Economics | Monetary Policy Explained with Examples

If you haven’t read the article on inflation, read it before proceeding further


In the last article we understood, although both inflation and deflation are bad for economy, deflation is worse and policymakers always have to guard against possible deflationary tendencies. In this respect, inflation becomes a necessary evil. One of the major adverse effect of inflation is due to uncertainty it creates in the minds of investors and risk of hyperinflation. Policymakers therefore want low and stable inflation in the economy.

What that target level should be is decided either by parliament by law or informally by govt and central bank. As we saw inflation helps in labour market adjustment and as emerging economies undergo rapid transition, slightly higher inflation helps in that adjustment. For this reason. while inflation target is about 2% in developed economies, it is 4-5% in developing economies.

In India RBI and govt signed an agreement for long term inflation target of 4% with 2% range either side i.e. 2-6% inflation.

Earlier, there was no explicit target for inflation (no inflation targeting), RBI used to target multiple indicators as objectives of monetary policy


 

Inflation has been a perennial problem for India. As we saw inflation is due to demand supply mismatch i.e. demand for goods being higher than supply. To control inflation, monetary authority i.e. RBI formulates monetary policy.

What is monetary policy?

As the name suggests it is policy formulated by monetary authority i.e. central bank which happens to be RBI in case of India.

It deals with monetary i.e money matters i.e. affects money supply in the economy.

Eg. CRR,SLR,OMO,REPO etc

What is fiscal policy then?

It is formulated by finance ministry i.e. government. It deals with fiscal matters i.e. matters related to government revenues and expenditure.

Revenue matters- tax policies, non tax matters such as divestment, raising of loans, service charge etc

Expenditure matters– subsidies, salaries, pensions, money spent on creation of capital assets such as roads, bridges etc.

Monetary policy and fiscal policy together deal with inflation.


 

Demand pull inflation is when people have more money to buy goods. It is easier for RBI to control as it can decrease the money supply in the economy, less money would lead to fall in prices.

But supply side inflation can not be dealt with by RBI. RBI can’t build roads or change agri policies to ensure smooth movement of grains. It does not control prices of oil or other commodities. Here role of government through fiscal policy becomes important.

Let us now understand how RBI formulates monetary policy to control inflation

It’s clear from what we have learnt so far that to control inflation, RBI will have to decrease money supply or increase cost of fund so that people do not demand goods and services.

Tools available with RBI


 

  1. Quantitative tools or general tools- they affect money supply in entire economy- housing, automobile, manufacturing, agriculture- everything.

Reserve ratio-  Banks have to set aside certain percentage of reserves as cash or RBI approved assets.

They are of two types

  1. Cash Reserve Ratio (CRR)– as the name suggests, banks have to keep this proportion as cash with the RBI. Bank cannot lend it to anyone. Bank earns no interest rate or profit on this.Bank cannot lend it to anyone. 
  2. Statutory Liquidity Ratio (SLR)-  As the name indicates banks have to set aside this much money into liquid assets such as gold or RBI approved securities mostly government securities. Banks earn interest on securities but as yield on govt securities is much lower banks earn that much less interest.

This reserve requirement is calculated on bank’s net demand (current and savings account) and time liabilities (Fixed deposits) which is roughly equivalent to total bank deposits.

At present CRR is 4% and SLR is 21.50% . But what if RBI tomorrow raised CRR or SLR, what would be it’s impact. 

Consider this-

Total deposits CRR (parking with RBI) No interest here SLR (Investment in liquid assets mainly govt securities) Amount available for lending
100 4 21.50 74.50
100 5 21.50 73.50
100 4 22.50 73.50

Consider interest rate as price for a commodity called money/ cash and apply demand supply principle of less commodity, higher prices i.e less money, higher interest rates

Less money with the banks # demand for money same # apply demand supply principle # interest rate will rise # costlier for you and I to borrow money to buy car # demand for car down # apply demand supply principle # cost of car will come down

Similarly business will borrow less # less expansion of business activity # wages will come down # less money with people # less demand for goods # prices wall

Net effect is that interest rate rises and prices fall.

What is dear money policy or contractionary monetary policy?

Money becomes costlier when interest rate rises and when RBI makes money to become costlier or dearer, it is said to be following dear money policy. As money supply decreases in the economy, i.e. contraction in money supply, it is also known as contractionary monetary policy.

What are the negative effects of dear money policy?

Businesses postpone expansion due to high cost of credit and investment comes down in the economy which drags down growth rates and hurts employment. That’s the reason why corporates and government always clamour for policies which lead to interest rate cuts such as reduction in CRR, SLR. Investment is thus negatively correlated with higher interest rates. 

2. Open market operations (OMO)– As the name indicates this refers to operations conducted by the RBI in open market i.e. RBI does not directly ask banks to do anything. In this policy, RBI buys and sells government securities in the open market to control money supply.

We talked about government security in SLR as well, what is this government security?

Govt security is a type of debt instrument on which govt pays regular interest. As chances of default on govt securities is practically zero, they are also called gilt-edges securities.

What happens when RBI sells government securities?

Consider this-

Total deposits at present OMO Banks govt securities worth Amount available for lending
100 none 20 80
100 RBI sells secuties worth 10 rs, banks buy 20+10 100-(20+10) =70
100 RBI buys govt securities worth 10rs 20-10 90

You can clearly observe that amount available for lending has come down i.e. money supply has contracted.

money going from the banks to the RBI # less money with the banks # dear money # higher interest rates # costlier for us to borrow to buy cars # less demand for cars #  prices decrease

In effect, govt securities increases with banks when RBI sells govt securities.

Doesn’t this look eerily similar to phenomenon when RBI raises SLR, only difference being then banks were forced to raise their holding of securities. This way RBI suck out liquidity from the market.

Opposite happens when RBI buy securities, it then injects liquidity in the market.

So basically to control inflation, RBI will sell securities and suck out liquidity from the market.

OMOs are used more to control temporary mismatches in liquidity due to foreign capital flow, a policy known as sterilization.

Let’s understand sterilization

Consider this-

Total money supply at present Net Foreign Investment Investors convert $ into rs to invest in INDIA

 

Eventual money supply
1000 0 0 0
1000 1$ = 67rs 67 1000+67=1067

When foreign investors invest in Indian economy, they buy rupees and sell dollars. RBI absorbs dollars and issues rupees. Net effect is that rupee supply or liquidity is increased in the economy. Higher liquidity or money supply chasing similar amount of goods will lead to inflation. RBI has to suck out excess liquidity from the market i.e. sterilize economy from capital flows.

What RBI would do

Undertake OMOs and sell government securities.

Total money supply before foreign investment Net Foreign Investment Money supply after foreign investment

 

RBI’s response Money supply
1000 1$ = 67rs 1067 Sell govt securities Less than 1067

Note that I didn’t mention RBI would bring money supply to 1000 as with FDI, productive capacity would rise and to that extent goods worth say 1020 may be manufactured in INDIA and in that scenario to keep inflation stable, RBI needs to sell securities worth 20rs only. What would be the actual growth is essentially a data dependent judgement call.

When investors bring back their money, they will sell rupees and buy dollars. RBI will absorb rupees resulting in less liquidity in the market. To adjust this RBI will buy govt securities and inject liquidity in the market.

RBI uses another instrument to keep the liquidity intact, it is known as Market Stabilization Scheme (MSS).

3.Policy rates

  1. Bank rate– When banks borrow long term funds from RBI. They’ve to pay this much interest rate to RBI.

At present bank rate is 7.75%. Bank rate is not the main tool to control money supply these days. Nowadays, RBI uses LAF ( liquidity adjustment facility) Repo rate as the main tool, to control money supply.

What’s the use of Bank rate then?

Penal rates are linked with Bank rate. For example, If a bank doesn’t maintain CRR, SLR as per the prescribed limit, penalty is prescribed as per bank rate.

It’s clear if RBI raises bank rate, costlier for banks to borrow from RBI # interest rate rises # repeat same story # costlier for you and I to borrow money to buy car # demand for car down # apply demand supply principle # cost of car will come down

What is Liquidity Adjustment Facility (LAF)

It’s evident from the name that RBI uses such instruments to adjust liquidity and money supply.

#1. REPO rate – REpurcahse OBligation

Rate at which banks buy from RBI on a short term basis.

What do they have to repurchase?

  • Banks have to put govt. securities as collateral and buy those securities back at the end of prescribed period, generally overnight
  • Banks can not use securities from SLR as collateral

On the Urjit Patel Committee’s recommendation — that the RBI stop fixing the repo rate in its quarterly reviews, and instead move to rate-setting on an ongoing basis, RBI started auctioning 7 day and 14 days term repo. In term repo, rate is market determined unlike overnight repo where RBI decides rate. Also RBI has restricted access to overnight repo to .25% on NDTL.

Clearly if RBI raises repo # costlier for banks to borrow # interest rate rises # repeat same story # costlier for you and I to borrow money to buy car # demand for car down # apply demand supply principle # cost of car will come down

#2. Reverse Repo as the name suggests is reverse of repo i.e. rate RBI pays to banks to park excess funds into RBI.

Reverse repo is linked to repo with,

Reverse repo = repo – 1

#3. Marginal Standing facility 

Penal rate at which banks can borrow money from the central bank over and above what is available to them through the rep window.

It is penal rate, hence REPO + 1

Reverse Repo + 1 = REPO; REPO + 1 = MSF

Under MSF banks can use up to 1% of securities from SLR.

Let’s recap all this. To control inflation RBI will follow dear or contractionary monetary policy to reduce money supply in the economy. It will increase reserve ratios (CRR,SLR), sell government securities under OMOs or raise various rates such as REPO, MSF, Bank rates etc.

But we see in India, even when RBI decreases rates banks don’t pass on the benefits to consumers and when banks raise interest rates when RBI raises rates, inflation does not come down. This suggest monetary policy is highly ineffective in India.

Monetary Policy Transmission Conundrum

Why banks don’t pass on the benefits of rate cut to consumers?

RBI cut repo rate by 125bp last year but banks decreased lending rate only by 60bp.

  1. RBI is not the main or even prominent money supplier for banks but Retail savers are so RBI rate cuts do not affect cost of funds much for the banks
  2. Deposits rates are mostly fixed and can not be reduced, only subsequent deposit rates can be reduced. i.e. If i have deposited 100 rs in FD for 5 years, banks will have to pay me 8% interest for next 5 years no matter whether RBI cuts rates or not
  3. Small saving instruments such as PPF, Post office accounts have high administered interest rates. If banks cut deposit rates below those rates, customers will shift to those instruments and banks will lose out on funds
  4. Banks as we all know are under stress. Keeping lending rates high increases their profit margins
  5. No well developed corporate bond market in India. Corporate have no choice but to come to banks to borrow

Government and RBI’s response to improve monetary transmission

  1. Government has decided to reduce interest rates on small saving accounts. Permanent solution would be to link small savings rates to bank rate
  2. RBI has asked banks to shift methodology of calculation of base rate to marginal cost of funds from average cost of funds at present<marginal cost is the cost of every extra unit of fund> <What is base rate? How will shift to marginal cost of funding promote transparency in base rate calculation and help consumers? Answer in the comments>

But why is RBI unable to control inflation even when banks immediately raise lending rates?

  1. Supply side issues not under RBI control- bottlenecks in agri marketing, high prices of crude oil, failure of monsoon etc.
  2. Higher government fiscal deficit
  3. Non-Monetized economy: in rural areas, many transactions are still of barter nature
  4. Lack of financial inclusion. Since most people are not in the banking net. They rely on Shroffs and moneylenders. Obviously moneylenders won’t listen to RBI
  5. Black money and cash economy

We have talked about quantitative tools so far but RBI also has some qualitative tools in its kitty which are not important for exams. So in brief

What are the qualitative tools?

They are Selective tools- can affect money supply in a specific sector of economy unlike general quantitative tools which affect money supply in the whole economy.

  • Margin Requirements- RBI can prescribe margin against collateral. For instance, lend only 70 rs for 100 rs value gold, margin requirement being 30%. Obviously if RBI raises margin requirement, customers will be able to borrow less.
  • Moral suasion– RBI persuade banks to park money in govt securities instead of certain sectors.
  • Selective credit control– Don’ loan to theses industries or to speculative businesses

Issue of autonomy of RBI

By now we have understood that govt and corporate are more interested in low interest rates which support investment and growth while primary task of RBI is to control inflation, keeping prices stable and thus protecting purchasing power of money. This is not to say that govt and corporate do not want low inflation, they do but their primary focus lie elsewhere. It is in this context that autonomy of RBI to decide on monetary policy matters becomes so important.

At present sole authority vests with RBI governor who is advised by a technical expert committee whose advice is not binding. Government intends to replace it with a monetary policy committee (recommended by FSLRC and Urjit Patel committee and followed in many countries) with members both from within and outside RBI.

Two important questions arise-

  1. Composition of such a committee- for autonomy it is important to have either RBI members majority or equal numbers from both sides with governor exercising a casting vote (just like speaker does in LokSabha). Having outside majority does seem to impinge on autonomy of RBI.
  2. Veto of governor– If governor is given veto power, it changes nothing. Even now, there’s a committee but it’s deliberations are only academic. If governor can’t convince his own committee of desirability of policy stance he advocates, he would seem to be on a weaker wicket.

Ideal committee would be one with RBI majority or equal members with casting vote with the governor without any veto. This along with explicit inflation target would give enough autonomy to go along with accountability.

To follow the story of Monetary Policy Committee and Autonomy of RBI, click here


UPSC ke sawaal

#1. With reference to inflation in India, which of the following statements is correct?

  • (a) Controlling the inflation in India is the responsibility of the Government of India only
  • (b) The Reserve Bank of India has no role in controlling the inflation
  • (c) Decreased money circulation helps in controlling the inflation
  • (d) Increased money circulation helps in controlling the inflation

#2. Which one of the following is likely to be the most inflationary in its effect?

  1. Repayment of public debt
  2. Borrowing from the public to finance a budget deficit
  3. Borrowing from banks to finance a budget deficit
  4. Creating new money to finance a budget deficit

#3. A rise in general level of prices may be caused by

  1. an increase in the money supply
  2. a decrease in the aggregate level of output
  3. an increase in the effective demand

Select the correct answer using the codes given below.

  1. 1 only
  2. 1 and 2 only
  3. 2 and 3 only
  4. 1, 2 and 3

#4. With reference to Indian economy, consider the following:

  1. Bank rate
  2. Open market operations
  3. Public debt
  4. Public revenue

Which of the above is/are component/components of Monetary Policy?

  • (a) 1 only
  • (b) 2, 3 and 4
  • (c) 1 and 2
  • (d) 1, 3 and 4

#5. When the Reserve Bank of India reduces the Statutory Liquidity Ratio by 50 basis points, which of the following is likely to happen?

  • (a) India’s GDP growth rate increases drastically
  • (b) Foreign Institutional Investors may bring more capital into our country
  • (c) Scheduled Commercial Banks may cut their lending rates
  • (d) It may drastically reduce the liquidity to the banking, system

#6. Supply of money remaining the same when there is an increase in demand for money, there will be

  1. a fall in the level of prices
  2. an increase in the rate of interest
  3. a decrease in the rate of interest
  4. an increase in the level of income and employment

#7. If the interest rate is decreased in an economy, it will

  1. decrease the consumption expenditure in the economy
  2. increase the tax collection of the Government
  3. increase the investment expenditure in the economy
  4. increase the total savings in the economy

#8. In the context of Indian economy; which of the following is/are the purpose/purposes of ‘Statutory Reserve Requirements’?

  1. To enable the Central Bank to control the amount of advances the banks can create
  2. To make the people’s deposits with banks safe and liquid
  3. To prevent the commercial banks from making excessive profits
  4. To force the banks to have sufficient vault cash to meet their day-to-day requirements

#9. An increase in the Bank Rate generally indicates that the

  1. Market rate of interest is likely to fall
  2. Central Bank is no longer making loans to commercial banks
  3. Central Bank is following an easy money policy
  4. Central Bank is following a tight money policy

#10. The Reserve Bank of India (RBI) acts as a bankers‘ bank. This would imply which of the following?

  • 1 Other bank retains their deposits with the RBI.
  • 2 The RBI lends funds to the commercial banks in times of need.
  • 3 The RBI advises the commercial banks on monetary matters.

Select the correct answer using the codes given below:

  • a )2 and 3 only
  • b )1 and 2 only
  • c )1 and 3 only
  • d )1, 2 and 3

#11. Which of the following is/are long term policy tools

  1. Repo
  2. Reverse repo
  3. Marginal Standing Facility
  4. Bank rate

Select the correct response

  • A 1,4
  • B 1,3,4
  • C 4 only
  • D all

#12. Which of the following measures would result in an increase in the money supply in the economy?

  1. Purchase of govt securities from the public by the central bank
  2. Deposit of currency in commercial banks by the public
  3. borrowing by the govt. from the central bank
  4. Sale of govt. securities to the public by the central bank

Other articles to understand basics of economics-

  1. Economics | Budget Deficits Explained
  2. Economics | Current Account Deficit Explained
  3. Exchange rate movement, NEER, REER explained
  4. GDP calculation and new methodology
  5. Non Performing Assets
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