Chapter Notes: Monetary Policy and Fiscal Policy

Monetary Policy

Monetary policy is the process by which the central bank, on behalf of the government, controls the supply, availability and cost of money in the economy to attain macroeconomic objectives such as growth and price stability. The principal variables influenced by monetary policy are the money supply, availability of credit and interest rates.

Objectives of Monetary Policy

• Maintain price stability (control inflation).
• Support sustainable economic growth by enabling appropriate credit expansion.
• Ensure systemic financial stability and adequate liquidity in the banking system.
• Manage interest rates and ensure smooth functioning of money and credit markets.

Types of Monetary Policy

• Expansionary (easy) monetary policy - increases money supply and lowers interest rates to stimulate economic activity. Used in recessions or periods of low demand to reduce unemployment and boost investment and consumption.
• Contractionary (tight) monetary policy - reduces money supply and raises interest rates to rein in inflation. Used when inflationary pressures arise and the central bank needs to cool aggregate demand.

Monetary Policy Framework

In May 2016 the central law was amended to provide a legislative mandate for the monetary policy framework. The framework entrusts the central bank with setting the policy (repo) rate based on current and evolving macroeconomic conditions and managing liquidity so that money market rates remain anchored to the policy rate. Changes in the repo rate transmit through money markets to the broader financial system and thereby influence aggregate demand, inflation and growth.

Monetary Policy Committee (MPC)

Under Section 45ZB of the amended Act, the government constitutes a six-member Monetary Policy Committee whose mandate is to determine the policy rate needed to achieve the inflation target. The committee's decision is binding on the central bank.

Composition of the MPC:

• RBI Governor - ex officio Chairperson
• Deputy Governor in charge of monetary policy
• An officer of the Bank nominated by the Central Board
• Three external members appointed by the central government (persons of ability, integrity and standing with knowledge and experience in economics, banking, finance or monetary policy)

Instruments (Tools) of Monetary Policy

The central bank uses several instruments to implement monetary policy. Major ones are listed below and then explained in detail.

• Repo rate
• Reverse repo rate
• Marginal Standing Facility (MSF)
• Standing Deposit Facility (SDF)
• Bank rate
• Cash Reserve Ratio (CRR)
• Statutory Liquidity Ratio (SLR)
• Open Market Operations (OMOs)
• Liquidity Adjustment Facility (LAF) and LAF corridor
• Term repos, Long-Term Repo Operations (LTROs), Targeted LTROs (TLTROs), Special LTROs (SLTROs)
• Market Stabilisation Scheme (MSS)
• Base rate, Marginal Cost of Funds based Lending Rate (MCLR), External Benchmark Lending Rates (EBLR)

Policy Rates: Repo and Reverse Repo

Repo rate (repurchase rate) is the rate at which the central bank lends short-term funds to banks against approved collateral. Changes in the repo rate directly influence short-term money market rates and thereby bank lending rates.

Reverse repo rate is the rate at which the central bank borrows funds from banks (i.e., banks park their surplus funds with the central bank). Raising the reverse repo rate encourages banks to hold funds with the central bank and thereby helps absorb liquidity from the banking system; lowering it does the opposite.

Liquidity Adjustment Facility (LAF) and the LAF Corridor

Liquidity Adjustment Facility (LAF) is the central bank's mechanism to inject or absorb liquidity in the banking system on a short-term basis. The principal components are the repo (injection) and reverse repo (absorption) operations.

The daily short-term interest-rate movements are contained within an operating corridor. The lower band of the corridor is typically the SDF / reverse repo rate and the upper band is the MSF rate. The policy repo rate is usually the operating rate around which the corridor is set.

Bank Rate

Bank rate (also known as discount rate) is the rate at which the central bank stands ready to lend long-term funds to commercial banks or to discount/rediscount eligible commercial papers and bills. Section 49 of the central bank Act requires publication of the standard rate at which the central bank is prepared to buy or re-discount eligible commercial papers. In practice, the bank rate in India has only a limited direct role because interest-rate structures and money-market segments are not fully linked to it.

Limitations of the bank rate as an instrument in India include:

• Interest-rate structure in the economy is not automatically linked to the bank rate.
• Commercial banks frequently use specific refinance facilities instead of rediscounting eligible securities with the central bank.
• The bill market is under-developed so the bank rate's direct influence is limited.

Marginal Standing Facility (MSF)

Marginal Standing Facility (MSF) allows scheduled commercial banks to borrow overnight funds from the central bank by dipping into their SLR securities beyond the statutory limits, up to a specified cap (the input cites up to 2% of NDTL at the end of the second preceding fortnight). Borrowing under MSF is at a rate above the repo rate (the input notes 25 basis points above the repo rate as an example of a penal spread in that period).

MSF functions as a safety valve for unexpected liquidity shocks. The MSF rate generally forms the upper band of the LAF corridor while the standing deposit facility or reverse repo forms the lower band.

Difference between Bank Rate and MSF (summary)

Cash Reserve Ratio (CRR)

The banking system operates under fractional-reserve banking: banks are required to keep only a fraction of deposits as liquid cash with the central bank to ensure safety and liquidity of deposits. The Cash Reserve Ratio (CRR) is the percentage of a bank's Net Demand and Time Liabilities (NDTL) that must be held as cash with the central bank. CRR does not earn interest for banks.

The law provides the central bank with flexibility to set CRR; historical statutory caps were amended to allow a wider range. Changes in CRR directly drain or inject liquidity from/to the banking system.

Statutory Liquidity Ratio (SLR)

Statutory Liquidity Ratio (SLR) is the proportion of demand and time liabilities that banks must maintain in specified liquid assets such as cash, gold or approved government/dated securities. SLR is maintained by banks themselves (not with the central bank) and SLR holdings typically earn interest. The SLR percentage is specified by law and can be adjusted by the central bank.

The input notes that, as on 1 June 2022, scheduled commercial banks were required to maintain an SLR of 18% of their demand and time liabilities (the exact statutory rate is subject to periodic changes by the authorities).

Demand Liabilities and Time Liabilities (definitions)

Demand liabilities are liabilities payable on demand and include current deposits, certain portions of savings deposits, margins held against letters of credit/guarantees if payable on demand, balances in overdue fixed deposits, unclaimed deposits, and other similar items.

Time liabilities are liabilities payable otherwise than on demand and include fixed deposits, cash certificates, cumulative/recurring deposits and other term deposits.

Difference between CRR and SLR (summary)

Standing Deposit Facility (SDF)

Standing Deposit Facility (SDF) permits banks to place deposits with the central bank on an overnight basis. The SDF rate acts as the lower bound of the interest-rate corridor. The SDF was empowered by amendment of Section 17 of the central bank Act in 2018. Deposits under SDF are not eligible to be counted towards CRR but may be eligible for SLR maintenance as per law.

Open Market Operations (OMOs)

Open Market Operations (OMOs) refer to the central bank's buying and selling of government securities in the secondary market.

• When the central bank buys government securities, it injects liquidity into the banking system; buying raises bond prices and lowers bond yields.
• When the central bank sells government securities, it withdraws liquidity; selling lowers bond prices and raises yields.

Term Repos, LTROs, TLTROs and SLTROs

The central bank conducts term repos (repos of tenors longer than overnight, such as 7, 14, 28 days) to inject liquidity for a period longer than overnight and help develop the interbank market.

Long-Term Repo Operations (LTROs) (e.g., one-year, three-year tenors) have been used to improve monetary transmission and support credit offtake.

Targeted LTROs (TLTROs) direct liquidity to specific sectors or types of borrowers facing stress.

Special LTRO (SLTRO) - as an example during the pandemic period, the central bank conducted SLTROs for Small Finance Banks (SFBs) amounting to ₹10,000 crore to be deployed for fresh lending to specified segments (fresh loans up to ₹10 lakh per borrower), with three-year tenor at the policy repo rate. Such operations are typically time-bound and aimed at targeted credit support.

Variable Rate Reverse Repo (VRRR)

VRRR auctions are reverse repo operations conducted at variable rates and are used to absorb surplus liquidity from the system, often at longer maturities than the fixed-rate overnight reverse repo window.

Market Stabilisation Scheme (MSS)

The Market Stabilisation Scheme (MSS) involves the Government issuing specific instruments (such as Treasury Bills or dated securities) by way of auction in addition to regular borrowings to absorb durable liquidity from the system. MSS was designed to mop up excess liquidity that is structural in nature.

Refinance and Sector-Specific Liquidity Facilities

The central bank provides sector-specific refinance facilities to achieve targeted objectives by supplying liquidity at rates linked to the policy repo rate. These facilities support priority sectors and development objectives.

Bank Lending Rate Frameworks: Base Rate, MCLR, EBLR

Base rate system was introduced on 1 July 2010 to replace the earlier Benchmark Prime Lending Rate (BPLR) regime. The base rate was the minimum lending rate below which banks were not permitted to lend.

Marginal Cost of Funds based Lending Rate (MCLR) replaced the base rate system. MCLR was implemented on 1 April 2016 and is a methodology for banks to determine their minimum lending rates based on marginal cost of funds, deposit rates, operating costs and tenor premium.

External Benchmark Lending Rates (EBLR) were recommended by an internal study group chaired by Dr Janak Raj to improve monetary policy transmission. The study found that internal benchmarks (base rate/MCLR) had not delivered effective transmission. The recommendation was a time-bound transition to external benchmarks for new floating-rate retail loans, including reference to specific external benchmarks. From 1 October 2019, floating-rate loans to Micro and Small Enterprises extended by banks were required to be linked to an external benchmark.

Permissible external benchmarks include:

• RBI policy repo rate
• Government of India 3-month Treasury Bill yield (published by FBIL)
• Government of India 6-month Treasury Bill yield (published by FBIL)
• Any other benchmark market interest rate published by FBIL

Monetary Policy Transmission

Monetary policy transmission is the process by which changes in policy rates (repo, SDF, MSF) affect money market rates, bank lending rates and ultimately aggregate demand, inflation and growth. Effective transmission requires functioning money, bond and credit markets and appropriate behaviour by banks and financial intermediaries.

Fiscal Policy

Fiscal policy is the use of government revenue collection (taxation) and public expenditure to influence the economy. Unlike monetary policy (which manipulates money supply and interest rates), fiscal policy operates through taxation, public spending and transfers.

Instruments of Fiscal Policy

• Government expenditure (capital and revenue spending, subsidies, transfers).
• Taxation (direct and indirect taxes, tax rates, tax bases and incentives).
• Public borrowing and debt management.
• Automatic stabilisers (e.g., progressive taxes, unemployment benefits).

Effects of Taxation

Taxes affect the economy in multiple ways:

• They change disposable income of households and thereby consumption and savings decisions.
• They affect firms' costs and investment incentives, influencing aggregate investment and output.
• They influence prices and relative incentives across sectors.
• Tax structure and levels also affect income distribution and resource allocation.

Objectives of Fiscal Policy in India

Primary objectives:

• Promote economic growth.
• Maintain price stability and macroeconomic stability.

Additional objectives:

• Mobilise resources for public investment and development.
• Promote allocative efficiency and optimal use of resources.
• Reduce inequality of income and wealth through progressive taxes and transfers.
• Create an enabling environment for private-sector investment.

Fiscal Responsibility and Budget Management (FRBM) Act - Overview

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 was enacted to institutionalise fiscal prudence and reduce the government's fiscal deficit over time. The FRBM framework aimed to improve fiscal discipline, introduce a medium-term fiscal framework, and ensure transparent fiscal management.

Key statutory requirements (as contained in the original Act and related rules) include:

• The government must present three statements each year along with the Budget covering medium-term fiscal policy, fiscal policy strategy and macroeconomic framework.
• Targets were set to reduce fiscal deficit (commonly a target near 3% of GDP) and to eliminate the revenue deficit by a specified date (the original target date was 31 March 2008).
• The Act placed restrictions on direct monetisation of deficit financing by prohibiting the central government from borrowing directly from the central bank in routine operations and barred the central bank from subscribing to primary issues of government securities. The Act also required the government to set ceilings on guarantees.
• The Finance Minister is required to review implementation and keep the legislature informed through periodic reports and corrective measures where necessary.

The broader theme of the FRBM Act is to reduce dependence on borrowings, ensure prudent debt management and provide a medium-term framework for fiscal consolidation.

N. K. Singh Committee on FRBM (2016-2017) - Key Recommendations

The government constituted a high-level committee chaired by N. K. Singh to review the FRBM Act; the committee submitted its report in January 2017. Important recommendations included:

• Adopt debt-to-GDP as the primary target for fiscal policy, aiming for an overall general government debt-to-GDP ratio of 60% by a specified horizon. The committee suggested a split of 40% for the Centre and 20% for the States.
• Set yearly intermediate targets to progressively reduce fiscal and revenue deficits to achieve the targeted debt trajectory by 2023.
• Create an autonomous Fiscal Council (with a chairperson and two members appointed by the Centre) to prepare multi-year fiscal forecasts, recommend fiscal strategy changes, improve fiscal data quality, and advise the government on deviations and corrective measures.
• Allow deviations from specified fiscal targets in exceptional circumstances (national security, calamities, collapse of agriculture, large decline in real output growth or structural reforms with fiscal implications), subject to limits (the committee suggested deviations not exceeding 0.5% of GDP in a year) and subject to the Fiscal Council's advice.
• Ask the 15th Finance Commission to recommend state-wise debt trajectories based on fiscal performance and prudence.
• Retain restrictions on direct borrowing from the central bank except under certain limited circumstances, such as temporary revenue shortfalls or to finance specified deviations as per the rules agreed between the government and the central bank.

Practical Links between Monetary and Fiscal Policy

Monetary and fiscal policies are complementary. Fiscal policy affects aggregate demand directly through government spending and taxation while monetary policy influences demand indirectly through interest rates and liquidity. Coordination (or at least awareness of each other's stance) is important because:

• Expansionary fiscal policy (higher deficit-financed spending) can raise demand and inflationary pressures that the central bank may need to counter via tighter monetary policy.
• Tight monetary policy (higher interest rates) can raise the cost of government borrowing and affect fiscal deficits.
• In times of severe downturns, coordinated fiscal expansion and accommodative monetary policy can be effective in supporting recovery.

Summary

Monetary policy uses interest rates, reserve requirements and market operations to manage liquidity, inflation and growth, with the repo rate as the key policy anchor in the current framework and the Monetary Policy Committee determining policy rate decisions. Fiscal policy uses taxation, expenditure and borrowing to influence economic activity and distribution. Institutional frameworks such as the FRBM Act and the recommendations of high-level reviews (for example, the N. K. Singh Committee) seek to make fiscal policy sustainable and transparent while preserving space for counter-cyclical action when required. Effective macroeconomic management requires well-functioning transmission channels, credible institutions and careful coordination between monetary and fiscal authorities.