Chapter 3

Reserve Bank of India: Monetary Policy and Instruments

Monetary policy is the management of money supply and interest rates by central banks
to influence prices and employment. Monetary policy works through expansion or contraction of
investment and consumption expenditure.

Monetary policy is the process by which the

government, central bank, or monetary authority of a country controls (i) the supply of money,
(ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of
objectives oriented towards the growth and stability of the economy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary
policy, where an expansionary policy increases the total supply of money in the economy, and a
contractionary policy decreases the total money supply. Expansionary policy is traditionally used
to stop unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates in order to stop inflation. Monetary policy is contrasted with fiscal
policy, which refers to government borrowing, spending and taxation.
Monetary policy rests on the relationship between the rates of interest in an economy, that
is the price at which money can be borrowed, and the total supply of money. Monetary policy
uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment. Where currency is
under a monopoly of issuance, or where there is a regulated system of issuing currency through
banks which are tied to a central bank, the monetary authority has the ability to alter the money
supply and thus influence the interest rate.
The beginning of monetary policy as such comes from the late 19th century, where it was
used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size
of the money supply or raises the interest rate. An expansionary policy increases the size of the
money supply, or decreases the interest rate.
Furthermore, monetary policies are described as follows: accommodative, if the interest
rate set by the central monetary authority is intended to create economic growth; neutral, if it is
intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
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On the external front, rupee value has been linked to the market forces. Current account
convertibility was achieved in August 1994. FERA was repealed and replaced by a new
legislation - Foreign Exchange Management Act (FEMA), in 1999. Further, the Exchange
Control Department of the Reserve Bank was renamed as Foreign Exchange Department.
Besides, a large number of innovative products and newer players have come to play active role
and new hedging instruments have been introduced, viz., foreign currency-rupee options, etc.
Authorized dealers could use cross-currency options, interest rate and currency swaps,
caps/collars and forward rate agreements (FRAs) in the international forex market.
In the context of monetary policy framework, there has been a greater focus on liquidity
management engendered by the growing integration of financial markets, domestically and
internationally. With the near total deregulation of interest rates, the Bank Rate has been
reactivated since April 1997 as a reference rate and as a signaling device to reflect the stance of
monetary policy. Following the recommendations of the Working Group on Money Supply:
Analytics and Methodology of Compilation (Chairman: Y. V. Reddy), the Reserve Bank has
commenced compilation and publication of four monetary aggregates [M0 (monetary base), M1
(narrow money), M2 and M3 (broad money)]; and introduced three new liquidity aggregates (L1,
L2 and L3) by incorporating deposits with post- office savings banks, term deposits, term
borrowings and certificates of deposits of term lending and refinancing institutions and public
deposits of non-banking financial institutions; broadening of the definition of credit by including
items not reflected in the conventional bank credit; redefining the net foreign assets of the
banking system to comprise banks holdings of foreign currency assets net of (a) their holdings of
FCNR(B) deposits and (b) foreign currency borrowings.
With the liberalization of the external sector, the monetary targeting framework came
under stress due to increasing liquidity mainly on account of increased capital inflows,
necessitating a review of the monetary policy framework and the Reserve Bank switched over to
a more broad-based "multiple indicators approach" since 1998 in monetary policy formulation.
The informal monetary policy strategy meetings review the monetary and liquidity conditions
and the process has been made consultative. The Financial Markets Committee (FMC) monitors
the developments in financial markets on a daily basis.

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Monetary and credit aggregates have witnessed deceleration since their peak levels in
October 2008. The liquidity overhang emanating from the earlier surge in capital inflows has
substantially moderated in 2008-09. The Reserve Bank is committed to providing ample liquidity
for all productive activities on a continuous basis.
In its mid- term review of monetary policy on October 24, 2008, the Reserve Bank had
indicated that it would closely and continuously monitor the liquidity and monetary situation and
respond swiftly and effectively to the impact of the global developments on Indian financial
markets. The Reserve Bank had also indicated that the challenge for the conduct of monetary
policy is to strike an optimal balance among preserving financial stability, maintaining price
stability and sustaining the growth momentum.
In response to emerging global developments, the Reserve Bank has taken a number of
measures since mid-September 2008. The aim of these measures was to augment domestic and
forex liquidity and to enable banks to continue to lend for productive purpose while maintaining
credit quality so as to sustain the growth momentum.
On a further review of the evolving developments, the Reserve Bank has taken the
following measures:
Enhancing Rupee Liquidity
The special term repo facility, introduced for the purpose of meeting the liquidity
requirements of mutual funds and non-banking finance companies would continue till end-march
2009. Banks can avail of this facility either on incremental or on rollover basis within their
entitlement of up to 1.5 per cent of net demand and time liabilities.
As the upside risks to inflation have declined, monetary policy has been responding to
slackening economic growth in the context of significant global stress. Accordingly, for policy
purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,
aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. The
growth in adjusted non-food credit, including investment in bonds/debentures/shares of public
sector undertakings and private corporate sector and CPs, is placed at 20.0 per cent.

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Objectives of monetary policy

The objectives of monetary policy have undergone a change in emphasis over the years.
In the planned economy, they perforce were very much similar to the objectives of economic
planning.

Accordingly, the objectives of monetary policy in India were (a) to accelerate

economic development in an environment of reasonable price stability, and (b) to develop

appropriate institutional set-up to aid this process. The key note of monetary policy may be said
to be controlled expansion of bank credit and money supply, with special attention to seasonal
requirements for credit. The Bank has been directing its attention to ensure that credit expansion
takes place in the light of price variations without affecting the output, particularly the industrial
output adversely. In other words, the objective has been one of disinflation without deflation.
The authorities have come to hold that monetary policy is able to make more effective
contribution to price stability than other objectives.
Further, it has come to be believed that by achieving reasonable price stability, it is possible to (a) Avoid waste of resources because inflation results in such a waste by increasing uncertainty
about the future.
(b) Create an environment in which efficient decisions are taken and greater employment,
poverty alleviation, and balanced growth.
In India, while the basic objectives of monetary policy, namely, price stability and
adequate credit flow to the productive sectors of the economy, have remained the same, the
operating environment has changed significantly. As pointed out in the RBIs Report on Currency
and Finance 2003-04, there is an increasing focus on the maintenance of financial stability in the
context of better linkages between various segments of the financial markets including money,
Government securities and forex markets. Managing the capital flows has emerged as an
important concern of monetary policy. The phasing out of adhoc treasury bills and their automatic
monetization in 1997 imparted a lot of flexibility to the RBI in monetary management.
Simultaneously, however, reserve flows through the balance of payments M3 in 2004-05 is
projected to expand by 14.0 per cent.

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Non-food credit adjusted for investment in commercial paper, shares/ debentures/bonds of

public sector undertakings (PSUs) and private corporate sector was projected to increase by 16.0
to 16.5 per cent in the annual policy statement of May 2004. This magnitude of credit expansion
was expected to adequately meet the credit needs of all the productive sectors of the economy.
Contrary to the assumptions underlying the annual policy statement for 2004-05, the south west
monsoon turned out to be deficient by 13 per cent in the current year. There was a surge in
inflation following the rise in international oil and metal prices. The carry forward of liquidity
compounded matters.
With a view to addressing these issues, the RBI increased the CRR by 50 basis points, in
two stages, to 5.0 per cent, thus bringing down the liquidity in the banking system by about Rs.
9,000 crores. The interest rate on eligible CRR balances was de-linked from the Bank Rate and
was reduced to 3.5 per cent per annum. The Government of India raised the ceiling of MSS from
Rs. 60,000 crores to Rs. 80,000 crores on August 26, 2004 to enable the RBI to effectively deal
with the problem of overhang of liquidity. As the inflation was supply induced, the Government
also reduced the duty rates on petroleum products twice in the year 2004-05. Taking the above
developments into account, the RBI in its mid-term review of the annual policy statement for
2004-05 (October 26, 2004), revised its GDP growth projection in 2004-05 from a range of 6.5 to
7.0 per cent to 6.0 to 6.5 per cent. Inflation projection on a point to point basis was raised
upwards to 6.5 per cent from around 5.0 per cent projected earlier. RBI has not affected any
change in its earlier projection of M3 and aggregate deposit target of commercial banks.
The objectives of the monetary policy are to maintain price stability and ensure adequate
flow of credit to the productive sectors of the economy. Stability for the national currency (after
looking at prevailing economic conditions), growth in employment and income are also looked
into. The monetary policy affects the real sector through long and variable periods while the
financial markets are also impacted through short-term implications.
The common objective of any kind of monetary policy is the stability in the economy and
price stability. It depends on the prevailing conditions of the countrys economy, as what
economic policy will be pursued by the RBI, which is the controlling authority of India through
its various instruments.

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Monetary policy instruments: quantitative & qualitative

Principal instruments of monetary policy or credit control of the central bank of a country are
broadly classified as: (a) Qualitative Instruments and (b) Quantitative Instruments. Qualitative
Instruments affects the quantum of

money, whereas Qualitative Instruments focus on the

particular areas which are effected by the problems discussed above.

Quantitative Instruments refers to those instruments of monetary policy which affect
overall money supply/credit in the economy. These instruments do not direct or restrict the flow
of credit to some specific sectors of the economy. Few recognized and most used quantitative
instruments are as follows:
a)

Interest Rates:
The bank rate is the minimum rate at which the central bank of a country as a lender of

last resort is prepared to give credits to the commercial banks. The increase in bank rate
increases the rate of interest and credit becomes dear. Accordingly, the demand for credit is
reduced and thus money power or purchasing power is reduced. This course of action is under
contractionary policy to handle inflation. On the other hand, decrease in the bank rate lowers the
market rate of interest charged by the commercial banks from their borrowers. Credit becomes
cheap and money becomes easily available to spend and thus demand in the economy for goods
and services increases and controls deflationary situation. Bank rate is the minimum rate. The
related interest rates which are controlled by the RBI is Repo Rate and Reverse Repo Rate.
Repo Rate
Repo Rate is the current rate, not the minimum rate. Funds are taken by the commercial
banks on the Repo Rate for overnight and fortnight requirements to maintain mandatory cash
reserves. The effect and operation of Repo Rate is same as Bank Rate in regard the monetary
policy. Effect of Repo Rate is generally not shifted to the public in general, it is absorbed, but as
it is dependent on Bank Rate, and Bank Rate is shifted to public through primary function of
advancing loan of the commercial banks.

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Reverse Repo Rate

Reverse Repo Rate is the another form of interest rate, this is the rate at which central
bank pays interest to the money deposited in the central bank by the commercial banks. If RBI
decides to pay more interest, commercial banks would deposit more money with central bank,
which will decrease the availability of money for the credit to public by commercial banks,
resulting in decreasing money supply.
Cash Reserve Ratio (CRR)
Cash Reserve Ratio (CRR) refers to the minimum percentage of a banks total deposits
required to be kept with central bank. Commercial banks have to keep with the central bank a
certain percentage of their deposits in the form of cash reserves as a matter of law.
For example: If the minimum reserve ratio is 10 per cent and total deposits of HDFC bank
is ` 1000 Crores, it will have to keep `100 crores with RBI bank. Now, HDFC is left with ` 900
Crores to avail for the credit and to invest. If CRR increases by 5% or decreases by 5%, it will
decrease and increase the availability of credit by ` 50 Crores. There is inverse relationship
between these two. The maximum and minimum limits of CRR is 15 % and 3 % respectively.
Statutory Liquidity Ratio (SLR):
Every bank is required to maintain a fixed percentage of its assets in the form of cash or
other liquid assets. With a view to reducing the flow of credit in the market, the central bank
increases this liquidity ratio. However, in case of expansion of credit, the liquidity ratio is
reduced. Success of CRR and SLR again depends on the amount of excess reserves with the
commercial banks. CRR and SLR would be rendered meaningless if banks are used to keeping
high excess reserves.
Open Market Operations:
Open market operations refer to the sale and purchase of securities in the open market by
the central bank. By selling the securities (like NSC bonds), the central bank withdraws cash
balances from within the economy. And, by buying the securities, the central bank contributes to
cash balances in the economy.
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Cash Balances are high powered money on the basis of which commercial banks create
credit. Thus, through open market operations, if cash balances are increased, flow of credit will
increase many times more, and if cash balances are reduced, the flow of credit will decrease
many times more. Open Market Operations affects the quantity of money supply also by
increasing and decreasing VM (Velocity of Money), which is multiplier while calculating money
supply.
The above discussed were the quantitative measures of monetary policy. Sometimes, just
controlling the money supply or increasing supply does not result in price stability. The problem
with the monetary supply is that they cannot achieve price stability, if the inflation is in one
particular sector or part of the economy. It cannot do anything if one bank is not following the
guidelines, sometimes there have to be harsh actions taken by central bank.

QUALITATIVE CANTROL
Margin Requirements:
The margin requirement of loan refers to the difference between the current value of the
security offered for loans and the value of loans granted. Suppose, a person mortgages an article
worth ` 100 with bank and bank gives him loan of ` 70. In this case, 30 % is the margin
requirement. If the margin requirement is increased, it will decrease the availability of credit to a
person. If the margin requirement is decrease, it will enable this person to get more loan for his
assets value worth ` 100.
Rationing of Credit:
Rationing of credit refers to fixation of credit quotas for different business activities.
Rationing of credit is introduced when the flow of credit is to be checked particularly for
speculative activities in the economy. The central bank fixes credit quota for different business
activities. The commercial banks cannot exceed the quota limits while granting loans.

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Direct Action and Moral Suasion:

The central bank may initiate direct action against the member banks in case these do not
comply with its directives. Direct action includes derecoginition of a commercial bank as a
member of the countrys bank system. Sometimes, the central bank makes the member banks
agree through persuasion or pressure to follow its directives with a view to controlling the flow of
credit.
This is hardly taken action due to fear of backlash from union of commercial banks. But
certainly moral suasion is pursued.
Factors affecting monetary policy:
It is not necessary that whatever the monetary policy will be formulated by government or
RBI will have the desired result, it may not have the desired result. It is dependent on other
factors, such as non-institutionalized or scheduled financing sector, structure of businesses and
mechanism use, and existence of investment market.
Bank Rate is dependent on the commercial banks upon the central bank for loans is one of
the factor, if commercial bank have their own surplus funds which they can utilize for high credit
needs, their dependence will be effected by this. It is important to note that in India there is
structure of financing created by Sahukars etc, which reaches to more public, even in remote
areas of the sector. The interest rates followed by this structure of financing is totally unrelated.
Open market operations are dependant on how the large sector companies are doing in the
market. When money through NSCs goes to RBI, it is presumed to go out of the circular flow of
economy, but when money is invested in PSUs they are considered safe as well as in the market.
If the PSUs and Maha Navratnas Companies are performing good in the economy, the open
market operations would not be launched by the RBI.

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