Monetary Policy
Monetary policy refers to the policy of the central bank of a country to regulate and manage the volume, cost, and allocation of money and credit in order to achieve the government’s goals of optimal production and employment, price stability, balance of payment equilibrium, or any other purpose.
Monetary and fiscal policy are inextricably linked and should be undertaken together. Fiscal policy often causes changes in the money supply via the budget deficit. An high budget deficit, for example, throws the responsibility of controlling inflation onto monetary policy. This necessitates a tight credit policy.
On the contrary, a fiscal policy that maintains the budget deficit at a low level relieves the monetary authority of the responsibility of implementing an anti-inflationary monetary policy. Monetary policy may thus play a constructive role in encouraging economic growth by providing financing to development projects.
In a growing country like India, prudent monetary policy may play a constructive role in providing the conditions for full-fledged economic development. Furthermore, since these economies are very vulnerable to inflationary pressures, monetary policy should help to contain inflation by encouraging individuals to save more, limiting credit growth by the banking system, and discouraging government deficit financing.
During the planning phase in India, the Reserve Bank’s monetary policy was designed to satisfy the demands of the planned economic growth.
With this broad goal in mind, monetary policy has been undertaken in order to meet the government’s dual economic policy objectives:
(a) To expedite the process of economic development in order to increase national income,
(b) To manage and mitigate inflationary pressures in the economy.
Thus, the Reserve Bank’s monetary policy throughout the planning period was accurately referred to as ‘managed expansion’. It attempts to appropriately finance economic expansion while guaranteeing acceptable price stability in the economy.
Policy of Credit Expansion
The overarching economic trend throughout the planning period has been one of continual currency and credit growth with the goal of satisfying the economy’s developmental demands.
This expansion has been accomplished by using the following measures:
Revisions to Open Market Operations
In October 1956, the Reserve Bank altered its open operations policy, and began providing discriminating assistance for the sale and acquisition of government securities. Between 1948 and 1951, the bank made massive acquisitions of government securities.
During the succeeding period, the Bank’s sales of government securities to the public outpaced its acquisitions. Between 1964 and 1969, this surplus sales practice was abolished in order to increase the economy’s cash and credit supply.
Liberalization of the Bill Market Scheme
The bill market system provides commercial banks with extra money from the Reserve Bank to satisfy their customers’ expanding credit demand. Since 1957, the Reserve Bank has expanded the bill market program to include export bills to assist commercial banks in providing unrestricted credit to exporters.
Facilities for Priority Sectors
Despite its overall strategy of limiting credit growth, the Reserve Bank continues to give loans to key sectors such as small-scale companies and cooperatives.
For example, in October 1962, banks were permitted to borrow extra cash from the Reserve Bank to support small-scale companies and cooperatives. The Reserve Bank has also offered short-term financing to rural cooperatives.
Refinance and Rediscounting Facilities
In recent years, the Reserve Bank has adopted a policy of selective refinancing and rediscounting facilities. Banks are now able to refinance up to 1% of their demand and time obligations at a 10% annual interest rate. There are additional refinance options for food purchase and export loans.
Credit Facilities from Financial Institutions:
The Reserve Bank has also played a role in the establishment of several financial institutions, including the Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Reconstruction Corporation of India (IRCI), Industrial Credit and Investment Corporation of India (ICICI), and State Finance Corporations (SFCs).
Agricultural Refinance and Development Corporation (ARDC) and National Bank of Agriculture and Rural Development (NABARD). The Reserve Bank offers medium- and long-term development finance via these entities.
Deficit financing.
The country’s money supply has been steadily increasing as a result of the government’s use of deficit financing to fund its budget. This was made feasible by adjustments in the Reserve Bank’s reserve requirements.
Two adjustments were made to the reserve system to increase its flexibility.
(a) By eliminating the proportionate reserve system, which required 40% of reserves to be held in gold (coins and bullion) and foreign securities, with the condition that the value of gold was not less than Rs. 40 crore.
(b) Modifying the minimum reserve system so that the Reserve Bank must only retain gold worth Rs. 115 crore, with the condition that the minimum requirement of keeping foreign securities worth Rs. 85 crore may be waived in severe circumstances.
Anti-inflationary fiscal policies
The Seventh Five Year Plan favors anti-inflationary fiscal policy above anti-inflationary monetary policy, and it emphasizes monetary policy’s positive, promotional, and explanatory roles. It has been suggested that “a fiscal policy that keeps the budget deficit down would give greater autonomy to monetary policy.”
In the seventh plan, the amount of deficit financing (i.e., net Reserve Bank Credit to the government) has been fixed at a level considered just sufficient to generate the additional money supply required to meet the expected increase in money demand. Such an anti-inflationary fiscal policy will relieve the Reserve Bank of its anti-inflationary responsibilities and allow it to extend sufficient credit facilities for the development of industry and trade.
Allocation of credit
The credit distribution pattern aligns with the plan priorities. The majority of the credit available is allocated to the public sector via legislative obligations and other ways. The differential rate of interest program and selective credit management provide a minimum of credit at concessional interest rates for key sectors. Private enterprises can get funding for investment reasons from state financial organizations.
Policy of Credit Control
Apart from addressing the economy’s developmental and expansionary needs, the Reserve Bank has also been tasked with keeping inflation under check. During the planning era, the huge and consistent growth in deficit financing and government spending increased monetary demand for goods and services.
However, circumstances such as production deficits, hoardings, and so on have resulted in inelasticity in commodity supply. As a consequence, the nation has been facing inflationary price increases since 1955-56, notably after 1973-74.
To address the country’s inflationary tendencies, the Reserve Bank has implemented a variety of credit control measures:
The Bank Rate
The bank rate is the interest rate at which the Reserve Bank lends to member banks against authorized securities or rediscounts qualified bills of exchange and other documents. The bank rate is regarded as a pacesetter in the money market. Changes in the bank rate affect the whole interest rate structure, including both short and long-term interest rates.
A rise in the bank rate causes an increase in other market interest rates, implying an expensive money policy that raises the cost of borrowing. Similarly, a decline in the bank rate causes a drop in the other market rates, implying a cheap money policy that lowers the cost of borrowing.
The Reserve Bank has modified the bank rate from time to time to reflect changing economic circumstances. In November 1951, the bank rate was increased from 3% to 3.5%, then to 4% in January 1963, 5% in September 1964, and finally to 6% in February 1965.
In March 1968, the bank rate was decreased to 5% due to the recessionary circumstances. It was then hiked to 7% in May, 9% in July 1974, and 10% in July 1981. In July 1991, the bank rate was again hiked to 11%. It was 12% effective October 8, 1991.
The bank rate hikes were intended to limit bank lending and keep inflation under check. Currently, the bank rate is 9%.
The situation, however, has altered with the implementation of economic reforms in the early 1990s. As part of its banking sector reforms, the Reserve Bank of India (RBI) has opted to use the Bank Rate as a policy tool for delivering monetary and credit policy signals. The bank rate currently acts as a benchmark for other rates in the financial markets.
With this new purpose assigned to the Bank Rate, and in order to fulfill the increased demand for credit from all sectors of the economy under liberalised economic circumstances, the Bank Rate has been cut in stages during the following years. It was dropped to 10% in June 1997, 9% in October 1997, 8% in March 1999, 7% in April 2000, 6.5% in October 2001, 6.25 percent in October 2002, and 6.0 percent in April 2003.
Net liquidity ratio
In September 1964, the Reserve Bank established the net liquidity ratio mechanism to prevent commercial banks from borrowing excessively from it. According to this system, a commercial bank can borrow from the Reserve Bank at the bank rate only if it maintains a minimum net liquidity ratio to its total demand and time liabilities, and it must pay a penalty rate of interest to the Reserve Bank if the net liquidity ratio falls below the minimum ratio set by the Reserve Bank.
Net liquidity of a borrowing bank includes:
(a) Cash on hand and Reserve Bank balances, plus.
(b) Currency account balances with other banks (plu).
(c) Investments in government and other permitted securities, net.
(d) Borrowing from the Reserve Bank, the State Bank of India, or the Industrial Development Bank of India.
When the system was first implemented in 1964, the net liquidity ratio was set at 28%, with an interest rate increase of 0.5% for every point in the ratio that fell. In 1973, the net liquidity ratio was increased to 40%, and the interest rate was set to rise by 1% over the bank rate for every 1% decrease in the net liquidity ratio. However, in 1975, the method was abandoned.
Open market operations
The central bank uses open market operations to affect banks’ excess reserves positions by buying and selling government securities, commercial papers, and so on.
When the central bank acquires assets from banks, it boosts their cash reserve position and hence their credit creation potential. However, when the central bank sells assets to banks, it diminishes their cash reserves and credit creation ability.
Sections (178) and 17(2)(a) of the Reserve Bank of India Act allow the Reserve Bank to buy and sell government securities, treasury bills, and other recognized securities. However, owing to the undeveloped securities market, the Reserve Bank’s open market activities are limited to government securities. These activities have also served as a tool for governmental debt management.
They help the Indian government raise borrowings. Generally, the Reserve Bank’s annual securities sales have outpaced its annual acquisitions since financial institutions are mandated to invest a percentage of their money in government and authorized securities.
In India, the Reserve Bank’s open market operations policy has not been very successful for the following reasons:
(a) Open market activities are limited to government securities.
(a) The gilt-edged market is limited.
(c) The majority of open market activities are switch operations, which include acquiring one loan in exchange for another.
Cash Reserve Requirement (CRR)
The central bank of a nation may adjust the bank’s cash-reserve requirement in order to impact its loan creation potential. An rise in the cash-reserve ratio decreases the bank’s surplus reserves, while a reduction in the cash-reserve ratio raises them.
The Reserve Bank of India Act of 1934 originally mandated commercial banks to maintain a minimum cash reserve of 5% of demand liabilities and 2% of time liabilities with the Reserve Bank. The 1956 amendment to the Act empowered the Reserve Banks to use the cash reserve ratio as a credit control instrument by varying it between 2 and 20% on demand liabilities and 2 and 8% on time liabilities. The 1962 amendment removes the distinction between demand and time deposits and authorizes the Reserve Bank to change the cash reserve ratio between 3 and 15%.
The Reserve Bank initially employed the variable cash-reserve ratio approach in June 1973, raising it from 3% to 5% and then to 7% in September 1973. Since then, the Reserve Bank has increased and lowered the cash-reserve ratio many times.
It was increased to 9% on February 4, 1984, 9.5% on February 28, 1987, 10% on October 24, 1987, 10.5% on July 2, 1988, and 11% on July 30, 1988.
The CRR was increased to its current maximum value of 15% in July 1989. The current CRR ratio is 11%, effective August 29, 1998. This drop is attributable to the government’s new liberalised policy.
The Narsimham Committee, in its November 1991 report, concluded that a high Cash Reserve Ratio (CRR) had a negative impact on bank profitability, putting pressure on banks to charge high interest rates on commercial sector lending. As a result, the government resolved to cut the CRR to less than 10% during the next four years.
As a first step toward this goal, CRR was cut in two stages: from 15% to 14.5% in April 1993, and then to 14% in May 1993. It dropped to 13% in April 1996. Again, in accordance with monetary policy aimed at ensuring appropriate credit availability to assist industrial recovery, the CRR was cut to 8% in April 2000, 7.5% in May 2001, 5.5% in October 2001, 4.75% in November 2002, and 4.50% in June 2003.
Statutory liquidity ratio (SLR)
Under the original Banking Regulation Act of 1949, banks were obliged to keep liquid assets in the form of cash, gold, and unencumbered authorized securities equivalent to at least 25% of their total demand and time deposit obligations. The minimum statutory liquidity ratio is in addition to the statutory cash-reserve ratio. The Reserve Bank may modify the minimum liquidity ratio.
As a result, the liquidity ratio increased from 25% to 30% in November 1972, 32% in 1973, 35% in October 1981, 36% in September 1984, 38% in January 1988, and 38.5% effective September 1990.
The Reserve Bank of India has two justifications for increasing its statutory liquidity requirements:
(a) It inhibits commercial banks’ ability to generate credit, so helping to control inflationary pressures.
(b) It makes more resources accessible to the government. In light of the Narsimham Committee recommendations, the government agreed to cut SLR gradually from 38.5% to 25%. The effective SLR on total outstanding net demand and time obligations of scheduled commercial banks was reduced to 27% by the end of December 1996.
Selective Credit Controls
Selective credit controls are qualitative credit control procedures used by the central bank to shift credit flow from speculative and unproductive to productive and urgent operations. Section 21 of the Banking Regulation Act of 1949 authorizes the Reserve Bank to make orders to banks about their advances.
These directions may apply to—
(a) The reason why progress may or may not be made.
(a) The margins should be maintained for secured loans.
(c) The maximum amount of advances allowed to any borrower.
(d) The maximum sum for which the financial firm may provide guarantees.
(e) The interest rate to be levied.