RBI Monetary Policy 2018

Monetary policy is a policy formulated by the central bank, i.e., RBI (Reserve Bank of India)
and relates to the monetary matters of the country. The policy involves measures taken for
regulating the money supply, availability and cost of credit in the economy. The policy also
oversees distribution of credit among users as well as borrowing and lending rates of
interest. In a developing country like India, it is significant in the promotion of economic
growth.

The various instruments of monetary policy include variations in bank rates, other interest
rates, selective credit controls, supply of currency, variations in reserve requirements and
open market operations.

Objectives of Monetary Policy

The main objectives of monetary policy are to encourage economic growth, ensure price
stability and exchange rate of the rupee with foreign currencies such as the dollar and
pound.
1. Inflation control or Price stability:
As India is a developing country, investment activity is the agricultural sector is
accompanied by pressure on prices. Therefore, in this regard, monetary policy contributes
to the short-run management. Structural changes are inevitable, however, the monetary
policy keeps the pricing stable, despite slight changes in the price level owing to a certain
rate of inflation.
2. Economic growth:
Another important objective of the monetary policy is the promotion of economic growth,
ensuring there is ample availability of credit and at a lower cost. Also, the policy needs to
be tightened in order to prevent rupee depreciation. Tightening of monetary policy involves
adequate availability of credit for private investments, lower lending rates and reduction of
liquidity of the banking system.
3. Stability in exchange rates:
The RBI’s monetary policy was formed to prevent large depreciation and appreciation of
foreign exchange rate. The Reserve Bank releases more dollars from its reserves in the
foreign exchange in order to prevent the depreciation of the rupee.

Monetary Policy Tools

To control inflation, the Reserve Bank of India needs to decrease the supply of money or
increase cost of fund in order to keep the demand of goods and services in control.

Quantitative tools – The tools applied by the policy that impact money supply in the entire
economy, including sectors such as manufacturing, agriculture, automobile, housing, etc.
1. Reserve Ratio:
Banks are required to keep aside a set percentage of cash reserves or RBI approved
assets. Reserve ratio is of two types:

Cash Reserve Ratio (CRR) – Banks are required to set aside this portion in cash with the
RBI. The bank can neither lend it to anyone nor can it earn any interest rate or profit on
CRR.

Statutory Liquidity Ratio (SLR) – Banks are required to set aside this portion in liquid
assets such as gold or RBI approved securities such as government securities. Banks are
allowed to earn interest on these securities, however it is very low.
2. Open Market Operations (OMO):
In order to control money supply, RBI buys and sells government securities in the open
market. These operations conducted by the Central Bank in the open market are referred
to as Open Market Operations.

When RBI sells government securities, the liquidity is sucked from the market, and the
exact opposite happens when RBI buys securities. The latter is done to control inflation.
The objective of OMOs are to keep a check on temporary liquidity mismatches in the
market, owing to foreign capital flow.

Qualitative tools:

Unlike quantitative tools which have a direct effect on the entire economy’s money supply,
qualitative tools are selective tools that have an effect in the money supply of a specific
sector of the economy.
1. Margin requirements – RBI prescribes a certain margin against collateral, which in turn
impacts the borrowing habit of customers. When the margin requirements are raised by
the RBI, customers will be able to borrow less.
2. Moral suasion – By way of persuasion, RBI convinces banks to keep money in
government securities, rather than certain sectors.
3. Selective credit control – Controlling credit by not lending to selective industries or
speculative businesses.
Market Stabilisation Scheme (MSS) -
1. Policy Rates:
Bank rate – The interest rate at which RBI lends long term funds to banks is referred to as
the bank rate. However, presently RBI does not entirely control money supply via the bank
rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant tools
to establish control over money supply.

Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed
SLR or CRR.

Liquidity Adjustment Facility (LAF) – RBI uses LAF as an instrument to adjust liquidity
and money supply. The following types of LAF are:

Repo rate: Repo rate is the rate at which banks borrow from RBI on a short-term basis
against a repurchase agreement. Under this policy, banks are required to provide
government securities as collateral and later buy them back after a pre-defined time.

Reverse Repo rate: It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in
order to keep additional funds in RBI. It is linked to repo rate in the following way:

Reverse Repo Rate = Repo Rate – 1

Marginal Standing Facility (MSF): MSF is the penal rate which the central bank lends
money to banks, over the rate available under the rep policy. Banks availing MSF can use
a maximum of 1% of SLR securities.

MSF = Repo Rate + 1

Monetary Policy Transmission

Borrowers fail to fully benefit from RBI’s repo rate cut due to the following reasons:
 Banks are not affected by RBI rate cuts as the Central Bank is not their primary money
supplier.
 Deposits already made are fixed at the rates when taken and cannot be reduced; the rate
cuts will only reflect in the new deposit rates.
 PPF, Post Office accounts and other small saving instruments are available at high
administered interest rates and in case of reduction of bank deposit rates, customers have
the choice to move to those funds.
 Banks do not prefer to lower their rates as high lending rates keeps their profit margins up.
 India does not have a well-developed corporate bond market, therefore corporate
customers have little choice but to reach out to banks for borrowing.
Steps to improve monetary transmission:

Both the government and RBI has taken and plans to take some steps in order to accelerate
the transmission of monetary policy.
 Government intends to bring down the interest rates on small saving accounts. If the small
saving rates are linked to the bank rate, this could serve as a permanent solution.
 In order to improve monetary transmission, RBI wants banks to change the calculation
methodology of base rate to marginal cost of funds from average cost of funds.
Despite banks raising the lending rates immediately after RBI’s rate cuts, the Central Bank is
unable to control inflation due to the following reasons:
 Financial deficit in the higher government.
 Issues at the supply side, such as crude oil prices, issues in agri marketing, etc.
 Lack of financial inclusion as borrowers still depend on moneylenders, who are not under
RBI’s control.
 Non-monetised economy in certain rural areas.
Dear Money Policy or Contractionary Monetary Policy:

Dear money policy is a policy when money become more expensive with the rise of interest
rate. Due to this, the supply of money also decreases in the economy, therefore it is also
referred to as the contractionary monetary policy.

This policy leads to a drop in business expansions owing to a high cost of credit, as well as a
fall in business expansion. This in turn affects employment as it brings down growth rates.
Therefore, interest rate cuts such as SLR and CRR are preferred by the government and the
corporates.

Fiscal Policy:

A policy set by the finance ministry that deals with matters related to government
expenditure and revenues, is referred to as the fiscal policy. Revenue matter include matters
such as raising of loans, tax policies, service charge, non-tax matters such as divestment,
etc. While expenditure matters include salaries, pensions, subsidies, funds used for creating
capital assets like bridges, roads, etc.

Demand Pull Inflation:

This is a state when people have excess money to buy goods in the market. RBI practises
easier control on this as it can lead to a fall in money supply in the economy, which in turn
would mean a drop in prices.

Supply Side Inflation:

Inflation in the economy owing to constraints in the supply side of goods in the market. This
cannot be controlled by RBI as it does not control prices of commodities. The government
plays an important role in this case through fiscal policy.

Conclusion:

RBI has been following a neutral policy stance for some time now. This means that with
inflation being at an all time low of 4.0%, and the growth projections of the Indian economy
being at a constant 7.30%, the RBI will try not to destabilize the delicate balance, by either
infusing or removing too much funds from the markets.
To this end, the Central Bank has cut both repo rate and Reverse Repo rate recently by 25
basis points taking them to 6.0% p.a. and 5.75% p.a. respectively. It has also reduced
Bank Rate and MSF to 6.25% each. This ensures that the government’s requirement for
more liquidity for industry growth is fulfilled, without the risk of increase in inflation being too
high.