Instruments of Monetary Control - Central Banking, Indian Financial System | Indian Financial System - B Com PDF Download

Gross Domestic Product (GDP): National output or GDP is the most important concept of macroeconomics. When GDP increases, it is a sign that the economy is getting stronger. While a reduction in the GDP indicates a state of weakening economy. How is GDP really calculated?

One of the most reliable methods to measure the GDP is the expenditure approach which totals up the following elements to calculate the GDP:

GDP = C + G + I + NX

where:

“C” = total private consumption in the country

“G” = total government spending

“I” = total investment made by the country’s businesses

“NX” = net exports (calculated as total exports minus total imports)

In short, the GDP is the state of the economy in a snapshot. The year on year GDP growth rate is closely monitored by investors and white it only indicates what has already happened in a previous time period, every time the GDP data gets published, analysts alter their stance on the future prospects of Indian economy.

Why?

One reason is because a lot of buying and selling in the stock market happens based on forecasting of the future (everybody wants to be the first to buy or sell). 

Those involved with Indian stock market analysis regularly forecast the GDP figure in advance. Of course, the actual GDP figure could (and almost always) vary. A below forecast GDP figure indicates that the economy did not grow as per analyst expectations. On the other hand, a higher than expected GDP figure would tend to indicate that the economy has strengthened more than analyst expectation.

Inflation

Wholesale Price Index (WPI) measures the price of a representative basket of wholesale goods including food articles, LPG, petrol, cement, metals, and a variety of other goods. Inflation is determined by measuring in percentage terms, the total increase in the cost of the total basket of goods over a period of time. . Most instruments of monetary policy in India (which are discussed below) are used by the RBI to keep inflation under check.

Interest Rate: Interest rates act as a vital tool of monetary policy when dealing with variables like investment, inflation, and unemployment. The Central Bank (RBI) reduces interest rates when it wants to increase investment and consumption in the economy. Reduced interest rates make it easier for people to borrow in order to buy goods and services such as cars, homes and other consumer goods. At the same time, lower interest rates can lead to inflation. When the Central Bank wants to control inflation, it increases the rate of lending. Banks and other lenders are then required to pay a higher interest rate to the Central Bank in order to obtain money. They pass this on to their customers by charging a higher rate of interest for lending money. This reduces the availability of money in the economy and helps in controlling inflation.

There are a number of other indicators which are closely monitored by analysts such as income and wealth data, unemployment rate, annual economic survey etc.

The RBI has numerous instruments of monetary policy at its disposal in order to regulate the availability, cost and use of money and credit. Using these monetary policy instruments, the RBI must walk a tightrope between trying to stimulate growth while keeping inflation under control.

Instruments of Monetary Policy used by the RBI

Direct regulation:

Cash Reserve Ratio (CRR):  Commercial Banks are required to hold a certain proportion of their deposits in the form of cash with RBI. CRR is the minimum amount of cash that commercial banks have to keep with the RBI at any given point in time. RBI uses CRR either to drain excess liquidity from the economy or to release additional funds needed for the growth of the economy.

For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks will now have to keep a lesser proportion of their total deposits with the RBI making more money available for business. Similarly, if RBI decides to increase the CRR, the amount available with the banks goes down.

Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the form of gold or government approved securities before providing credit to the customers. SLR is stated in terms of a percentage of total deposits available with a commercial bank and is determined and maintained by the RBI in order to control the expansion of bank credit. For example, currently, commercial banks have to keep gold or government approved securities of a value equal to 23% of their total deposits.

 Indirect regulation:

Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate. Whenever commercial banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI increases the Repo Rate, it makes borrowing expensive for commercial banks and vice versa. As a tool to control inflation, RBI increases the Repo Rate, making it more expensive for the banks to borrow from the RBI with a view to restrict the availability of money. The RBI will do the exact opposite in a deflationary environment when it wants to encourage growth.

Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest rate to commercial banks to park their money with the RBI. This results in a reduction in the amount of money available for the bank’s customers as banks prefer to park their money with the RBI as it involves higher safety.  This naturally leads to a higher rate of interest which the banks will demand from their customers for lending money to them.

The RBI issues annual and quarterly policy review statements to control the availability and the supply of money in the economy. The Repo Rate has traditionally been the key instrument of monetary policy used by the RBI to fight inflation and to stimulate growth.