Unit 3: Monetary Policy Chapter Notes | Business Economics for CA Foundation PDF Download

Overview

Introduction

The Reserve Bank of India (RBI) occasionally adjusts policy rates to manage liquidity conditions, and these adjustments are communicated with specific reasons. However, our understanding of the monetary factors that can either strengthen or destabilize the domestic economy is limited. This discussion aims to shed light on the widely recognized monetary measures used by governments to combat economic instability.

Understanding Monetary Policy

The Reserve Bank of India (RBI) employs monetary policy as a tool to manage economic fluctuations and ensure price stability, characterized by low and stable inflation. This involves adjusting the supply of money, primarily through the buying or selling of securities in the open market. Open Market Operations play a crucial role in influencing short-term interest rates, which subsequently affect longer-term rates and overall economic activity.

When the central bank lowers interest rates, it is easing monetary policy, and when it raises interest rates, it is tightening monetary policy.

The Framework for Monetary Policy

The central bank operates within a defined monetary policy framework that comprises three fundamental components:

• Objectives of monetary policy,
• Analytics of monetary policy focusing on transmission mechanisms, and
• Operating procedure, which includes operating targets and instruments.

Objectives of Monetary Policy

The objectives set for monetary policy are crucial as they provide clear guidance to policymakers. Monetary policy reflects a country’s economic policy, and thus, its objectives align with the broader goals of economic policy.
The Reserve Bank of India Act, 1934, outlines the Bank’s objectives as regulating bank note issuance and reserves to ensure monetary stability and to manage the currency and credit system for the country’s advantage. The primary goal of monetary policy is to maintain a balance between price stability and economic growth.
In developing countries, monetary policy also includes specific objectives such as:

• Promoting economic growth,
• Ensuring adequate credit flow to productive sectors,
• Maintaining moderate interest rates to encourage investment, and
• Creating an efficient market for government securities.

Recently, considerations of financial and exchange rate stability have gained importance in India due to the increasing openness of the economy and ongoing economic and financial sector reforms.

Transmission of Monetary Policy

The transmission of monetary policy refers to how changes made by the Reserve Bank in its monetary policy settings impact economic activity and inflation. This process is complex and involves uncertainty regarding the timing and magnitude of the effects on the economy. In simple terms, the transmission can be understood in two stages:

1. Changes in monetary policy influence interest rates in the economy.
2. Changes in interest rates affect economic activity and inflation.

While it is evident that monetary policy impacts output and inflation, the exact mechanism and timing of these effects are not entirely predictable, as they often manifest after an uncertain lag.

Channels of Monetary Policy Transmission

Saving and Investment Channel:
Monetary policy impacts economic activity by altering the incentives for saving and investment, which in turn affects consumption, housing investment, and business investment.

• Lower interest rates on bank deposits diminish the incentive for households to save, encouraging them to spend more on goods and services.
• Reduced interest rates for loans make borrowing cheaper for households, increasing their willingness to take out loans and boosting demand for assets like housing.
• Lower lending rates also stimulate business investment in capital goods such as new equipment or buildings, as the cost of borrowing decreases and demand for their products rises. This makes it more likely that the returns on these investments will exceed borrowing costs, justifying the expenses, particularly for businesses reliant on debt financing.

Cash-flow Channel:
Monetary policy affects interest rates, which in turn influences the cash available to households and businesses for spending on goods and services. This channel is particularly significant for those who are liquidity constrained, such as individuals and businesses that have borrowed up to their maximum limit.

• Lower lending rates reduce interest repayments on debt, increasing the cash available for households and businesses to spend. For instance, lower interest rates decrease mortgage repayments for households with variable-rate loans, leaving them with more disposable income.
• However, a reduction in interest rates also lowers the income from deposits, which may lead some households and businesses to restrict their spending.
• These two effects counterbalance each other, but the overall impact of lower interest rates is expected to boost spending in the Indian economy, with the positive effect outweighing the negative one.

Asset Prices and Wealth Channel:
The asset prices and wealth channel affects consumption and investment by influencing how much individuals and businesses can borrow and spend. When asset prices rise, individuals feel wealthier and are more likely to increase their spending, while businesses may also feel more confident in their financial position, leading to increased investment.

Channel of Asset Prices:

• Lower interest rates boost asset prices, including housing and equities, by stimulating demand for these assets. This is because the present discounted value of future income increases when interest rates are lower.
• Higher asset prices also enhance the equity (collateral) of assets that banks can lend against, making it easier for households and businesses to secure loans.

When asset prices rise, people's wealth increases, leading to higher consumption and housing investment, as households typically spend a portion of any increase in their wealth.

Exchange Rate Channel:

• The exchange rate plays a crucial role in influencing economic activity and inflation, particularly for export-oriented sectors and those facing competition from imported goods and services.
• When the Reserve Bank lowers the cash rate, it effectively reduces interest rates in India relative to the rest of the world. This differential makes Indian assets less attractive to investors, as the returns on these assets decrease compared to foreign investments. As a result, there is a shift in demand from Indian assets and rupees to foreign assets and currencies.
• Lower interest rates in India also lead to a depreciation of the exchange rate. This depreciation makes foreign goods and services more expensive relative to those produced in India, stimulating an increase in exports and domestic economic activity. However, it also contributes to inflation, as imports become costlier in Indian rupees.

Operating Procedures and Instruments

• These tools, implemented by the policy, influence the money supply across the entire economy, impacting various sectors such as manufacturing, agriculture, automobiles, and housing.

Reserve Ratio:

• Banks are mandated to set aside a certain percentage of cash reserves or RBI-approved assets. There are two types of reserve ratios:

Cash Reserve Ratio (CRR):

• Banks must keep this portion in cash with the RBI.
• The bank cannot lend this money or earn any interest on it.

Statutory Liquidity Ratio (SLR):

• Banks are required to set aside this portion in liquid assets such as gold or RBI-approved securities like government securities.
• Banks can earn interest on these securities, but the rate is typically low.

Open Market Operations (OMO):

• The RBI buys and sells government securities in the open market to control the money supply.
• When the RBI sells government securities, it withdraws liquidity from the market, and the opposite occurs when it buys securities.
• OMOs aim to address temporary liquidity mismatches in the market, often caused by foreign capital flow.

Qualitative Tools:

• Unlike quantitative tools that affect the entire economy’s money supply, qualitative tools target specific sectors of the economy.

Margin Requirements:

• The RBI sets certain margin requirements against collateral, influencing customers' borrowing habits.
• When margin requirements are increased, customers can borrow less.

Moral Suasion:

• The RBI persuades banks to invest in government securities instead of lending to specific sectors.

Selective Credit Control:

• The RBI controls credit by restricting lending to certain industries or speculative businesses.

Market Stabilisation Scheme (MSS):

• Involves the issuance of government securities to absorb excess liquidity in the market.

Policy Rates
Bank Rate:

• The interest rate at which the RBI lends long-term funds to banks.
• Currently, the RBI primarily uses the Liquidity Adjustment Facility (LAF), specifically the repo rate, to control the money supply.
• The bank rate is used to penalize banks that do not comply with prescribed SLR or CRR.

Liquidity Adjustment Facility (LAF):

• The Reserve Bank of India (RBI) employs the Liquidity Adjustment Facility (LAF) as a tool to manage liquidity and regulate the money supply in the economy. There are two main types of LAF:

Repo Rate:

• The repo rate is the interest rate at which banks borrow funds from the RBI on a short-term basis, backed by a repurchase agreement. In this arrangement, banks provide government securities as collateral and agree to buy them back after a specified period.

Reverse Repo Rate:

• The reverse repo rate is the opposite of the repo rate. It is the rate at which the RBI pays interest to banks for keeping their excess funds with the central bank. The reverse repo rate is linked to the repo rate, typically calculated as:
• Reverse Repo Rate = Repo Rate - 1

Marginal Standing Facility (MSF) Rate

• The MSF rate is the penal interest rate at which the central bank lends money to banks, above the rate available under the repo policy. Banks availing of the MSF rate can use a maximum of 1% of their Statutory Liquidity Ratio (SLR) securities for this purpose. The MSF rate is calculated as:
• MSF Rate = Repo Rate + 1

The Organisational Structure for Monetary Policy Decisions

• The instruments of monetary policy have been discussed. To understand how monetary policy is implemented in India, it is essential to grasp the organisational structure behind monetary policy decisions.
• On June 27, 2016, the Reserve Bank of India (RBI) Act of 1934 was amended to provide statutory support for the Monetary Policy Framework Agreement (MPFA) and to establish a Monetary Policy Committee (MPC). The MPFA is an agreement between the Government of India and the RBI regarding the maximum acceptable inflation rate that the RBI should aim for to maintain price stability. The amended RBI Act (2016) gives a legal basis for implementing the flexible inflation targeting framework.
• Inflation targeting refers to the official announcement of a target range for inflation. In January 2014, an Expert Committee led by Urijit Patel recommended that the RBI shift from a ‘multiple indicator’ approach to making inflation targeting the primary goal of its monetary policy. The inflation target is set by the Government of India, in consultation with the RBI, every five years. Accordingly, the Central Government has set a 4 per cent Consumer Price Index (CPI) inflation target for the period from August 5, 2016, to March 31, 2021, with an upper tolerance limit of 6 per cent and a lower tolerance limit of 2 per cent.

The RBI is required to publish a Monetary Policy Report every six months, outlining the causes of inflation and inflation forecasts for the next six to eighteen months. The central government has specified the following as indicators of a failure to meet the inflation target:

• Average inflation exceeding the upper tolerance level of the inflation target for any three consecutive quarters; or
• Average inflation falling below the lower tolerance level for any three consecutive quarters.

The choice of CPI as the inflation target was made because it closely reflects the cost of living and has a greater impact on inflation expectations compared to other measures. With this approach, India aligns itself with countries like New Zealand, the USA, the UK, the European Union, and Brazil. Recently, many countries are shifting away from this approach and are targeting nominal GDP growth instead.

Conclusion

The theoretical understanding of monetary policy may seem straightforward. However, selecting a monetary policy action is quite complex due to various uncertainties and the need to balance growth and inflation concerns. This complexity is heightened in the context of an emerging market like India, which faces challenges such as a basic and non-competitive financial system, a lack of integrated money and interbank markets, external uncertainties, and issues related to the operational autonomy of the central bank. Implementing explicit inflation targeting requires a significant degree of operational independence for the central bank and effective coordination between fiscal and monetary authorities.