Monetary Policy: Types and Instruments in India

Monetary PolicyThe objective of monetary policy is to achieve the desired expansion of economy by facilitating the availability of money supply needed for the expansion. The role of formulating monetary policy in India is performed by Reserve Bank of India. It is aimed at ensuring the availability required money supply for all the legitimate economic activities while it should not be available so as to create inflationary pressure.

The primary aim of monetary policy in India is to maintain price stability while keeping in mind the objective of economic growth.

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Types of Monetary Policy

There are three common types of monetary policy. These are:

  1. Expansionary Monetary Policy
  2. Contractionary Monetary Policy
  3. Unconventional Monetary Policy

Expansionary Monetary Policy

Expansionary monetary policy is the monetary policy which seeks to increase aggregate demand and economic growth in the economy. It involves increasing the money supply and lowering the interest rates. The lower interest rate encourages the borrowers to buy more which increases the economic activity. The increased economic activity leads to more employment opportunities thus decreasing unemployment. It also increases the inflation as more money is available to buy goods and services.

It is also known as Easy Money Policy or Loose Money Policy as central banks seeks to increase the money supply by lowering the interest rates.

Contractionary Monetary Policy

Contraction monetary policy is the monetary policy which is used to fight the inflation in economy. It involves decreasing the money supply and increasing the interest rates. As reduction in money supply increases the interest rates, the borrowers will be reluctant to borrow the money due to higher borrowing cost which ultimately reduces the economic activity. It leads to decrease in inflation, increase in unemployment and slowdown in economy.

It is also known as tight money policy as central banks seeks to reduce the money supply by restricting credit by increasing interest rates.

Unconventional Monetary Policy

Unconventional monetary policy is pursued by central banks when their traditional instruments of monetary policy cease to achieve their goals. The one such unconventional monetary policy was employed us United States after the financial crisis of 2007 in the form Quantitative Easing (QE).

Instruments of Monetary Policy in India

The Reserve Bank of India employs various instruments of monetary policy in India to achieve the objectives of price stability and higher economic growth. Some of the important instrument or tools of monetary policy in India are:

  • Open Market Operations (OMO)
  • Cash Reserve Ration (CRR)
  • Statutory Liquidity Ratio (SLR)
  • Liquidity Adjustment Facility (LAF)
  • Selective Credit Control
  • Moral Suasion

Open Market Operations (OMO)

It is the process of buying and selling of government securities, bond or Treasury Bills (T-Bills) to regulate the money supply in economy. If government wants to reduce money supply, it issues these bonds. The money is consumed to buy these bonds thus it reduced the monetary base of the economy. Similarly to increase the money supply, the government sells these bonds thereby increasing the monetary base of the economy. In India, the open market operations are conducted by Reserve Bank of India through its core banking solution e-Kuber.

Cash Reserve Ratio (CRR)

It refers to the cash which banks have to maintain with the Reserve Bank of India as percentage of Net Demand and Time Liabilities (NDTL). An increase in CRR makes it mandatory for banks to hold large portion of their deposits with the RBI. Therefore it reduces their deposit available for credit and they lend less which affect their profitability and also reduces the money supply in economy.

Statutory Liquidity Ratio (SLR)

Apart from CRR, the banks in India are required to maintain liquid assets in the form of gold, cash and approved securities. The increase/decrease in SLR affects the availability of money for credit with banks.

Liquidity Adjustment Facility (LAF)

Under Liquidity Adjustment Facility (LAF) the banks purchase money from RBI on repurchase agreements.

  • Repo Rate: It is the interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF)
  • Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF

Marginal Standing Facility

Under SF, the scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system

Bank Rate

It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers.

Selective Credit Control

Under this method, the central influence the credit growth in country through following techniques:

  • Specifying the margin requirements and differential rate of interests
  • Regulating the credit for consumer durables

Moral Suasion

The central persuades the commercial banks to regulate the credit growth through oral and verbal communication.

Why monetary policy is ineffective in India?

There are many reasons for monetary policy not able to achieve its intended objectives. Some of the reasons are:

  • Higher proportion of Non-Bank Credit
    The credit market in India is largely occupied by non-bank credit providing institutions like money lenders, cooperatives, relatives, friends etc. This large segment is not affected by monetary policy instrument.
  • Introduction of new financial instruments
    Mutual Fund, Venture Capital, IPO etc. have influence on overall liquidity in the economy. The monetary policy intervention by Reserve Bank of India is insignificant in these segments of financial system.
  • High currency-deposit ratio
    The rural economy in India has more inclination towards the usage of cash. Thus there is high currency-deposit ratio. The monetary policy only touches the deposit section. Thus any intervention by way of monetary policy has meager effect on economy.

Monetary Policy Transmission Mechanism

It is the process by which monetary policy interventions get transmitted to achieve the ultimate objectives like inflation or economic growth.

Monetary Policy Committee

The Monetary Policy Committee (MPC) has been constituted by central government in September 2016 for maintaining price stability, while keeping in mind the objective of growth

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