Monetary policy is an important economic tool used to manage and control a country’s economy. Monetary policy is an important factor in economic management, carried out under the authority of the Reserve Bank of India. The policy often targets inflation or interest rates to ensure price stability and growth in the economy. Candidates who have cleared the JAIIB exam can appear in the upcoming CAIIB June 2024 Exam. Our experts have been working on the CAIIB study material 2024, which includes videos, notes in the form of ePDFs, mock tests, etc. Monetary policy is one of the main topics of CAIIB exam. The blog will help you understand all the major aspects of monetary policy.
Objectives of Monetary Policy
Growth with Stability is the aim of the monetary policy in India. The policy contributes in the regulation of the availability, cost, and use of money. The primary objectives of the monetary policy are:
- Price Stability: The primary objective of monetary policy is to maintain price stability, which is done by controlling inflation within the country. As the price level is affected by the money supply, the monetary policy regulates the money supply by various ways to maintain price stability. In an “Inflation Targeting” framework the RBI is mandated to manage price stability. India adopted Inflation Targeting in 2016 and consequently targets 4% of inflation with a band of 2%.
- Economic Growth: One of the major objectives of monetary policy is to ensure that there is a necessary supply of money and credit in an economy for growth. It is important as these things are vital for India’s economic growth and with sufficient credit availability. This objective is also related to employment growth because businesses invest more in their capital equipment when unemployment is low to increase
productivity, thus contributing to economic growth.
- Employment Generation: Monetary policies influence the level of unemployment in the economy. For example, an expansionary monetary policy decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market. The Reserve Bank of India allocates different economic activities with varying labor intensities in the country which in turn leads to employment opportunities. Additionally, by managing inflation monetary policy helps consumers encourage spending and investment.
- Manage Aggregate Demand: The Reserve Bank of India tries to stabilize the aggregate demand with the aggregate supply of goods and services in the economy. If RBI wants to increase aggregate demand, it expands the credits, and the interest rate comes down. Because of low-interest rates, more people tend to take loans to buy goods and services, increasing aggregate demand and vice versa.
- Financial Market Stability: RBI develops a more secure financial system in the economy by preventing financial dreads in case of bank failure. The central bank provides funds to such banks. In addition, the central bank is eventually the last source of funds in a money market.
- Interest Rate Stability: Interest rate stability is important as fluctuations in Interest rates will create a lot of uncertainty in an economy and it will become difficult for people to buy sustainable things like a house or a car. This will directly affect the economy in the long run.
- Regulate and Expand Banking: The Reserve Bank of India regulates the banking system in the Indian economy by issuing regulations to the banks for setting up rural branches to promote agricultural credit. However, for the same purpose, the government has also set up different cooperative and rural banks.
- Control Business Cycle: A business cycle consists of different phases, out of which boom and depression are the major ones, and monetary policy keeps a check on these phases. When a business goes through a boom phase, RBI reduces credit to minimize money supply and check inflation. However, during a depression phase, credit is increased to raise the money supply, and total demand in an economy also increases.
- Promote Exports and Substitute Imports: Monetary policy encourages and helps industries to improve the position of balance payments by providing loans to the export and import units at a reduced rate of interest to help promote these sectors.
- Ensuring More Credit for the Priority Sector: Monetary policy aims to provide more funds to priority sectors by lowering interest rates for sectors such as agriculture, small-scale industry, and weaker sections of society.
- Encouraging Savings and Investments: To encourage saving among people, the RBI offers lower interest rates and a high saving rate leads to more investment in the country.
Types of Monetary Policy
There are two prime types of monetary policy:
- Expansionary monetary policy: At times of slowdown or recession in an economy, an expansionary policy boosts economic activities by lowering interest rates, expanding money supply, and consumer spending, borrowing increases and easing reserve requirements.
- Contractionary monetary policy: It aims to decrease the money supply and control inflation by raising interest rates, reducing the money supply, and boosting reserve requirements in the economy.
Tools of Monetary Policy
- Bank Rate
- Cash Reserve Ratio
- Statutory Liquidity Ratio
- Market Stabilization Scheme
- Repo Rate
- Reverse Repo Rate
- Open Market Operations
- Marginal Standing Facility (MSF)
- Standing Deposit Facility (SDF)
- Base Rate
- Marginal Cost of Funds based Lending Rate (MCLR)
- External Benchmark Lending Rates (EBLR)
Monetary Policy Committee(MPC)
The Monetary Policy Committee (MPC) is a committee constituted by the Central Government and led by the Governor of RBI and is responsible for fixing the benchmark interest rate in India to restrain inflation within a particular target level. The meetings of the Monetary Policy Committee are held at least four times a year and it publishes its decisions after each such meeting.
The Monetary Policy Committee (MPC) was constituted by the Central Bank, as per Section 45ZB under the RBI Act of 1934. The first meeting of MPC was conducted on September 29, 2016
Composition of MPC
The committee consists of six members, out of which three members are from RBI and rest three are appointed by the Government of India.
The MPC consists of six members:
⦁ RBI Governor
⦁ RBI Deputy Governor in charge of monetary policy
⦁ One member nominated by the RBI Board
⦁ The Government of India will propose three members (committee chaired by the Cabinet Secretary).
⦁ Members of the MPC will have to serve for four years and are not eligible for reappointment in the committee.
Making of The Monetary Policy Committee
⦁ The committee determines the policy interest rate required to achieve the targeted inflation rate.
⦁ Four MPC meetings are held in a year.
⦁ Each of the six members has one vote right, and in the case of any equality of votes, the Governor has a right to second or cast a vote.
⦁ Once every six months, the Reserve Bank is required to publish a document called the Monetary Policy Report to explain the sources and forecasts of inflation for 6-18 months ahead.
Failure of the Monetary Policy Committee(MPC)
- When, for any three consecutive quarters, average inflation is more than the upper tolerance level of the inflation target.
- When the average inflation is less than the lower tolerance level for any three consecutive three-quarters.
So, Monetary policy is one powerful tool that regulates macroeconomy-based variables like unemployment and inflation. In the ever-evolving landscape of the economy and banking sector, monetary policy remains of paramount importance.