Monetary Policy: Objectives, Classification, & Policy Tools

Introduction

Monetary policy refers to the measures and actions implemented by an RBI to regulate the supply of money, interest rates, and credit in the economy. It aims to achieve various macroeconomic objectives such as price stability, employment generation and sustainable economic growth. It is the policy under which RBI uses monetary instruments (interest rate and other instruments) under the RBI Act, 1934, to influence money supply in the economy to achieve certain macroeconomic goals.

Objectives of Monetary Policy

• Accelerating economic growth.
• Price stability
• Exchange rate stabilization
• Balancing savings and investment.
• Employment generation.

Classification of Monetary Policy

• Expansionary Monetary Policy: Increases money supply in the economy [UPSC 2019, 2020]
  • Low interest rates (RBI reduces repo rate/ bank rate/ SLR/ Marginal Standing Facility Rate leaving more liquidity with banks)
  • Increases demand
• Contractionary Monetary Policy: Decreases money supply
  • Increase in Interest rates
  • Decreases demand

Policy Tools to Control Money Supply

• Quantitative tools: Changing the CRR, or bank rate or open market operations(OMO); 
• Qualitative tools: persuasion by the RBI to discourage or encourage lending in commercial banks.  [UPSC 2015]

Quantitative Tools in Indian Monetary Policy: 

• The Liquidity Adjustment Facility (LAF): Used to aid banks in adjusting the daily fluctuations in liquidity; 
  • Allows banks to park their excess money with the RBI in case of excess liquidity or to avail liquidity from the RBI at the time of deficit on an overnight basis against the collateral of government securities; 
  • Consists of two main instruments: Repo and Reverse Repo. 
• Open Market Operations: Buying and selling of bonds issued by the Government in the open market; Entrusted to the Central bank on behalf of the Government. 
  • When RBI buys the Government bonds, money supply in the economy increases; When RBI sells the Government bonds, money supply in the economy decreases.[UPSC 2013] 
• There are two types of open market operations: 
  • Outright open market operations: Permanent in nature: without any promise from the central bank to buy or sell the bonds back. 
  • Repo open market operations: When there is an agreement to sell the purchased bonds by the central bank, the agreement is called Repurchase Agreement or Repo; 
    • Central bank may sell the securities through an agreement which has a specification about the date and price at which it will be repurchased; 
    • Agreement is called a Reverse Repurchase Agreement or Reverse Repo. 

• Marginal Standing Facility (MSF): A penal rate at which scheduled banks can borrow money from the RBI over and above what they can borrow from the RBI under the LAF window; Always fixed at a higher rate than the Repo rate.
  • Repo rate is usually higher than the reverse repo rate; 
  • High repo rate means it is costly for banks to borrow money from the central bank thus it will reduce the money supply in the economy. 
  • On the contrary, lower repo rate will increase the money supply in the economy.
• Long Term Repo Operations (LTRO) is a tool used by the Reserve Bank of India (RBI) to lend money to banks for one to three years at the current repo rate.
• Bank Rate: Rate at which it lends money to commercial banks. 
  • By increasing the bank rate, loans taken by commercial banks become more expensive; this reduces the reserves held by the commercial bank and hence decreases money supply.

Qualitative Tools in Indian Monetary Policy: 

• Marginal Requirements: Commercial banks set a margin (Difference between the market value of security and the loan value)  to grant loans. 
  • When the central bank aims to restrict the flow of money, it increases the margin requirement, and vice versa for an expansionary credit policy.
• Selective Credit Control (SCC’s): This instrument selectively influences the flow of credit to specific sectors, either positively by encouraging credit flow to priority sectors or negatively by restricting credit to a particular sector.
• Moral Suasion: This technique involves non-binding persuasion by the central bank to encourage commercial banks to comply with monetary policy.

Transmission of Monetary Policy

• Interest Rate Channel: Monetary easing, marked by reduced interest rates, lowers the cost of capital, stimulating aggregate demand through increased business investment and consumption. 
  • Conversely, a tightening of monetary policy has the opposite effect, dampening demand and inflation.
• Exchange Rate Channel: Lower domestic interest rates can lead to a depreciation of the domestic currency. 
  • This has dual effects: enhancing export competitiveness globally and bolstering domestic demand and economic activity. 
  • However, it may also directly increase the rupee prices of imported inputs, raising costs for imports such as crude oil.
• Credit Channel: An expansionary monetary policy activates the credit channel, resulting in higher deposits and increased credit disbursal by banks. 
  • This, in turn, elevates investment and output in the economy.
• Asset Price Channel: Lower interest rates bolster asset prices, encouraging demand for assets like housing and equities. 
  • Higher asset prices also enhance the equity (collateral) available for banks to lend against, facilitating borrowing for households and businesses. 
  • Increased asset prices contribute to higher wealth, potentially leading to elevated consumption and housing investment.
• Expectation Channel: By establishing an inflation target, the central bank can anchor inflation expectations, reducing uncertainty for economic agents. 
  • With a clearer outlook, households and businesses gain confidence in making decisions about saving and investment.

Monetary Policy Stances

• Accommodative Stance 
  • It means RBI may reduce the policy rates to increase the money supply in the economy. 
  • This policy is adopted when there is a slowdown in the economy
• Neutral Stance 
• • It means RBI would have the flexibility to either increase or decrease the policy rates by taking into account the macroeconomic conditions. 
  • Policy rates would move in either direction.
  • This policy is adopted when the inflation rate is stable.
• Calibrated Tightening 
  • Policy rates either remain unchanged or increase. No decrease. 
  • This policy is adopted when there are concerns of a higher rate of inflation.

Unconventional Monetary Policy Tools

• Zero Interest Rate Policy (ZIRP) 
• • Central bank sets its target short-term interest rate at or close to 0%. 
  • The goal is to spur economic activity by encouraging low-cost borrowing and greater access to cheap credit by firms and individuals. 
  • Because nominal interest rates are bound by zero, some economists warn that a ZIRP can have negative consequences such as creating a liquidity trap.
• Negative Interest Rate Policy (NIRP) 
  • Central bank sets its target nominal interest rate at less than zero percent.
  • This extraordinary monetary policy tool is used to strongly encourage borrowing, spending, and investment rather than hoarding cash, which will lose value to negative deposit rates. 
  • This policy was followed in developed economies such as Japan, Denmark, Sweden, Switzerland.
• Helicopter Money: Refers to increasing a nation’s money supply through more spending, tax cuts, or boosting money supply.

Conclusion

• The monetary policy of the RBI plays a pivotal role in steering India’s economy by regulating the money supply, interest rates, and credit availability. 
• Through a combination of tools and strategies, the RBI aims to maintain price stability, support economic growth, and ensure financial stability. 
• Effective monetary policy decisions are critical for achieving these objectives and fostering a conducive environment for sustainable development and prosperity.