Monetary Policy of India Everything You Should Know About

Monetary policy in India is determined and implemented by the Reserve Bank of India (RBI), whose main objective is to control inflation and promote economic growth. The main instruments include the repo rate, reverse repo rate, and cash reserve ratio (CRR). The repo rate, currently at 4%, is the rate at which banks borrow funds from the RBI. The reverse repo rate, set at 3.35%, is the rate at which the RBI borrows money from banks. CRR, at 4%, directs banks to keep a certain portion of their deposits with the RBI. These rates are reviewed at regular intervals by the Monetary Policy Committee (MPC) of the RBI, which evaluates economic conditions every two months and makes adjustments accordingly. Recent important days include bi-monthly MPC meetings and announcements of policy changes.

Monetary policy, as implemented by the Reserve Bank of India, encompasses strategies related to interest rates, cash supply, and credit availability. It acts as an important tool to control inflation in the country. The Reserve Bank of India achieves its objectives by using various monetary instruments such as relief rate, counterpart relief rate, SLR (Statutory Fund Ratio), and CRR (Cash Reserve Ratio). The main objective of monetary policy is to control economic changes such as interest rates and credit availability so as to achieve macroeconomic goals. The strategies implemented evolve with economic conditions and are constantly adjusted to maintain stability.

Monetary policy, which is managed by the central bank, regulates the money supply so as to control inflation or inflation. The option of increasing money supply through more money is implemented to stimulate economic growth. It is generated by reducing key interest rates and increasing market liquidity. This is commonly adopted during periods of economic downturn. Conversely, an expansionary monetary policy aims to prevent inflation, which is achieved by reducing the money supply. This is achieved by increasing key interest rates, reducing market liquidity, often used during extreme economic periods. One of the prime examples of expansionary policy is the actions of the US Federal Reserve during the 2008 financial crisis, while the European Central Bank’s printed policy in 2011 exemplifies the contractionary stance. Both policies are important in stabilizing economies, each designed to address particular economic situations.

The Reserve Bank of India (RBI) conducts monetary policy under the rules laid down by the Reserve Bank of India Act of 1934. In recent years, significant changes have been made to the elements of India’s monetary policy. The Monetary Policy Framework (MPF), the Monetary Policy Committee (MPC), and the Monetary Policy Process (MPP) were introduced during this period. The MPF was implemented in 2016 to establish a target for inflation, with the aim of maintaining it within specified limits. The MPC, which was formed in 2016, is responsible for setting interest rates to capture inflation. MPP explains the principled process through which monetary policy decisions are made. These changes indicate a shift towards a more transparent and structured approach towards monetary policy in India.

The main objective of India’s monetary policy is to maintain price stability, ensuring that inflation remains under control. This objective is important for sustainable economic development. The Government of India usually sets inflation targets for five-year periods, with the Reserve Bank of India (RBI) playing a key role in the consultation process. Currently, India’s inflation-targeting framework is flexible, allowing adjustments to meet economic conditions. By managing inflation, monetary policy aims to create an enabling environment for economic growth, while quickly rising inflation can erode purchasing power and broadly impact economic stability. This approach reflects the importance of balancing inflation control with economic expansion.

In India, the “Flexible Inflation Targeting Framework” (FITF) was implemented by the Ministry of Finance in 2016 after the amendment of the Reserve Bank of India (RBI) Act of 1934. Under this framework, the authority to implement monetary policy has to be exercised by the government every five years in consultation with the Reserve Bank of India. On August 5, 2016, the central government set the consumer price index (CPI) inflation target at 4% for the period up to March 31, 2021, with the upper tolerance at 6% and the lower tolerance at 2%. Non-achievement of the inflation target occurs if inflation exceeds the maximum tolerance limit for three consecutive quarters or falls below the minimum tolerance limit for three consecutive quarters. This framework provides a structured approach to ensure containment of inflation and sustainable economic growth.

The monetary policy framework in India is guided by the Monetary Policy Framework (MPF), which is established by the government but implemented by the Reserve Bank of India (RBI). This framework is set by the amended RBI Act, which provides legislative authority to the RBI to conduct monetary policy. The main objective is to determine the policy (repo) rate by assessing the financial situation and aligning the liquidity position to align cash market rates around the repo rate. Changes in the repo rate affect the entire financial system, impacting benchmark demand, and thereby impacting inflation and growth. The operating framework involves daily cash management activities to maintain the Weighted Average Call Rate (WACR) around the repo rate. This system ensures effective dissemination of monetary policy decisions. This development of the system reflects the RBI’s commitment to maintaining price stability and promoting economic growth.

The Monetary Policy Committee (MPC) in India is established under Section 45ZB of the amended RBI Act of 1934. This committee is composed of six members appointed by the Central Government. This committee meets in at least four annual meetings, in which the policy rate of inflation is jointly decided. A committee of four members has a majority, and if there is a tie, the governor is given the final decision. Proposals for committee meetings are published in a timely manner. Additionally, the Reserve Bank of India (RBI) publishes the Economic Finance Report. This report clarifies the sources of inflation and provides inflation forecasts for the coming 6-18 months. This comprehensive documentation aids in transparency and understanding of RBI’s monetary policy decisions.

The Monetary Policy Committee (MPC) was constituted by the Constitution by the Central Government with the following members:

  1. Governor of the Reserve Bank of India – Chairman, Volunteer.
  2. Deputy Governor in charge of Monetary Policy, Reserve Bank of India – Member, Volunteer.
  3. An officer of the Reserve Bank of India, nominated by the Central Committee – Member, Volunteer.
  4. Shashank Bhide, Senior Advisor, National Council for National Utilities (NCAER) – Member.
  5. Ashima Goyal, Professor, Indira Gandhi Institute of Development Research in Mumbai – Member.
  6. Jayant Verma, Professor, Indian Institute of Management Ahmedabad – Member.

Members 4 to 6 are appointed to serve for a term of four years or until further notice. The specialization of the MPC ensures diverse expertise in economic policy formulation and analysis.

The monetary policy process (MPP) is guided by the Monetary Policy Committee (MPC), which is responsible for setting the policy interest rate to achieve the inflation target. The MPC is significantly assisted by the Monetary Policy Department (MPD) of the Reserve Bank which collects inputs from key stakeholders and conducts analytical research. The Financial Markets Operations Department (FMOD) implements monetary policy through the expression of liquidity management. The Financial Markets Committee (FMC) evaluates financial conditions for daily review, ensuring consistency through the policy repo rate. This integrated process makes effective monetary policy implementation possible. Collaboration between departments in this process and regular reviews are important to maintain monetary stability.

1. Repo Rate and Reverse Repo Rate

The repo rate, introduced in 2000, is the interest rate at which the RBI provides short-term funding to marketing banks by placing assets, usually collateral against government authorities. By adjusting the repo rate, RBI can influence the cost of loans and the terms of liquidity in the banking system. Inversely, the reverse repo rate, established in 2001, is the rate at which the RBI residually absorbs cash from banks. With these rates, the RBI’s monetary policy framework is formed, allowing it to manage inflation and stimulate economic growth through changes.

2. Liquidity Adjustment Facility (LAF)

The LAF, introduced in 1998, allows banks to manage daily liquidity requirements by funding distributions by the RBI. In particular, term repo, inter-bank term encourages the development of the cash market, giving effect to liquidity policy actions through the promotion system. By interweaving liquidity terms through LAF, RBI can effectively implement its monetary policy objectives and maintain financial stability.

3. Marginal Standing Facility (MSF)

Established in 2011, the MSF provides a mechanism for banks to employ short term cash at the time of unexpected cash shortages remedied by the RBI. The MSF rate is usually higher than the repo rate, which acts as a penalty to banks for accessing cash beyond their legal limits. This facility works as a safety valve for the banking system, ensuring stability during cash shortages and strengthening confidence in the financial markets.

4. Bank Rate

The bank rate, linked to the MSF rate, is used by the RBI for borrowing checks or purchasing bills of exchange and commercial paper. Historically, changes in the bank rate have been used to signal changes to the RBI’s monetary policy, affecting loan rates and credit relations. Although its direct use has diminished over time, the bank rate remains an important tool in the RBI’s arsenal to manage liquidity and interest rate activities.

5. Cash Reserve Ratio (CRR)

Introduced in 1962, CRR obliges banks to keep a certain percentage of their collateral in cash reserves with the RBI. By adjusting the CRR, RBI can control the amount of cash available in the banking system, thereby impacting credit creation and money supply dynamics. Although CRR has faced several amendments, its role has remained crucial in influencing liquidity conditions.

6. Legal Liquidity Ratio (SLR)

Established along with the CRR in 1962, the SLR prescribes banks to hold certain assumptions of their deposits in government authorities, elements such as cash and gold. This ratio acts as a secondary cash reserve for banks, ensuring their balance and stability in times of financial crises. Additionally, the SLR plays an important role in shaping the composition of the asset portfolio of banks and ensuring the development of the government authorities market.

7. Open Market Operations (OMOS)

Since its introduction, the RBI has performed open market operations to regulate liquidity conditions and interest rates in the financial markets. RBI has the power to provide tradability and messages to government authorities to buy and sell cash in the financial market through OMOS, increase or decrease the quantity of cash, regulate long-term interest rates and market messages. RBI has the power to influence the financial markets. OMOS is a tool used by the RBI to address external imbalances in cash balance, manage inflation expectations, and establish the stability of financial markets.

8. Market Stabilization Scheme (MSS)

Introduced in 2004, the MSS provides a mechanism for the RBI to absorb excess liquidity from capital flows into the economy. By issuing sovereign debt and treasury bills under the MSS, the RBI can absorb the impact of money lending on the domestic currency and stabilize economic growth on the domestic currency and exchange rates. The scheme plays an important role in maintaining macroeconomic stability and preventing excessive volatility in the financial markets.

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