Monetary policy is the defining function of central banks. Historically, central banking is identified with the function of designing and implementing monetary policy. In the current global context, monetary policy occupies the most important part of macroeconomic policy. The central bank’s control over the interest rate, supply of money and liquidity are decisive in influencing general economic activities like consumption, investment and ultimately economic growth.
The central bank being the issuer of currency, controller of credit given by the commercial banks and provider of interest rate signals in the economy, is in the right position to influence economic activities through the policies related with these. Monetary policy thus can be termed as the policy of the central bank regarding the use of interest rate and supply of money to influence the general economic activities. Through monetary policy implementation, the Central Bank can influence the major macroeconomic variables – price level, stability of the financial institutions, economic growth etc.
Monetary Policy Committee of the RBI: the Basics Simplified
What is Liquidity Adjustment Facility of the RBI?
Difference between CRR and SLR
What is monetary policy?
As the name suggests, monetary policy is the policy related to money. Since money is issued by the central bank, monetary policy is designed and implemented by the central bank and in India, it is the Reserve Bank of India.
Going for a definition, “Monetary policy is the policy of the Central Bank, influencing the cost and availability of money by using various policy instruments to realise certain economic objectives.”
| Monetary Policy – Basic Facts | |
| What is monetary policy? | Monetary policy is the policy of the Central Bank, influencing the cost and availability of money by using various policy instruments to realise certain economic objectives. |
| What is meant by cost and availability of money? | Cost of money means the cost for availing loan- ie., interest rate. Availability of money means adequate supply of money (quantity). |
| Why monetary policy? | Monetary policy can ensure price stability or stable price level (no big inflation or deflation, can ensure credit supply and can support economic growth. Importance of price stability is that if there is high inflation or deflation, economic activities -production, investment, savings, consumption etc. will not be delivered smoothly. |
| Why the RBI is the best-fit institution to design monetary policy? | RBI is the issuer of currency; besides, it regulates and supervises the banks who deals most with money and loans in the economy. |
| Why the interest rate policy based on repo rate becomes the critical element of monetary policy rather than supply of money? | Previously, the quantity of money supply was the most important element. But now, the rules for deciding how much money to be supplied by the RBI is so fine tuned. The RBI here sets annual targets for the additional supply of money to be made, based on its expectation of economic growth. Higher economic growth means higher transactions (buying and selling) by the people and also investment and savings. Hence, the money supply should be increased accordingly. Arbitrary change in money supply is not followed by the central banks including RBI. Hence, the money supply part of monetary policy become simple.
Now, the second and the most decisive part is cost or the interest rate. People takes more loans if interest rate charged by banks are lower. Lower interest rate thus will expand loans, money in use, money supply, price level and thus inflation. Hence, to influence the inflation level, the RBI most tries to influence the credit supply of banks though interest rate policy. If the RBI increases its repo rate (the interest rate for the short-term loans given by the RBI to banks), banks also will increase their interest rate. This will discourage people to take loans, loan growth comes down, money supply reduces and thus price level and inflation also come down. Hence the most important component of monetary policy in the modern times is interest rate policy and the most important instrument is repo rate. |
| What are the objectives of monetary policy? | The objectives of monetary policy are three:
(1) Price Stability (the prime objective for any central bank), (2) financial stability (banks remain stable and healthy and are not failing and (3) economic growth (by ensuring adequate credit to different sectors of the economy. |
| How monetary policy is implemented? | The monetary policy is implemented with the help of monetary policy instruments. |
| What are the monetary policy instruments? | The monetary policy instruments are the tools that helps the RBI to realise the objectives. The most important tool is the repo rate. Remember, it is the repo rate that has the main responsibility to target inflation. Hence, repo rate is called ‘the policy rate.’ The RBI’s monetary policy governing body, the MPC takes decisions about repo rate.
Effectively, there are large number of tools. Most of them are having specific way of working and intended objectives. Usually, the instruments are classified under Direct Instruments and Indirect Instruments. The instruments extend from the vintage instruments of CRR and SLR to modern instruments like repo rate, Standing Deposit Facility etc. The direct instruments are: CRR, SLR and refinance facilities. The indirect instruments are: Indirect instruments are: · Repo rate, · Reverse repo rate, · Liquidity Adjustment Facility (LAF), · Open Market Operations, · MSF (Marginal Standing Facility), · Long Term Repo Operations (LTRO), · Targeted Long Term Repo Operations (TLTRO), · Rupee-Dollar swap facility, · Market Stabilization Scheme (MSS), · Term Repo, · Standing Deposit Facility (SDF), · Corridor and · Bank Rate. |
The financial system especially, the banking system is critical in facilitating the monetary policy actions and making them effective in the economy. The main objective of monetary policy is price stability or to ensure a reasonably stable level of prices without having too much inflation and not having deflation in the economy.
Why monetary policy is effective?
Several schools of economists believe that the monetary policy of the central bank is effective than fiscal policy of the government because:
- Monetary policy has only small lags compared to fiscal policy (time difference between a monetary policy implementation and getting the result).
- Monetary policy is designed only on the basis of economic rationale. On the other, fiscal policy suffers from political/popular considerations.
The interest rate signal of repo, liquidity adjustments, external sector stabilisation measures etc. some of the popular monetary policy interventions. Supporters of the monetary policy describe it as the ‘only game in the town’.
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