owe a great many thanks to a great many people who helped &
supported me doing the writing of this book.

My deepest thanks to lecturer, Mrs. Riya Rupani guide of the project for
guiding & correcting various documents of mine with attention & care.

She has taken pains to go through my projects & make necessary

corrections as & when needed.

I extend my thanks to the principal of, NES Ratnam College of Arts,

Science & Commerce, Bhandup (W), for extending her support.

My deep sense of gratitude to Principal Mrs. Rina saha of NES Ratnam

College of Arts, Science & Commerce for support & guidance. Thanks &
appreciation to the helpful people at NES Ratnam College of Arts,
Science & Commerce, for their support.

I would also thank my institution & faculty members without whom this
project would have been a distant reality.
Summary:
 INDEX

SR.NO TOPIC PAGE NO.

1 Introduction of Monetary Policy
2 Concept of Monetary Policy
3 Objective of Monetary Policy
4 Monetary Policy V/s Fiscal Policy
5 History of Reserve Bank of India
6 Functions of Reserve Bank of India
7 Instrument of Monetary policy
8 Monetary Management of Reserve
Bank of India
9 Implementation of Reserve Bank
of India
10 Measures taken by Reserve Bank
of India for management of short
term liquidity
11 Recent changes in Reserve Bank of
India’s Monetary policy
12 Achievements & Limitation of
Monetary Policy of Reserve Bank
of India
13 Effectiveness at time of Recession
14 Bibliography
 INTRODUCTION OF 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 has become a very
important economic policy instrument of modern welfare state to achieve the
desired changes in the size and composition of national income and employment
in the economy.

Monetary Policy involves changes in the base rate of interest to influence the rate
of growth of aggregate demand, the money supply and ultimately price inflation.
Monetarist economists believe that monetary policy is a more powerful weapon
than fiscal policy in controlling inflation. Monetary policy also involves changes in
the value of the exchange rate since fluctuations in the currency also impact on
macroeconomic activity (incomes, output and prices).

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 Central bank has the duty to see that legitimate credit requirements
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 expansion.

“Monetary policy refers to the use of instruments under the control of

the central bank to regulate the availability, cost and use of money
and credit.”
 CONCEPT OF MONETARY POLICY

There are five types of monetary policy:

1. Money supply : The money supply or money stock is the total amount
of monetary assets available in an economy at a specific time. There are
several ways to define "money," but standard measures usually
include currency in circulation and demand deposits. Money supply data
are recorded and published, usually by the government or the central bank
of the country.
2.
3. Expansionary monetary policy: A type of fiscal policy focused on
increasing the size of a country's money supply in relation to demand,
taking advantage of the increased capital to announce tax cuts and
higher government expenditures to spur economic growth.
Reducing interest rates and allowing increased discount window lending
are also indirect method of expansionary monetary policy.
4.
5. Contractionary monetary policy:When the Federal Reserve uses its
tools to put the brakes on the economy in order to prevent inflation. The
will typically mean raising the federal funds rate, which
in turn, increases the rate that banks will charge each other
to borrow funds in order to meet the requirement of the Federal Reserve.
Thus, raising the federal funds rate will decrease the money supply because
it is essentially better for the banks to lend a little bit less and not have to
pay a higher federal funds rate.

6. Federal reserve system: The central bank of the United States. The Fed,
as it is commonly called, regulates the U.S. monetary and financial system.
The Federal Reserve System is composed of a central governmental agency
in Washington, D.C. (the Board of Governors) and twelve regional Federal
Reserve Banks in major cities throughout the United States.
7. Nominal interest rate: Nominal interest rate refers to the rate of interest
prior to taking inflation into account. Depending on its application, an
inflation and risk premium must be added to the real interest rate in order
to obtain the nominal rate.
 OBJECTIVE OF MONETARY POLICY

The main objective 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.
Following are the main objectives of monetary policy in India:

1. Growth With Stability :-

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
‘Growth with Stability’. 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.

2. Regulation, Supervision And Development Of Financial Stability :-

Financial 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 external shocks. Such shocks can
destabilize 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
objective of growth. Therefore, RBI is focusing on regulation,
supervision and development of financial system.

3. Promoting Priority Sector :-

Priority sector includes agriculture, export and small scale
enterprises and weaker section of population. RBI with the help of bank
provides timely and adequately credit at affordable cost of weaker
sections and low income groups. RBI, along with NABARD, is focusing
on microfinance through the promotion of Self Help groups and other
institutions.
4. Generation Of Employment :-
Monetary policy helps in employment generation by influencing the
rate of investment and allocation of investment among various
economic activities of different labour Intensities.

5. External Stability :-
With the growth of imports and exports India’s linkages with global
economy are getting stronger. Earlier, RBI controlled foreign exchange
market by determining exchange rate. Now, RBI has only indirect
control over external stability through the mechanism of ‘managed
Flexibility’, where it influences exchange rate by buying and selling
foreign currencies in open market.

6. Encouraging Savings And Investments :-

RBI by offering attractive interest rates encourage savings in the
economy. A high rate of saving promotes investment. Thus the
monetary management by influencing rates of interest can influence
saving mobilization in the country.

7. Redistribution Of income And Wealth :-

By control of inflation and deployment of credit to weaker sectors of
society the monetary policy may redistribute income and wealth
favoring to weaker sections.

8. Regulation Of NBFIs:-
Non – Banking Financial Institutions (NBFIs), like UTI, IDBI, and IFCI
plays an important role in deployment of credit and mobilization of
savings. RBI does not have any direct control on the functioning of such
institutions. However it can indirectly affects the policies and functions
of NBFIs through its monetary policy.
 FISCAL POLICY v/s MONETARY POLICY

Economic policy-makers are said to have two kinds of tools to influence

a country's economy: fiscal and monetary.

Fiscal policy:
It relates to government spending and revenue collection. For example,
when demand is low in the economy, the government can step in and
increase its spending to stimulate demand. Or it can lower taxes to
increase disposable income for people as well as corporations.

Monetary policy:

It relates to the supply of money, which is controlled via factors such

as interest rates and reserve requirements (CRR) for banks. For
example, to control high inflation, policy-makers (usually an
independent central bank) can raise interest rates thereby reducing
money supply.
 DIFFERENCE BETWEEN FISCAL & MONETARY
POLICY

SERIAL POINTS FISCAL POLICY MONETARY POLICY

NO.
1 Definition Fiscal policy is the use of Monetary policy is the
government process by which the
expenditure and monetary authority of a
revenue collection to country controls the
influence the economy. supply of money, often
targeting a rate of
interest to attain a set of
objectives oriented
towards the growth and
stability of the economy.
2 Principle Manipulating the level Manipulating the supply
of aggregate demand in of money to influence
the economy to achieve outcomes like economic
economic objectives of growth, inflation,
price stability, exchange rates with
full employment, and other currencies and
economic growth. unemployment
3 Policy Tools: Taxes; amount of Interest rates; reserve
government spending requirements; currency
peg; discount window;
quantitative easing;
open market operations;
signaling
4 Policy-maker: Government (e.g. U.S. Central Bank (e.g. U.S.
Congress, Treasury Federal Reserve)
Secretary)
 HISTORY OF RESERVE BANK OF INDIA

The Reserve Bank of India is the central bank of the country.

Central banks are a relatively recent innovation and most
central banks, as we know them today, were established around
the early twentieth century.

The Reserve Bank of India was set up on the basis of the

recommendations of the Hilton Young Commission. The Reserve
Bank of India Act, 1934 (II of 1934) provides the statutory basis
of the functioning of the Bank, which commenced operations
on April 1, 1935.

The Bank was constituted to

 Regulate the issue of banknotes

 Maintain reserves with a view to securing monetary stability and
 To operate the credit and currency system of the country to its
advantage.

The Bank began its operations by taking over from the

Government the functions so far being performed by the
Controller of Currency and from the Imperial Bank of India, the
management of Government accounts and public debt. The
existing currency offices at Calcutta, Bombay, Madras, Rangoon,
Karachi, Lahore and Cawnpore (Kanpur) became branches of the
Issue Department. Offices of the Banking Department were
established in Calcutta, Bombay, Madras, Delhi and Rangoon.
 RBI
Hilton Young Board of Share RBI
Telegram Commenceme RBI History
Commission Directors Certificates Nationalisation
nt
Burma (Myanmar) seceded from the Indian Union in 1937 but the
Reserve Bank continued to act as the Central Bank for Burma till
Japanese Occupation of Burma and later up to April, 1947. After the
partition of India, the Reserve Bank served as the central bank of
Pakistan up to June 1948 when the State Bank of Pakistan commenced
operations. The Bank, which was originally set up as a shareholder's
bank, was nationalized in 1949.

An interesting feature of the Reserve Bank of India was that at its very
inception, the Bank was seen as playing a special role in the context of
development, especially Agriculture. When India commenced its plan
endeavors, the development role of the Bank came into focus, especially
in the sixties when the Reserve Bank, in many ways, pioneered the
concept and practice of using finance to catalyze development. The Bank
was also instrumental in institutional development and helped set up
institutions like the Deposit Insurance and Credit Guarantee Corporation
of India, the Unit Trust of India, the Industrial Development Bank of India,
the National Bank of Agriculture and Rural Development, the Discount
and Finance House of India etc. to build the financial infrastructure of the
country.

With liberalization, the Bank's focus has shifted back to core central
banking functions like Monetary Policy, Bank Supervision and Regulation,
and Overseeing the Payments System and onto developing the financial
markets.
 FUNCTIONS OF RESERVE BANK OF INDIA

MEANING:
The Reserve Bank of India is the central bank of India it was established as a
shareholder’s bank on 1st April 1935. Its share capital was Rs. 5 crore, divided in to
5 lakhs fully paid up shares of Rs. 100 each. On 1st January 1949 it was
nationalized. Its headquarters is at Mumbai. RBI, like any other bank performs
almost all traditional Central banking functions. Due to country’s development it
has also undertaken developmental and promotional functions.

FUNCTIONS OF RBI :-

RBI performs many functions, some of them are:-

1. Issue Of Currency Notes :-

Under section 22 of RBI Act, the bank has the sole right to issue currency notes
of all denominations except one rupee coins and notes. The one-rupee notes and
coins and small coins are issued by Central Government 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.

2. Banker To The Government :-

The RBI acts as a banker agent and adviser to the government. It has obligation
to transact the banking business of Central Government as well as State
Governments. E.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 Government – both Central and
states – to float new loans and manage public debt. The bank makes ways and
meets advances of the government. On behalf of central government it sells
treasury bills and thereby provides short-term finance.

3. Banker’s bank And Lender Off Last Resort :-

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
interbank’s payments.

4. Controller Of Credit :-
RBI has power to control the volume of credit created by banks. The RBI
through its various quantitative and qualitative techniques 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.

5. Exchange control And Custodian Of Foreign Reserve :-

RBI has the responsibility of maintaining fixed exchange rates with all member
countries of IMF. For this, RBI has centralized all foreign exchange reserves
(FOREX). RBI functions as custodian of nation’s foreign exchange reserves. It has
to maintain external value of Rupee. RBI achieves this aim through appropriate
monetary fiscal and trade policies and exchange control.

6. Collection And Publication Of Data :-

The RBI collects and complies statistical information on banking and financial
operations of the economy. The Reserve Bank of India’ Bulletin 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.

7. Regulatory And Supervisory Functions :-

The RBI has wide powers of supervision and control over commercial and co-
operative banks, relating to licensing, establishment, branch expansion, liquidity
of Assets, management and methods of working, amalgamation, re-construction
and liquidation. 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.

8. Clearing House Functions :-

The RBI acts as a clearing house for all member banks. This avoids unnecessary
transfer of funds between the various banks.
9. Development And Promotional Functions :-
The RBI has helped in setting up Industrial Finance Corporations of India (IFCI),
State Financial Corporation’s (SFCs), Deposit Insurance Corporation, Agricultural
Refinance and Development Corporation (ARDC), units Trust of India (UTI) etc.
these institutions were set up to mobilize savings, promote saving habits and to
provide industrial and agricultural finance.

RBI has a special Agricultural Credit Department (ACD) which studies the
problems of agricultural credit. For this Regional Rural banks, Co-operative,
NABARD etc. were established. The RBI has also taken measures to promote
organized 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, export trade etc.
 INSTRUMENTS OF MONETARY POLICY

Fiduciary or paper money is issued by the Central Bank on the basis

computation of estimated demand for cash. Monetary policy guides the Central
Bank’s supply of money in order to achieve the objectives of price stability (or low
inflation rate), full employment, and growth in aggregate income. This is
necessary because money is a medium of exchange and changes in its demand
relative to supply, necessitate spending adjustments.

To conduct monetary policy, some monetary variables which the Central Bank
controls are adjusted-a monetary aggregate, an interest rate or the exchange
rate-in order to affect the goals which it does not control. The instruments of
monetary policy used by the Central Bank depend on the level of development of
the economy, especially its financial sector.

The commonly used instruments are discussed below:

 Reserve Requirement: The Central Bank may require Deposit Money

Banks to hold a fraction (or a combination) of their deposit liabilities
(reserves) as vault cash and or deposits with it. Fractional reserve limits
the amount of loans banks can make to the domestic economy and thus
limit the supply of money. The assumption is that Deposit Money Banks
generally maintain a stable relationship between their reserve holdings
and the amount of credit they extend to the public.

 Open Market Operations: The Central Bank buys or sells ((on behalf of
the Fiscal Authorities (the Treasury)) securities to the banking and non-
banking public (that is in the open market). One such security is Treasury
Bills. When the Central Bank sells securities, it reduces the supply of
reserves and when it buys (back) securities-by redeeming them-it
increases the supply of reserves to the Deposit Money Banks, thus
affecting the supply of money.

 Lending by the Central Bank: The Central Bank sometimes provide credit
to Deposit Money Banks, thus affecting the level of reserves and hence
the monetary base.
 Interest Rate: The Central Bank lends to financially sound Deposit
Money Banks at a most favorable rate of interest, called the minimum
rediscount rate (MRR). The MRR sets the floor for the interest rate
regime in the money market (the nominal anchor rate) and thereby
affects the supply of credit, the supply of savings (which affects the
supply of reserves and monetary aggregate) and the supply of
investment (which affects full employment and GDP).

 Direct Credit Control: The Central Bank can direct Deposit Money Banks
on the maximum percentage or amount of loans (credit ceilings) to
different economic sectors or activities, interest rate caps, liquid asset
ratio and issue credit guarantee to preferred loans. In this way the
available savings is allocated and investment directed in particular
directions.

 Moral Suasion: The Central Bank issues licenses or operating permit to

Deposit Money Banks and also regulates the operation of the banking
system. It can, from this advantage, persuade banks to follow certain
paths such as credit restraint or expansion, increased savings
mobilization and promotion of exports through financial support, which
otherwise they may not do, on the basis of their risk/return assessment.

 Prudential Guidelines: The Central Bank may in writing require the

Deposit Money Banks to exercise particular care in their operations in
order that specified outcomes are realized. Key elements of prudential
guidelines remove some discretion from bank management and replace
it with rules in decision making.

 Exchange Rate: The balance of payments can be in deficit or in surplus

and each of these affect the monetary base, and hence the money
supply in one direction or the other. By selling or buying foreign
exchange, the Central Bank ensures that the exchange rate is at levels
that do not affect domestic money supply in undesired direction,
through the balance of payments and the real exchange rate. The real
exchange rate when misaligned affects the current account balance
because of its impact on external competitiveness. Moral suasion and
prudential guidelines are direct supervision or qualitative instruments.
The others are quantitative instruments because they have numerical
benchmarks.
 MONETARY MANAGEMENT OF RESERVE BANK OF INDIA

The Monetary Policy of RBI is not merely one of credit restriction, but it has also
the duty to see that legitimate credit requirements 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. Quantitative Credit Control Methods :-

In India, the legal framework of RBI’s control over the credit structure has been
provided Under Reserve Bank of India Act, 1934 and the Banking Regulation Act,
1949. Quantitative credit controls are used to maintain proper quantity of credit o
money supply in market.
Some of the important general credit control methods are:-
1. Bank Rate Policy :-
Bank rate is the rate at which the Central bank lends money to the
commercial banks for their liquidity requirements. Bank rate is also called
discount rate. In other words bank rate is the rate at which the central bank
rediscounts eligible papers (like approved securities, bills of exchange,
commercial papers etc) held by commercial banks.Bank rate is important
because it is the pace setter to other market rates of interest. Bank rates
have been changed several times by RBI to control inflation and recession.
By 2003, the bank rate has been reduced to 6% p.a.

2. Open market operations :-

It refers to buying and selling of government securities in open market in
order to expand or contract the amount of money in the banking system.
This technique is superior to bank rate policy. Purchases inject money into
the banking system while sale of securities do the opposite. During 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 liquidity.
3. Cash Reserve Ratio (CRR) :-
The Cash Reserve Ratio (CRR) is an effective instrument of credit control.
Under the RBl Act of, l934 every commercial bank has to keep certain
minimum cash reserves with RBI. The RBI is empowered to vary the CRR
between 3% and 15%. A high CRR reduces the cash for lending and a low
CRR increases the cash for lending. The CRR has been brought down from
15% in 1991 to 7.5% in May 2001. It further reduced to 5.5% in December
2001. It stood at 5% on January 2009. In January 2010, RBI increased the
CRR from 5% to 5.75%. It further increased in April 2010 to 6% as
inflationary pressures had started building up in the economy. As of March
2011, CRR is 6%.

4. Statutory Liquidity Ratio (SLR) :-

Under SLR, the government has imposed an obligation on the banks to;
maintain a certain ratio to its total deposits with RBI in the form of liquid
assets like cash, gold and other securities. The RBI has power to fix SLR in
the range of 25% and 40% between 1990 and 1992 SLR was as high as
38.5%. Narasimham Committee did not favor maintenance of high SLR.
The SLR was lowered down to 25% from 10thOctober 1997.It was further
reduced to 24% on November 2008. At present it is 25%.

5. Repo And Reverse Repo Rates:

In determining interest rate trends, the repo and reverse repo rates are
becoming important. Repo means Sale and Repurchase Agreement. Repo
is a swap deal involving the immediate Sale of Securities and simultaneous
purchase of those securities at a future date, at a predetermined price.
Repo rate helps commercial banks to acquire 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 excess funds with RBI. Repo and reverse repo operations are
used by RBI in its Liquidity Adjustment Facility. RBI contracts credit by
increasing the repo and reverse repo rates and by decreasing them it
expands credit. Repo rate was 6.75% in March 2011 and Reverse repo rate
was 5.75% for the same period. On May 2011 RBI announced Monetary
Policy for 2011-12. To reduce inflation it hiked repo rate to,7.25% and
Reverse repo to 6.25%.
 II. SELECTIVE / QUALITATIVE CREDIT CONTROL METHODS :-

Under Selective Credit Control, credit is provided to selected borrowers for

selected purpose, depending upon the use to which the control tries to regulate
the quality of credit - the direction towards the credit flows.
The Selective Controls are:-

1. Ceiling On Credit:
The Ceiling on level of credit restricts the lending capacity of a bank to grant
advances against certain controlled securities.

2. Margin Requirements:
A loan is sanctioned against Collateral Security. 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 encourager to discourage the flow of
credit to a particular sector. It varies from 20% to 80%. For agricultural
commodities it is as high as 75%. Higher the margin lesser will be the loan
sanctioned.

3. Discriminatory Interest Rate (DIR):

Through DIR, 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.

4. Directives:-
The RBI issues directives to banks regarding advances. Directives are regarding
the purpose for which loans may or may not be given.

5. Direct Action:-
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.

6. Moral Suasion:-
Under Moral Suasion, RBI issues periodical letters to bank to exercise control over
credit in general or advances against particular commodities. Periodic discussions
are held with authorities of commercial banks in this respect.
 MEASURES TAKEN BY RESRVE BANK OF INDIA FOR
MANAGEMENT OF SHORT TERM LIQUIDITY

RBI’S SHORT TERM LIQUIDITY MANAGEMENT:-

Liquidity Management of Central bank means supplying to the market the

amount of liquidity that is consistent with a desired level of short-term interest
rate. It is defined “as 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 objective of price stability”.

In RBI’s overall management short term liquidity management occupies a very

important place due to following factors:-

1) In financial sector, in 1990’s, many reforms were introduced. The important

reforms are deregulation of interest rates and exchange rates. Earlier 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.

2) Due to liberalization capital flows between countries have increased. From

US $118 Million during 1991-92, capital flows to. India rose to US $15 billion
in 2004-05.

3) Foreign capital flows have increased employment. It adds to the supply of

foreign exchange and has resulted into appreciation of domestic currency.
With this, the exports have become more expensive.

4) When capital inflows are converted into rupees, they get injected into the
economy thereby, increasing the money supply.

So to maintain price stability RBI has to manage the exchange rate and Interest
rate.
 B) RBI’S MEASURES FOR SHORT TERM LIQUIDITY MANAGEMENT:-

1. Repo I Reverse Repo:-

To improve short term liquidity management, RBl. introduced repos in December
1992. Repo is Sale and Repurchase Agreement. It is a swap deal involving the
immediate Sale of Securities and simultaneously purchase of those securities at a
future date, at a predetermined price. Such deals take place between RBI and
banks. Due to lack of demand repos auctions were discontinued in March 1995,
they were resumed again in 1997. Reverse repo rate is the rate that banks get
from RBI for parking their short term excess funds with RBI.

2. Interim Liquidity Adjustment Facility (ILAR):-

To develop short term money market Narasimham Committee 1998
recommended LAF. Accordingly in 1999 RBI introduced ILAF. It (ILAF) provided a
mechanism for liquidity management through a combination of repos, export
credit refinance and collateralized lending facilities supported by Open Market
Operations.

3. Liquidity Adjustment Facility (LAP):-

RBI introduced-full-fledged LAF. It has been revised further. Under LAF, Reverse
repo auctions and Repo auctions are conducted on daily basis. In India, the
emergence of LAF was a single biggest factor which helped RBI to manage short
term liquidity and maintain interest rate stability. In 2009-10, liquidity absorption
through reverse repo reached its peak on 4th September 2009 at Rs. 1,
68,215crore.

4. Sterilization:-
Sterilizations mean re-cycling of foreign capital inflows to prevent appreciation of
domestic currency and to check the inflationary impact of such capital.
Sterilization is carried out through open market operations. But Sterilizations can
also leads to some problems. Thus RBI also, uses a variety of other measures to
manage interest rates.
5. Market Stabilization Scheme (MSS):-
Till 2003-04 the impact of large capital inflows was managed through day-to-day
LAF and OMO. In the process, the government securities available with RBI
declined, as they were being used for absorbing excess liquidity. In order to
handle these issues, RBI signed a Memorandum of Understanding (MOU) with
Government for issuance of Treasury Bills and dated government securities under
Market Stabilization Scheme (MSS). These Bills and Securities are used to absorb
excess liquidity from market and: maintain stability in foreign exchange market.
 RECENT CHANGES IN RBI’S MONETARY POLICY

Since 1991 RBI’s monetary management has undergone some major

changes:

1. Multiple Indicator Approach :-

Up to late 1990s, 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.
After 1991 reforms this approach became difficult to follow. So RBI adopted
multiple indicator Approach in which it looks at a variety of economic indicators
and monitor their impact on inflation and economic growth.
2. Selective Methods Being Phased Out :

With rapid progress in financial markets, the selective methods of credit

control are being slowly phased out. Quantitative methods are becoming more
important.
3. Reduction In Reserve Requirements :

In post-reform period the CRR and SLR have been progressively lowered. This
has been done as a part of financial sector reforms. As a result, more bank funds
have been released for lending. This has led to the growth of economy.
4. Deregulation Of Administered Interest Rate System :

Earlier lending rate of banks was determined by RBI. Since 1990s this system
has changed and lending rates are determined by commercial banks on the basis
of market forces.

5. Delinking Of Monetary Policy From Budget Deficit :

In1994 government phased out the use of adhoc treasury Bills.These bills
was used by government to borrow from RBI to finance fiscal deficit. With
phasing out of Bills, RBI would no longer lend to government to meet fiscal
deficit.
 6. Liquidity Adjustment Facility (LAF):

LAF allows banks to borrow money through repurchase agreement LAF was
introduced by RBI during June, 2000, in phases. The funds under LAF are used by
banks to meet day-to-day mismatches in liquidity.

7. Provision Of Micro Finance:

By linking the banking system with Self Help Groups, RBI has introduced the
scheme of micro finance for rural poor. Along with NABARD, RBI is promoting
various other microfinance institutions.

8. External Sector:

With globalization large amount of foreign capital is attracted. To provide

stability in financial markets, RBI uses sterilization and LAF to absorb the excess
liquidity that comes in with huge inflow of foreign capital.

9. Expectation As A Channel Of Monetary Transmission:

Traditionally, there were four key channels of monetary policy transmission

Interest rate, credit availability, asset prices and exchange rate channels. Interest
rate is the most dominant transmission channel as any change in monetary policy
has immediate effect on it. In recent year’s fifth channel, Expectation has been
added. Future expectations about asset prices, general price and Income levels
influence the four traditional channels.
 ACHIEVEMENT & LIMITATION OF MONETARY POLICY OF
RBI

EVALUATION OF MONETARY POLICY :-

The RBI aims at one time was controlled expansion. On one hand it
was taking steps to expand bank credit. On other hand RBI uses
quantitative and qualitative methods to control credit. These two
contradictory objectives limited the success of monetary policy. The
performance of monetary policy can be seen from its achievements and
failures, let us discuss.

Achievements / Positive Aspects Of Monetary Policy :-

1. Short Term Liquidity Management :-

RBI has developed various methods to maintain stability in interest rate
and exchange rate like LAF, OMO and MSS. RBI has also managed its
sterilization operations very well.
2. Financial Stability :-
With the help of controls, regulation and supervision mechanism, RBI
has been successful in maintaining financial stability. During the period
of global crisis it has also been able to maintain macro economic
stability.
3. Financial Inclusion :-
Along with NABARD, RBI has made a great impact in the growth of
microfinance. RBI has supported Self Help Group Model and promoted
other microfinance institutions.
4. Adaptability:-
In India monetary policy is flexible, as it changes with time. RBI has
developed new methods of credit control and shifted from monetary
targeting to multiple indicator approach.
5. Increase In Growth:-
To maintain the growth of economy RBI has used its instruments'
effectively. At present India has the second highest rate of GDP growth
after China. Thus monetary policy has played an important role.

6. Increase In Bank Deposits:-

The increase in bank deposits over the years indicates trust and
confidence of people in banking sector. Effective supervision of RBI
over banks and financial institutions is largely responsible for trust and
confidence of public in banking sector.

7. Competition Among 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. Now-a-days due to
professionalism banks provide better service to customers.
 FAILURES / LIMITATIONS OF MONETARY POLICY

1. Huge Budgetary Deficits :-

RBI makes every possible attempt to control inflation and to balance
money supply in the market. However Central Government's huge
budgetary deficits have made monetary policy ineffective. Huge
budgetary deficits have resulted in excessive monetary growth.

2. Coverage Of Only Commercial 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.

3. Problem Of Management Of Banks And Financial Institutions :-

The monetary policy can succeed to control inflation and to bring
overall development only when the management of banks and
Financial 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.

4. Unorganized Money Market :-

Presence of unorganized sector of money market is one of the main
obstacles in effective working of the monetary policy. As RBI has no
power over the unorganized sector of money market, its monetary
policy becomes less effective.

5. Less Accountability:-
At 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.
6. 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 Supply in a country remains outside
the purview of RBI's monetary management.

7. Increase Volatility :-
The integration of domestic and foreign exchange markets could lead to
increased volatility in the domestic market as the impact of exogenous
factors could be transmitted to domestic market. The widening of
foreign exchange market and development of rupee - foreign exchange
swap would reduce risks and volatility.

8. Lack Of Transparency :-
According to S. S. Tara pore, the monetary policy formulation, in its
present form in India, cannot be continued indefinitely. For a more
effective policy, it would be necessary to have greater transparency in
the policy formulation and transmission process and the RBI would
need to be clearly demarcated.
 EFFECTIVENESS AT THE TIME OF RECESSION

The objective of this thesis is to describe, analyze and discuss the

traditional monetary policy and its instruments during a recession.
There are some discussions amongst different schools of economists,
the Keynesian and the Monetarist, on whether the monetary policy will
have an effect on the real economy. Where fiscal policy affects the
economy directly through the multiplier effect the monetary policy will
only indirectly affect the real economy through the transmission
channels.

Its efficiency has especially been questioned when the economy is

caught in a liquidity trap where the monetary interest rates are close to
the zero-limit bound. Four alternative strategies that could help the
economy to escape the liquidity trap are therefore presented in section
6.Most central banks agree on price-stability as the most important
medium to long term target that a central bank can pursue. Denmark
has for a long time had a fixed exchange rate first to the deutschmark
and later to the euro. Since the Danish krone is fixed to the euro the
degree of freedom in terms of monetary policy is rather limited as the
spread between the two monetary interest rates can not be too
significant. This is to make sure that the exchange rate is held within a
certain bound.

Other regimes, i.e. inflation targeting, have been used by other central
banks in order to reach the goal of price-stability. Research has shown
that both fixed exchange rate policy and inflation targeting are almost
equally efficient in terms of reaching price stability.After years of global
economic boom and high inflation the economic situation changed with
the start of the financial crisis.
Negative growth rates in real GDP in 2008 and 2009 had severe
consequences for the economy in general. The start of the financial
crisis challenged the stability of the financial sector and the distrust
amongst the financial institutions in the Danish economy meant that
the money market froze. The spread seemed to be the result of a
money market where the counterparties were extremely risk-averse
and were very careful as to take on more risk.

This is supported by the empirical data analyzed by an econometric

model that measures credit- and liquidity risk influences on the money
market interest rate. The interest rate in the traditional monetary
policy can in such a situation, as we saw under the financial crisis, be
ineffective as it can not reduce the risk premium on the money market
by itself.

The analysis shows that Denmark’s National bank and other central
banks have used alternative monetary strategies besides its traditional
monetary strategy in order to stabilize the financial sectors. The
economy has still not fully recovered and looking at the Danish
monetary policy isolated it has not been found sufficient but have been
necessary supplement to other economic alternatives, i.e. fiscal policy
and banking packages.
 CONCLUSION:

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.