Monetary Policy in India and its Regulation

RBI, The Central Bank of India has the responsibility to operate the monetary policy of India. Monetary policy refers to those policies of Central Bank (Reserve Bank of India) which are used to control interest rates, money supply in the economy and the availability of credit in the economy. In other words, monetary policy is the use of monetary instruments such as Repo rate, Reverse repo rate, CRR, SLR etc by RBI to regulate interest rates, money supply, credit availability and to control inflation etc. in the country.
Monetary policy is announced every year in the month of April by RBI, which is followed by three quarterly reviews in the month of July, October and January. However, RBI can announce the monetary policy measures at any point of time. The annual monetary policy consists of (a) the macroeconomic and monetary developments, and (b) the actions taken and fresh policy measures.


Goals of monetary policy of RBI

  • To control inflation and maintain price stability: RBI uses monetary policy to increase or reduce money supply in the economy in order to control inflation and maintain price stability. This is essential for facilitating a favourable environment for economic growth and industrial development of the country.
  • To manage and control the expansion of bank credit: RBI uses monetary policy to control the expansion of the money supply and bank credit. RBI gives special attention to the seasonal credit requirements without affecting the output of different sectors of the economy.
  • To promote fixed investment for increasing the productivity of investment by putting a restrain on nonessential fixed investment.
  • To ensure distribution of credit to priority sector: RBI through its monetary authority controls the decisions related to the allocation of credit to the priority sector such as agriculture, small scale industries etc. RBI decides about the specified percentage of credit which is to be allocated for priority sector lending.
  • To ensure equitable distribution of credit to all the sectors of the economy and to different socio-economic groups of the population.
  • To improve the efficiency of the financial system: RBI like every other Central Bank tries to improve the efficiency of the financial system by incorporating structural changes such as deregulation of interest rates, removing operational constraints in the credit delivery system, and by introducing new money market instruments etc.
  • To reduce rigidity and bring flexibility in the financial system: RBI tries to bring flexibility in the financial system by encouraging competitive environment and diversification. It tries to provide considerable autonomy in the operations of the financial system.
  • To ensure Rapid economic growth: RBI through its monetary policy tries to improve economic growth of the country by ensuring availability of sufficient credit at reasonable interest rates. Maintaining price stability and controlling inflation also helps in achieving this goal.
  • To maintain exchange rate stability: RBI uses the tool of monetary policy and open market operations etc to maintain a stable exchange rate of Indian currency. This is essential for the stability of the economic system of the country and to preserve it from external shocks.
  • To maintain the balance of payment equilibrium: one of the most important objectives of monetary policy is to maintain the balance of payment equilibrium which is essential for economic development and growth of the country.
  • To promote investment and trade: RBI uses of monetary policy for boosting Investments and exports and to increase trade.

Flexible inflation targeting framework

Inflation refers to the sustained increase in the level of prices of the basket of goods and services which is generally measured as an annual percentage change. The prices of goods and services rise under inflationary conditions. This rise in prices leads to fall in the value of money.
Inflation targeting refers to the monetary policy used by central banks (RBI in case of India) to maintain the prices within a certain range. The primary objective of inflation targeting is price stability as rising prices can create uncertainties in the decision making which can adversely affect savings and can encourage speculations in Investments. Inflation targeting improves the predictability and transparency in the decisions of monetary policy. In India, inflation targeting was introduced as the country has experienced a high level of inflation.
  • Flexible inflation targeting framework was introduced in India in 2016 after amending the Reserve Bank of India RBI act, 1934. After this amendment in the RBI act, the inflation target is to be set by the government in consultation with RBI. This target is to be usually revised once in 5 years.
  • As per the August 2016 notification of government, the inflation target is 4% with a tolerance level of 2%. The upper and lower tolerance levels are 6% and 2% respectively for a period up to March 31, 2021.
  • If the average inflation rate is greater than the upper tolerance level of the target for any three consecutive quarters, or if the average inflation rate is below the lower tolerance level for any three consecutive quarters, it constitutes a failure in achieving the inflation target.

Monetary policy framework agreement

  • Monetary policy Framework agreement was signed between Reserve Bank of India and the Government of India on 20th February 2015. This agreement made inflation targeting and price stability the responsibility of the Reserve Bank of India. In the union budget 2016-17 the Reserve Bank of India RBI Act, 1934 was amended to give statutory backing to the monetary policy Framework agreement and for the setting up of the monetary policy committee.
  • The Reserve Bank of India has the responsibility to operate the monetary policy framework and the amended RBI act provides the mandate to RBI to operate it.
  • The objective of this Framework is to set repo rate based on the current and evolving microeconomic conditions and on the basis of liquidity conditions in the economy.
  • Repo rate changes affect the entire financial system and aggregate demand which in turn affects the inflation rate and economic growth. After the announcement of Repo Rate, the operating framework of RBI envisages the liquidity management on daily basis through proper actions. It aims to keep the operating target- the weighted average call rate around the announced repo rate.

Monetary policy committee (MPC)

  • The monetary policy committee is committee under RBI headed by RBI Governor which has the responsibility to fix the benchmark policy rate, repo rate to maintain inflation rate within the specified range. It is a six member committee constituted by the government under section 45ZB of the amended Reserve Bank of India (RBI) act, 1934.
  • The committee consists of six members of which 3 members are from RBI and other three members are appointed by the central government. The search-cum-selection committee headed by the cabinet Secretary recommends the three members to be appointed by the government.
  • The quorum for the proceedings of monetary policy committee is four members and one of them has to be the Governor and in his absence the Deputy Governor. The decisions are taken on the basis of majority vote and in case of a tie, the Governor will have the second or casting vote. The decision taken by the monetary policy committee is binding on RBI.
  • The monetary policy committee has to organise at least four meetings in a year. The resolution of the monetary policy committee is published after its every meeting. RBI has to publish the monetary policy report once every six months to explain the sources of inflation and to give the inflation forecast for the next 6 to 18 months.
  • The repo rate is determined by the monetary policy committee to achieve the inflation target. The Reserve bank s monetary policy department helps the committee in the formulation of monetary policy decisions.
  • The monetary policy is operationalised through daily liquidity management operations by the financial markets by the financial markets operations department.

Instruments of monetary policy of RBI

RBI uses various instruments of monetary policy for achieving the inflation target. These can be categorised into quantitative instruments and qualitative instruments.


Quantitative instruments used by RBI

Quantitative instruments are the general tools of monetary policy which are used to control the quantity of money supply in the market. The quantitative tools are also known as general tools of credit control which are indirect in nature and are used to influence the quantity of credit in the economy.
  • Liquidity adjustment facility- liquidity adjustment facility is used to inject or absorb liquidity from the market using repo rate and reverse repo rate. The repo rate injects liquidity in the market, while the reverse repo rate absorbs the liquidity from the economy.
  • Repo rate (repurchase agreement rate)- repo rate is the interest rate at which RBI provides funds to commercial banks for short periods of time against the guarantee of government securities. The RBI purchases government bonds at a fixed rate from the banks with an agreement to sell them back at the at the fixed date. The government securities can include long term treasury notes ( 2 to 30 years) or short term treasury bills (91 days, 182 days or 364 days). The main objective of the repo rate is to inject liquidity in the market. Reduction in repo rate makes cheaper for banks to borrow money which ultimately reduces the interest rates charged by banks on their loans.
  • Reverse repo rate- it is the interest rate at which RBI borrows funds from the commercial banks for short periods. It is used as a tool to absorb liquidity from the banking system. Banks use this facility by depositing their extra funds with RBI and earn interest on it. Increasing the reverse repo rate, RBI reduces liquidity from the banking system.
  • Cash reserve ratio (CRR)- it refers to the certain proportion of deposits in the form of cash which all the scheduled commercial banks and cooperative banks are required to deposit with RBI. This feature comes from the section 42(1) of Reserve Bank of India Act, 1934. Banks do not earn interest from RBI on these deposits. The present cash reserve ratio is 4%. All the banks have to maintain a minimum cash reserve ratio up to 95% of their average daily required CRR. If banks fail to maintain these reserves, RBI charges an interest rate of 3% above the bank rate on the amount by which the bank reserves fall short.
  • Statutory liquidity ratio- It refers to the minimum proportion of total Net Demand and Time Liabilities in the form of liquid assets such as gold, government securities, approved securities etc that every bank has to maintain. This amount has to be maintained with the banks itself and is not required to be deposited with RBI. The current statutory liquidity ratio as 19.5%. The RBI has the authority to increase the statutory liquidity ratio to a maximum of 40%.
  • Bank rate- it refers to the interest rate at which the Reserve Bank of India provides long term loans to the commercial bank, cooperative banks, and Development Banks etc. It is a long term measure of RBI to control money supply in the market. Collateral is not required by the banks for borrowing money under the bank rate. Collateral securities are required for borrowing under the repo rate. Also, the bank rate is higher than the repo rate. The current bank rate is 6.5 %.
  • Marginal standing Facility- it is the new window created by RBI under its credit policy of May 2011. Under this facility, the banks can borrow funds from RBI by pledging government securities within the limits of the statutory liquidity ratio. Whereas, under the repo rate facility, banks pledge government securities above the statutory liquidity ratio. The interest rate charged is 1% above the repo rate. The maximum borrowing limit is up to 1% of the net demand and time liabilities of the bank. The minimum amount is rupees one crore and it's multiples thereof.
  • Open market operations- it refers to the actions of purchase and sale of government securities by the Reserve Bank of India. RBI sells government securities in the market to suck out excess liquidity (rupee) from the economy. In case of liquidity crunch, RBI buys government securities from the market which increases liquidity in the economy.
  • Bank base rate-it is the minimum interest rate at which the banks can give the loan to its customers. Banks cannot lend money to its customers below the base rate except in cases allowed by the RBI. Bank base rate was introduced by RBI from 1st July 2011 as the new benchmark rate for lending operations of banks. It was introduced to bring transparency in the bank lending rates of the banking system.

Qualitative instruments

Qualitative instruments are used by RBI for discriminating between different uses of credit. It can be used to discriminate by favouring exports over imports, or essential credit supply over nonessential lendings. It is not directed towards the quality of credit supply.
    • Marginal requirement- It refers to the proportion of loan which the borrower has to raise in order to get finance for his purpose. RBI can increase the marginal requirements for those activities for which credit supply is to be restricted.
    • Rationing of credit- RBI can put a maximum limit on loans and advances that can be made by banks for specific categories. This method of rationing is used for checking credit flow, particularly for speculative activities.
    • Direct action- RBI has the authority to take direct strict action against any bank if it refuses to obey the directions given by RBI. RBI can put restrictions on advancing loans on such banks.
    • Moral suasion- it refers to the request and suggestions of Reserve Bank of India to the banks to take certain actions as per the emerging trends of the economy. It is mainly an informal and psychological means of credit control. RBI can ask the commercial banks not to give certain kinds of loans and advances.
  • RBI guidelines- RBI can issue some directives and guidelines for the commercial banks in framing their lending policy. RBI can influence credit structures and supply of credit for some specific purposes. For example, RBI can issue directives to banks for not giving loans to the speculative sector such as securities etc beyond a limit.
  • Customer credit regulation- it refers to the rules issued by RBI regarding down payments, maximum maturities, installment amount etc of the loan installments for the purchase of some goods etc.

Monetary policy current rates as per RBI

The monetary policy rates as of 29/7/2018
  • Policy repo rate: 6.25%
  • Reverse repo rate: 6%
  • Marginal standing Facility rate: 6.50%
  • Bank rate: 6.50%
  • Cash reserve ratio CRR: 4%
  • Statutory liquidity ratio: 19.5%

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