RBI Monetary Policy - Objectives, Policy Instruments, and Roles

RBI Monetary Policy – Objectives, Policy Instruments, and Roles

Reserve Bank of India aka RBI brings national monetary policy every two months and it is the most talked about topic in the Indian economy.

A lot of people as well as experts have an opinion on what RBI should do and how they do it, but not everyone has an understanding of what RBI actually does.

I think knowing these things helps improve your understanding of the current scenario in India and at the same time give you a good idea about what may happen next.

What is RBI Monetary Policy?

RBI Monetary policy is an economic policy decided by the monetary policy committee governed by the Reserve bank of India that manages the interest rate of the country, size, and growth rate of the money supply in an economy.

It is a very powerful tool to regulate macroeconomic factors such as inflation and unemployment.

These policies are executed through different tools, such as the adjustment of interest rates, the purchase or sale of government securities like bonds, and changing the amount of cash distribution in the economy.

The central bank of the country (Incase of India it is RBI) or a similar regulatory organization is responsible for formulating these policies.

The objectives of RBI Monetary Policy

1. Curb Inflation

The Reserve Bank of India’s duty is to curb the rate of inflation in India as its primary metric for monetary policy. If prices rise faster than their target, RBI tightens monetary policy by increasing interest rates (repo rate) or other hawkish policies.

With higher interest rates borrowing is more expensive, trimming both consumption and investment, both of which depend heavily on credit.

Similarly, if inflation dips and economic output falls, the Reserve bank of India will lower interest rates and make borrowing cheaper, along with various other possible expansionary policy tools.

2. Reduce Unemployment

Monetary policies have been constantly utilized by the central bank RBI and governments since a good monetary policy could be one of the most powerful tools to stabilize consumer prices, increase economic output, and which leads to creating job space for the general public.

When unemployment increases, the authority must improve credit as well as the supply of money, which in turn will boost the demand for investment from domestic companies as well as international companies.

3. Stabilize Currency Exchange Rates

Using its fiscal authority, RBI can regulate the exchange rates between the domestic currency Rupee, and foreign currencies like US Dollar, Euro, Great Britain Pound (GBP), Japanese Yen, etc.

For example, the central bank may increase or decrease the money supply by issuing more currency or selling government bonds respectively. In such cases, the domestic currency becomes cheaper or more expensive relative to its foreign counterparts.

Key Instruments of RBI Monetary Policy

1. Cash Reserve Ratio (CRR)

Cash Reserve Ratio is a specific amount of bank guarantees that banks are mandated to keep up with the RBI in the form of reserves or balances.

The higher the cash reserve ratio with the RBI, the lower will be the liquidity in the market and vice versa. The CRR was reduced from 15% to 5 % between 1990 to 2002. As of 31st September 2022, the CRR is at 4.5%.

2. Statutory Liquidity Ratio (SLR)

Statutory liquidity ratio also called SLR is a certain quantity of liquid assets all financial institutions have to maintain with themselves at any point in time of their total time and demand liabilities.

These assets can be kept in non-cash forms such as Bullions (Gold/Siver), bonds, etc. As of September 2022, SLR stands at 18%.

3. Interest rate adjustment (Repo Rate)

The Reserve Bank of India (RBI) can influence interest rates by changing the repo rate. The repo rate (base rate) is an interest rate charged by a central bank (RBI) to banks for short-term loans.

For example, if a central bank increases the repo rate, the cost of borrowing for the general banks increases.

Afterward, the banks will increase the interest rate they charge their retail customers and businesses. Therefore, the cost of borrowing in the economy will rise, and the money supply will fall.

4. Open Market Operations

The central bank of the country, RBI in the case of India can either purchase or sell securities issued by the government to affect the monetary supply.

For example, RBI can purchase government bonds. As a result of which banks in India will obtain more money to increase the lending and supply of money in the market.

5. Credit Ceiling

Using this instrument, RBI issues prior notification or direction that loans to the commercial bank will be given up to a specific limit.

In this case, a commercial bank will be tightened in offering loans to the public. They will distribute loans to limited sectors.

A few sectoral credit ceiling examples are agriculture sector advances and priority sector lending.

Role of the Monetary Policy Committee (MPC)

Reserve Bank of India Act, 1934 which was amended by the Finance Act, 2016, to provide for a statutory and institutionalized framework for a Monetary Policy Committee (MPC), for maintaining consumer price stability, while keeping the growth of the economy in mind.

The Monetary Policy Committee is appointed to fix the benchmark interest rate, also called the repo rate required to contain inflation within the specified target level.

The committee consists of six members including three officials of the Reserve Bank of India (RBI) and three external members nominated by the government of India. The members need to follow a “silent period” seven days before and after the interest rate decision for “utmost confidentiality”.

The governor of the RBI is the chairperson ex officio of the monetary policy committee (MPC). Interest rates are taken by the majority votes with the governor having the casting vote in case of a tie.

Key Takeaway

  • A sound monetary policy is one that appropriately balances the twin goals of price stability and sustainable growth in output.
  • Its policy instruments include the repo rate (the primary instrument for setting monetary policy), cash reserve ratio, foreign exchange reserves, open market operations, and liquidity adjustment facility.
  • The RBI also engages in discussions with banks on their lending rates as a part of its transmission mechanism.

Leave a Reply

Your email address will not be published. Required fields are marked *