Monetary And Credit Policy

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INTRODUCTION

  • Monetary policy is made by the central bank to manage supply of money to achieve specific goals such as constraining inflation, maintaining an appropriate exchange rate, generating jobs and economic growth.
  • Monetary policy involves changing interest rates, either directly or indirectly through open market operations, setting reserves requirements, or trading in foreign exchange markets.

MONETARY POLICY

  • The use by the central bank of interest rate and other instruments to influence money supply to achieve certain macroeconomic goals is known as monetary policy.
  • Credit policy is part of monetary policy as it deals with how much and at what rate, credit is advanced by the banks.
  • Monetary policy can be expansionary or contractionery.
  • Expansionary policy increases the total supply of money in the economy as in 2008-9 all over the world including India to beat recession and slowdown.
  • And a contractionary policy decreases the total money supply by tightening credit conditions.
  • Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rate, while contractionary policy has the goal of raising interest rates to control inflation.

OBJECTIVES OF MONETARY POLICY:

  • Generating employment
  • Exchange rate stabilization
  • Prices stability
  • Accelerating growth of economy
  • Balancing savings and investment

Historically monetary policy was announced twice a year in a slack season policy (April to September) and a busy season policy (October to march) in accordance’s with agriculture cycle. Initially the reserve bank of India announced all its monetary measures twice a year in a monetary and credit policy.

The Tools available for the central bank to achieve the monetary policy ends are the following:

  • Intervention in the forex market
  • Bank rate
  • Open market operation
  • Moral suasion
  • Bank rate

READY FORWARD CONTRACTS (REPOS)

  • It is a transaction in which two parties agree to sell and repurchase the same security.
  • Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and price.
  • Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price.
  • In India RBI lends on a short term basis to banks on the security of the government bonds (repo). Banks undertake to repurchase the security at a later date over night or few days. RBI charges a repo rate for the money it lends.
  • Reverse Repo rate is when RBI borrows from the market (absorbs excess liquidity) with the sale of securities and repurchase them the next day or after a few days. The rate at which it borrows is called reverse repo rate as it is the reverse of the repo operations. Reverse repo rate 100% basis points (1%) below the repo rate.
  • The repo or reverse repo transaction can only be done at Mumbai and in securities as approved by RBI (treasury bills, central and state govt. securities).
  •  RBI uses repo and reverse repo as an instrument for liquidity adjustment in the system.
  • Repo rate is known as policy rate and is used as signal to the financial system to adjust their lending and borrowings operations. 
  • Reserve bank of India hiked repo rate 13 times between March 2010 and October 2011 before pausing and lowering because inflation was rising.

BANK RATE

  • It is a rate at which RBI lend long term loan to commercial banks.
  • Bank rate is a tool which RBI uses for maintaining money supply.
  • Any revision in bank rate by RBI is a signal to banks to revise deposit rates as well as prime lending rate (PLR is the rate at which bank lend to the bank customers).
  • It is not in use any more.
  • Last time it was set was in 2003 when the 6% rate was fixed. In 2011, the bank rate was aligned with the newly introduced Marginal standing facility.
  • Today it stands at 9% 2012.
  • Bank rate is aligned with marginal standing facility (MSF) rate which in turn is linked to the policy Repo rate. This should be viewed and understood as one time technical adjustment to align the bank rate with the MSF rate rather than a change in the monetary policy stances.
  • The bank rate has been kept unchanged at 6% since 2003. This was mainly for the reason that monetary policy signaling was done through changes in the repo. The bank rate acts as the penal rate charged on banks for shortfalls in meeting their service requirements (Cash reserve ratio and statutory liquidity ratio).

Marginal standing facility

  • In 2011 RBI introduced the marginal standing facility as a window through which commercial banks can borrow from the RBI at a rate that is 1% more than the repo rate.
  • It is meant to ease liquidity in the market.
  • Banks can use the repo route for the securities over and about the mandatory SLR Holdings 24% of bank deposits.
  • MSF is open to the banks that want to borrow from the RBI even if the credit is costlier by a percentage point.
  • MSF can be availed with security above the 24% SLR limit or even below.
  • Totally 1% of the value of deposits is the limit for the MSF window for each bank. It was raised to 2% in 2012.
  • The aim is liquidity in a graded manner. It has in monetary transmission also.
  • MSF is the penal rate because the repo limit is exhausted and also because the SLR limit is breached. Bank rate is also a penal rate for breaching the SLR and CRR limits. Therefore there is a need to bring bank rate on par with the MSF as was done by the RBI 2011 -12.
  • MSF window also has become necessary because the repo operations are limited to a specific period during the day.

Liquidity adjustment facility
Liquidity adjustment facility (LAF) was introduced by RBI in 2000. Funds under liquidity adjustment facility are used by the banks for their day to day mismatches in liquidity. LAF covers credit at repo and reverse repo rates.

Reserve requirements
In economics fraction reserve banking is the near universal practice of banks in which banks keep a fraction of the total deposits managed by a bank as reserves that are not to be lent. The reserve ratios are periodic really changed by the RBI. The reserve requirement is a bank regulation that sets the minimum reserves each bank must hold as a part of the deposits. These reserves are designed to satisfy various needs like providing loans to the government (SLR) kept with themselves or cash that is kept with the RBI.

Statutory liquidity ratio (SLR)

  • It is the portion of time(fixed deposits) and demand liabilities (savings bank and current accounts) of banks that they should keep in the form of designated liquid assets like government securities and other RBI approved securities like public sector bonds, current account balance with other banks and gold. SLR aims at ensuring that the need for government funds is partly but surely meet by the banks.SLR was progressively brought down from 38.5% in 1991 24% in 2012.
  • Banks need more liquidity to lend at lower rates in the current economic downturn. Therefore RBI reduced the SLR by 1% to 24% temporarily after the global financial crisis erupted and it was restored to 25% 2009. But in 2010 it was lowered to 24% to argument liquidity in a growing economy. SLR is a blunt instrument and was unchanged for more than decade and half is the Lehman induced global financial and economic crisis of 2008.
  • The reserve bank of India act 1934 and the banking regulation act 1949 fixed the floor and cap On SLR 25% and 40% respectively. But the amendment made in these statutes in 2007 removed the lower limits but retained the cap and 40%. RBI has as a result the freedom to that reduce the SLR to any rate depending on the macro economic conditions. The amendment was an enabling one.

Cash reserve ratio

  • Cash Reserve ratio (CRR) is a monitoring tool to regulate money supply. It is the portion of the bank deposits that a bank should keep with the RBI in cash form. CRR deposits earn to interest. The reserve bank of India act 1934 and the banking regulation act 1949 fixed the floor and cap On CRR 3% and 20% respectively. But the amendment made in these statutes in 2007 removed the limits lower and upper. RBI had as a result greater operational flexibility to make its monetary adjustments.
  • CRR is adjusted to manage liquidity and inflation. The more the CRR the less the money available for lending by the banks players in the economy. CRR was 15% in 1991 and today it is 4.75% 2012.

Open market operations of RBI
OMSs of the RBI can be described as outright purchase sale of government securities in the open market (open market essentially means banks and financial institutions) by the RBI in order to influence the volume of money and credit in the economy. Purchases of government securities inject money into the market and thus expand credit.

Selective credit controls
Certain businesses can be given more and certain other May get less credit from banks on the order of the RBI. Thus selective credit controls can be imposed for meeting various goals like discouraging hoarding and black marketing of certain essential commodities by traders etc by giving less credit.

Moral suasion
A persuasion measures used by Central bank to influence and pressure, but not force banks into adhering to policy. Measures uses are closed door meeting with bank directors, increased severity of inspections, discussions on appeals to community spirit etc.

The growing importance of monetary policy
Democratically elected governments resist using fiscal policy to fight inflation as it requires government to take unpopular actions like reducing spending or raising taxes. Political realities favor a bigger role for monetary policy during times of inflation. Fiscal policy may be more suited to fighting unemployment as the government can set up spending to credit public works and in the process jobs, while monetary policy may be more effective in fighting inflation. There is a limit to how much monetary policy can do to help the economy during a period of severe economic crisis.

Market stabilization bonds
In 2004 RBI began floating government securities and T-bills, as part of market stabilization scheme, to absorb excess liquidity from the market. The excess liquidity is the result of RBI buying dollars from the market.

Developing countries and monetary policy
Developing countries have problems operating monetary policy effectively. The primary difficulty is that fiscal policy of the government set priorities and the Central bank is not actively involved in decisions related to money supply through borrowings.

Interest rates and their significance
Interest rates the rates offered to money that is deposited in the banks, rates offered for investment in bonds, rates at which money is borrowed from banks and financial institutions, and rates charged from the borrowers, etc.
The determinants of interest rate are as follows

  • Inflation-the higher the inflation, the higher the interest rates because the same money invested in commodities and other assets should not fetch  more because of the inflation
  • Global trends as we need to retain foreign fund.
  • Need to generate demand- interest rates, come down consumer demand for credit goes up and there will be a stimulus for growth.
  • Governments need to borrow- the magnitude of governments borrowing programme also determines interest rates. The more the borrowing, the higher the interest rates.
  • Promotion of savings
  • need for growth- lower interest rates reduced cost of credit and facilitate investment for growth
  • promotion of savings

Floating and flexible rates of interest

  • There are two types of interest rates, fixed and floating. (Note: Fixed rate of interest means an interest rate which is fixed & static & not going to change. Floating rate of interest means an interest rate that is allowed to change itself according to market situations.)
  • Floating interest rates are linked to an underlying benchmark rate.
  • In other words the interest rate offered floats in relation to the interest rate of a government security instrument of similar maturity (5 years on 10 years maturity) as determined by the market.

Inflation targeting
Under this policy approach the target is to keep inflation in a particular range or at a particular level. Government and RBI agree on convergence between the fiscal and the monetary policies to achieve the common foal. RBI is given autonomy to manage inflation while the government agrees to have a fiscal policy that will contribute to price stability for example not borrow excessively etc. India does not follow it.

Reserve bank of India
The Central bank of the country is the reserve bank of India (RBI). It was established in 1935 with a share capital of Rs 5 crore on the basis of the recommendations of the Hilton Young commission. RBI was nationalized in the year 1949. The reserve bank of India act 1934 come into effect in 1935.

Functions

  • RBI has sold right to issue bank notes of all denominations.
  • RBI should maintain gold and foreign exchange reserves of Rs.200 crore of which are Rs.115 crore should be in gold.
  • RBI can prints notes according to the need of the economy.
  • RBI acts as government banker, agent and adviser.
  • It is the controller of credit that is it has the power to influence the volume of credit created by  banks in India
  • RBI functions as national clearing house.
  • Custodial of foreign reserves.

Supervisory functions

  • Control the nonbanking finance operations.
  • Ensuring the health of financial system through one site and off-site verifications.
  • Granting license to banks.
  • Implementation of deposit insurance scheme.
  • Periodical review of the work of commercial banks.
  • Inspect and make enquiry or determine position in respect of matters under various sections of RBI and the banking regulation act.
Practice Questions
Q1
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