Monetary Policy

Monetary Policy refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit. The main objectives of monetary policy are – Maintaining price stability, ensure adequate flow of credit to the productive sectors to support economic growth and financial stability. However, the relative emphasis among the objectives varies from time to time, depending on evolving macroeconomic developments. The various instruments available to the regulator are as under:

Direct Instruments:

Cash Reserve Ratio (CRR): The share of net demand and time liabilities that banks must maintain as cash balance with the Reserve Bank. The Reserve Bank requires banks to maintain a certain amount of cash in reserve as a percentage of their deposits to ensure that banks have sufficient cash to cover customer withdrawals. At present the stipulated CRR is 4%. Regulator uses CRR for dual purpose as liquidity reserve and as a monetary policy tool. On weekly basis, Banks have to report their daily deposit position and balances with RBI to enable them to monitor maintenance of CRR.

Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as government securities, cash and gold. Banks are advised to invest in securities issued and guaranteed by government known as Statutory Liquidity Ratio (SLR). At present SLR requirement is 19.50% of demand and time liabilities of bank. It is another liquidity cushion. The SLR securities are part of the investment portfolio of the bank. The HTM book primarily consists of SLR investments which have to be held permanently.

Refinance facilities: Sector-specific refinance facilities (e.g., against lending to export sector) provided to banks.

Indirect Instruments:

Liquidity Adjustment Facility (LAF): It is a mechanism for liquidity management through combination of repo operations, export credit refinance facilities and collateralized lending facilities, supported by open market operations of the RBI at set interest rates. RBI manages its liquidity in the market through the operation of LAF as part of its monetary policy and money supply targets. It undertakes reverse repo transactions to mop up liquidity and repos to supply liquidity in the market. The LAF transactions are currently being conducted on overnight basis. Consists of daily infusion or absorption of liquidity on a repurchase basis, through repo (liquidity injection) and reverse repo (liquidity absorption) auction operations, using government securities as collateral.

Repo/Reverse Repo Rate: These rates under the Liquidity Adjustment Facility (LAF) determine the corridor for short-term money market interest rates. In turn, this is expected to trigger movement in other segments of the financial market and the real economy. Repo is a money market instrument, which enables collateralized short term borrowing through sale operations in debt instruments. It is also called a ready forward transaction as it is a means of funding by selling a security held on a spot (ready) basis and repurchasing the same on a forward basis. Generally, repos are done for a period not exceeding 14 days. Repo rate is the rate at which banks borrow rupees from RBI and a reduction in Repo rate helps the banks to get funds at a cheaper rate and increase in Repo rate makes the borrowing more expensive. The present rate is 8%. Reverse Repo is the mirror image of a repo. Under reverse repo, securities are acquired with a simultaneous commitment to resell. Hence whether a transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction. When the reverse repurchase transaction matures, the counter-party returns the security to the entity concerned and receives its cash along with a profit spread. Reverse Repo rate is the rate at which RBI borrows money from banks. An increase in Reverse Repo rate can cause the banks to transfer more funds to RBI and similarly reduction of rate may dampen the interest of the banks to lend to RBI. The present rate is 7%

Open Market Operations (OMO): Outright sales/purchases of government securities, in addition to LAF, as a tool to determine the level of liquidity over the medium term.

Marginal Standing Facility (MSF): was instituted under which scheduled commercial banks can borrow over night at their discretion up to one per cent of their respective NDTL at 100 basis points above the repo rate to provide a safety valve against unanticipated liquidity shocks.

Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. It also signals the medium-term stance of monetary policy. The present rate is 9%.

Market Stabilization Scheme (MSS): This instrument for monetary management was introduced in 2004. Liquidity of a more enduring nature arising from large capital flows is absorbed through sale of short-dated government securities and treasury bills.

In an expansionary monetary policy, money supply increases causing an expansion in aggregate demand through lower interest rates. This stimulates interest sensitive spending on investment for manufacture of goods, housing, export, business etc. and in turn, acting through multiplier leads to a rise in gross domestic product. The reverse process takes place when monetary policy is tightened. However, in a fully employed economy monetary expansion would primarily raise prices and nominal gross domestic product with little effect on real GDP as the higher stock of money would be chasing the same amount of output.

Withdrawal of old series Bank Notes: In a move that is likely to hit currency hoarders and counterfeiters, the Reserve Bank of India (RBI) has decided to withdraw from circulation all currency notes issued prior to 2005. This move is a well thought out exercise by RBI to capture the “money flows’’ into the system and also help flush out counterfeit notes as well as black money. RBI Notes issued after 2005 have added security features that make counterfeiting difficult. Money has value as long as it is a medium of exchange and store of value. It loses its value when it ceases to be a medium of exchange. As per the guidelines, the holders of currency notes prior to 2005 need approach banks for exchange from 1st April 2014 and they continue to be legal tender. However, from 1st July 2014, those wanting to exchange more than 10 pieces of 500 and 1000 rupee notes in a bank where they do not have an account will have to provide proof of residence and identity. With the RBI setting terms for exchange of these notes and income-tax authorities scrutinizing big spends, it will now become that much simpler for the authorities to track these transactions. Banks are advised to stop reissue of older series and these notes are to be sorted and deposited in the Currency Chests under the Linkage scheme or forwarded to the nearest Issue Office of RBI for disposal.

Other concepts:

Hot Money: Money held in one currency that is liable to switch to another currency, in a flash, in response to better returns or in apprehension of adverse circumstances. Such a flight of money might cause the currency’s exchange rate to plunge.

Reserve Money (M0): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities. M1 – Currency with the public + Demand deposits with the banking system + ‘Other’ deposits with the RBI. M2 – M1 + Savings deposits with Post offices. M3 – M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector. M4 – M3 + Deposits with post office (excluding NSCs).

Inflation: It is termed as the continual rise in the general level of prices. It is commonly expressed as an annual percentage rate of change on an index number. Hyper Inflation: An express growth in the rate of inflation whereby, money loses its value to the extent where other mediums of exchange like barter or foreign currency come into vogue.

Stagflation: A condition in the economy that is characterized by the twin economic problems viz., slow economic growth and rising prices.

Deflation: A sustained fall in the general price level of goods and services, usually accompanied by fall in output and jobs.

Recession: A phase of dismal economic activity, usually accompanied by rising unemployment. It is defined by two successive quarters of negative GDP growth and is considered to have a cyclic character. An imminent global recession is likely as signs of dismal economic performance are being witnessed.

Stagnation: It is a period during which economy does not grow or grows very slowly. As a result, unemployment increases and consumer spending slows down.

Devaluation: A fall in the fixed official rate at which one currency is exchanged for another in a fixed exchange rate system. While it is mostly by a deliberate act of government policy, in recent years, financial speculation has also been identified as a responsible factor.

Demonetization: Withdrawal of currency from circulation with an aim to strike at counterfeiting of currency and unaccounted money. In 1978, currency notes of denomination of  1000/-,  5000/- and  10000/- were demonetized.

Arthakranthi is a suggestion which is being widely debated to address the important issues such as rampant corruption and fiscal deficit that are being confronting the country. It suggests abolition of taxes except for Customs and Import duties and introduction of bank transaction tax on receipts. It also suggests currency compression by ensuring that the highest currency denomination is  50/-, which paves the way to adopt banking system extensively and also enables to phase-out fake currency from the system which is the need of the hour. Though, the suggestion appears simple and attractive but needs political will and revamping of entire eco system.