Monetary Policy Concepts and Objectives

Recently updated on April 13th, 2023 at 06:38 pm

Monetary policy refers to the policy of the central bank of a country to regulate and control the volume, cost and allocation of money and credit with the aim of achieving the objectives of optimum levels of output and employment, price stability, balance of payment equilibrium, or any other goal set by the government.

Monetary and fiscal policies are closely interrelated and therefore should be pursued in coordination with each other. Fiscal policy generally brings about changes in money supply through the budget deficit. An excessive budget deficit, for example, shifts the burden of control of inflation to monetary policy. This requires a restrictive credit policy.

On the contrary, a fiscal policy, which keeps the budget deficit at a very low level, frees the monetary authority from the burden of adopting an anti-inflationary monetary policy. The monetary policy can then play a positive role in promoting economic growth by extending credit facilities to development programmes.

In a developing economy like India, appropriate monetary policy can play a positive role in creating conditions necessary full rapid economic growth. Moreover, since these economies are highly sensitive to inflationary pressures, the monetary policy should also serve to control inflationary tendencies by increasing savings by the people, checking credit expansion by the banking system and discouraging deficit financing by the government.

In India, during the planning period, the aim of the monetary policy of the Reserve Bank has been to meet the needs of the planned development of the economy.

With this broad aim, the monetary policy has been pursued to achieve the twin objectives of the economic policy of the government:

(a) To accelerate the process of economic growth with a view to raise national income, and

(b) To control and reduce the inflationary pressures in the economy.

Thus, the monetary policy of the Reserve Bank during the course of planning has been appropriately termed as that of ‘controlled expansion’. It aims at adequately financing of economic growth and, at the same time, ensuring reasonable price stability in the country.

POLICY OF CREDIT EXPANSION

The overall trend in the economy during the planning period has been that of continuous expansion of currency and credit with an objective of meeting the developmental needs of the economy.

This expansion has been achieved by adopting the following measures:

  1. Revision of Open Market Operations

The Reserve Bank revised its open operations policy in October 1956, according to which it started giving discriminatory support to the sale and purchase of government securities. Between 1948-51 the Bank made large purchases of government securities.

In the subsequent period, the Bank’s sales of the government securities to the public exceeded its purchases. This excess sales method was discontinued between 1964 and 1969 with a purpose of expanding currency and credit in the economy.

  1. Liberalisation of the Bill Market Scheme

Through the bill market scheme, the commercial banks receive additional funds from the Reserve Bank to meet the increasing credit requirements of their borrowers. Since 1957, the Reserve Bank has extended the bill market scheme to include export bills in order to help the commercial banks to provide credit to exporters liberally

  1. Facilities to Priority Sectors

The Reserve Bank continues to provide credit facilities to priority sectors such as small-scale industries and cooperatives, even though the general policy of the Bank is to control credit expansion.

For instance, in October 1962, the banks were allowed to borrow additional funds from the Reserve Bank in order to provide finance to small scale industries and cooperatives. The Reserve Bank has also been providing short-term finance to the rural cooperatives.

  1. Refinance and Rediscounting Facilities

In recent years, the Reserve Bank has been following a policy of providing selective refinance and rediscounting facilities. At present, the banks are permitted to refinance equal to one per cent of the demand and time liabilities at the rate of 10 per cent per annum. Refinance facilities are also available for food procurement credit and export credit.

  1. Credit Facilities through Financial Institutions:

The Reserve Bank has also been instrumental in the establishment of various financial institutions like Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), Industrial Reconstruction Corporation of India (IRCI), Industrial Credit and Investment Corporation of India (ICICI), State Finance Corporations (SFCs).

Agricultural Refinance and Development Corporation (ARDC) and National Bank for Agriculture and Rural Development (NABARD). Through these institutions, the Reserve Bank provides medium-term and long-term credit facilities for development.

  1. Deficit Financing

Continuous increase in money supply in the country has been caused by adopting the method of deficit financing to finance the budgetary deficit of the government. This has been made possible through changes in the reserve requirements of the Reserve Bank.

The reserve system was made more flexible by making two changes:

(a) By dropping proportional reserve system which required keeping of 40 per cent of reserves in gold (coins and bullion) and foreign securities, with the provision that the value of gold would not be less than Rs. 40 crore.

(b) Modifying the minimum reserve system so that the Reserve Bank need keep only gold worth Rs. 115 crore with the provision that the minimum requirement of keeping foreign securities of the value of Rs. 85 crore can be waived during extreme contingency.

  1. Anti-Inflationary Fiscal Policy

The Seventh Five Year Plan prefers an anti-inflationary fiscal policy to an anti- inflationary monetary policy and emphasises a positive, promotional and expository role for monetary policy. It is believed that “a fiscal policy that keeps the budget deficit down would give greater autonomy to monetary policy.”

In the seventh plan, the amount of deficit financing (i.e., net Reserve Bank Credit to the government) has been fixed at a level considered just sufficient to generate the additional money supply needed to meet expected increase in the demand for money, such an anti-inflationary fiscal policy will liberate the Reserve Bank for its anti-inflationary responsibilities and will enable it to extend sufficient credit facilities for the development of industry and trade.

  1. Allocation of Credit

The pattern of allocation of credit is in accordance with the plan priorities. The major part of the total credit available goes to the public sector through statutory requirements and other means. A certain minimum of credit at concessional rates of interest is ensured for the priority sectors through selective credit control and the differential rate of interest scheme. Private industries can secure funds for investment purposes through public financial institutions.

POLICY OF CREDIT CONTROL

Apart from meeting developmental and expansionary requirements of the economy, the Reserve Bank has also been assigned the task of controlling the inflationary pressures in the economy. During the planning period, the large and continuous increase in the deficit financing and government expenditure has been expanding the monetary demand for goods and services.

But, on the other hand, the factors like shortfalls in production, hoardings, etc., have been creating inelasticity’s in the supply of commodities. As a result the country has been experiencing an inflationary rise in prices ever since 1955-56 and particularly after 1973-74.

The Reserve Bank has adopted a number of credit control measures to check the inflationary tendencies in the country:

  1. Bank Rate

The bank rate is the rate at which the Reserve Bank advances to the member banks against approved securities or rediscounts the eligible bills of exchange and other papers. Bank rate is considered as a pace-setter in the money market. Changes in the bank rate influence the entire interest rate structure, i.e., short- term as well as long term interest rates.

A rise in the bank rate leads to a rise in the other market interest rates, which implies a dear money policy increasing the cost of borrowing. Similarly, a fall in the bank rate results in a fall in the other market rates, which implies a cheap money policy reducing the cost of borrowing.

The Reserve Bank has changed the bank rate from time of time to meet the changing conditions of the economy. The bank rate was raised from 3% to 3.5% in November 1951 and was further raised to 4% in January 1963, to 5% in September 1964, to 6% in February 1965.

In March 1968, the bank rate was reduced to 5% in view of the recessionary conditions. Subsequently, it was further raised to 7% in May to 9% in July 1974 and to 10% in July 1981. The bank rate was again raised to 11% in July 1991. It was 12% w.e.f October 8, 1991.

The increases in the bank rate were adopted to reduce bank credit and control inflationary pressures. At present the bank rate is 9%.

The situation, however, has changed since the introduction of economic reforms in early 1990s. As a part of financial sector reforms, the Reserve Bank of India (RBI) has decided to consider the Bank Rate as a policy instrument for transmitting signals of monetary and credit policy. Bank rate now serves as a reference rate for other rates in the financial markets.

With this new role assigned to the Bank Rate and to meet the growing demand for credits from all sectors of the economy under the liberalised economic conditions, the Bank Rate has been reduced in phases in subsequent years. It was reduced to 10% in June 1997, to 9% in October 1997, to 8% in March 1999, to 7% in April 2000, to 6.5% in October 2001, to 6.25% in October 2002, to 6.00% in April 2003.

  1. Net Liquidity Ratio

In order to check excessive borrowings from the Reserve Bank by the commercial banks, the Reserve Bank introduced the system of net liquidity ratio in September 1964. According to this system, a commercial bank can borrow from the Reserve Bank at the bank rate only if it maintains a minimum net liquidity ratio to its total demand and time liabilities, and it will have to pay a penal rate of interest to the Reserve Bank, if the net liquidity ratio falls below the minimum ratio fixed by the Reserve Bank.

Net liquidity of a borrowing bank comprises:

(a) Cash in hand and balances with the Reserve Bank plus.

(b)  Balances in currency account with other banks, plu.

(c) Investments in government and other approved securities, minus.

(d) Borrowing from the Reserve Bank, the State Bank of India and the Industrial Development Bank of India.

In 1964, when the system was introduced, the net liquidity ratio was fixed at 28%, and for every point drop in the ratio, the interest rate was to go up by 0.5%. In 1973, the net liquidity ratio was raised to 40% and the rate of interest was to go up by 1% above the bank rate for every 1% drop in the net liquidity ratio. In 1975, however the system was abandoned.

  1. Open Market Operations

Through the technique of open market operations, the central bank seeks to influence the excess reserves position of the banks by purchasing and selling of government securities, commercial papers, etc.

When the central bank purchases securities from the banks, it increases their cash reserve position, and hence their credit creation capacity. On the other hand, when the central bank sells securities to the banks, it reduces their cash reserves and the credit creation capacity.

Sections (178) and 17(2)(a) of Reserve Bank of India Act authorise the Reserve Bank to purchase and sell the government securities, treasury bills and other approved securities. However, due to underdeveloped security market, the open market operations of the Reserve Bank are restricted to government securities. These operations have also been used as a tool of public debt management.

They assist the Indian government in raising borrowings. Generally the Reserve Bank’s annual sales of securities have exceeded the annual purchases because of the reason that the financial institutions are required to invest some portion of their funds in government and approved securities.

In India, the open market operations policy of the Reserve Bank has not been so effective because of the following reasons:

(a) Open market operations are restricted to government securities.

(b) Gilt-edged market is narrow.

(c) Most of the open market operations are in the nature of switch operations, i.e., purchasing one loan against the other.

  1. Cash-Reserve Requirement (CRR)

The central bank of a country can change the cash-reserve requirement of the bank in order to affect their credit creation capacity. An increase in the cash- reserve ratio reduces the excess reserve of the bank and a decrease in the cash-reserve ratio increases their excess reserves.

Originally, the Reserve Bank of India Act of 1934 required the commercial banks to keep with the Reserve Bank a minimum cash reserve of 5% of their demand liabilities and 2% of time liabilities. The amendment of the Act in 1956 empowered the Reserve Banks to use the cash reserve ratio as an instrument of credit control by varying them between 2 and 20% on the demand liabilities and between 2 and 8% on the time liabilities- Further, amendment of the Act in 1962 removes the distinction between demand and time deposits and authorises the Reserve Bank to change cash-reserve ratio between 3 and 15%.

The Reserve Bank used the technique of variable cash-reserve ratio for the first time in June 1973 when it raised the ratio from 3% to 5% and further to 7% in September 1973. Since then, the Reserve Bank has raised or reduced the cash-reserve ratio many times.

It was raised to 9% on February 4, 1984, to 9.5% on February 28, 1987, to 10% with effect from October 24, 1987, to 10.5% effective from July 2, 1988 and further to 11% effective from July 30, 1988.

The CRR was raised to its existing maximum limit of 15 % with effect from July, 1989. The present CRR ratio is 11% w.e.f. August 29, 1998. This reduction is due to the new liberalised policy of the government.

The Narsimham Committee in its report submitted in November 1991, was of the view that a high Cash Reserve Ratio (CRR) adversely affects the bank profitability and thus puts pressure on banks to charge high interest rates on their commercial sector advances. The government therefore decided to reduce the CRR over a four year period to a level below 10%.

As a first step in the pursuit of this objective, CRR was reduced in two phases from 15% to 14.5% in April 1993 and further to 14% in May 1993. It was reduced to 13% in April 1996. Again in line with the monetary policy aimed at facilitating adequate availability of credit to support industrial recovery, the CRR was further reduced to 8% in April 2000, to 7.5% in May 2001, to 5.5% in October 2001, to 4.75% in November 2002, to 4.50% in June 2003.

  1. Statutory Liquidity Ratio (SLR)

Under the original Banking Regulation Act 1949, banks were required to maintain liquid assets in the form of cash, gold and unencumbered approved securities equal to not less than 25% of their total demand and time deposits liabilities. This minimum statutory liquidity ratio is in addition to the statutory cash-reserve ratio. The Reserve Bank has been empowered to change the minimum liquidity ratio.

Accordingly, the liquidity ratio was raised from 25% to 30% in November 1972, to 32% in 1973, to 35% in October 1981, to 36% in September 1984, to 38% to in January 1988, and to 38.5% effective from September 1990.

There are two reasons for raising statutory liquidity requirements by the Reserve Bank of India:

(a) It reduces commercial banks’ capacity to create credit and thus helps to check inflationary pressures.

(b) It makes larger resources available to the government. In view of the Narsimham Committee report, the government decided to reduce SLR in stages from 38.5% to 25%. The effective SLR on total outstanding net demand and time liabilities of the scheduled commercial banks come down to 27% by the end of December 1996.

  1. Selective Credit Controls

Selective credit controls are qualitative credit control measures undertaken by the central bank to divert the flow of credit from speculative and unproductive activities to productive and more urgent activities. Section 21 of the Banking Regulation Act 1949 empowers the Reserve Bank to issue directives to the banks regarding their advances.

These directives may relate to-

(a) The purpose for which advances may or may not be made.

(b) The margins to be maintained on the secured loans.

(c) The maximum amount of advances to any borrower.

(d) The maximum amount upto which guarantees may be given by the banking company.

(e) The rate of interest to be charged.

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