Monetary Policy

  • 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 may be expansionary policy, or a contractionary policy.
  • 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 combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation.
  • Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. 

Tools of Monetary Policy: 

Bank Rate

  • Bank rate, also referred to as the discount rate, is the rate of interest which a central bank charges on he loans and advances that it extents to commercial banks and other financial intermediaries.
  • Changes in the bank rate are often used by central banks to control the money supply. However, the role of the bank rate as an instrument of monetary policy has been very limited in India because of these basic factors:

(a) The structure of interest rates was administered by RBI — they are not automatically linked to the bank rate;

(b) Commercial banks enjoy specific refinance facilities, and not necessarily rediscount their eligible securities with RBI at bank rate; and

(c) The bill market is under-developed and the different sub-markets of the money market are not influenced by the bank rate. 

Cash  Reserve Ratio (CRR)

  • The present banking system is called a “fractional reserve banking system’, as the banks are required to keep only a fraction of their deposit liabilities in the form of liquid cash with the central bank for ensuring safety and liquidity of deposits.
  • The Cash Reserve Ratio refers to this liquid cash that banks have to maintain with the Reserve Bank of India (RBI) as a certain percentage of their net demand and time liabilities.
  • CRR is an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. CRR is increased when money supply is increasing and causing an upward pressure on inflation.

Statutory Liquidity Ratio (SLR)

  • Statutory Liquidity Ratio refers to the amount that all banks require maintaining in cash or in the form of Gold or approved securities. Statutory Liquidity Ratio is determined as percentage of net demand and time liabilities.
  • In India, Reserve Bank-of India determines the percentage of Statutory Liquidity Ratio. At present (with effect from 18th Dec 2010), the minimum limit of Statutory Liquidity Ratio set by the RBI is 24 per cent.
  • The main objectives for maintaining the Statutory Liquidity Ratio are the following:
    • Statutory Liquidity Ratio is maintained in order to control the expansion of Bank Credit. By changing the level of Statutory Liquidity Ratio, Reserve bank of India can increase or decrease bank credit expansion.
    • Statutory Liquidity Ratio in a way ensures the solvency of commercial banks.
    • By prescribing Statutory Liquidity Ratio, Reserve Bank of India, in a way, compels the commercial banks to invest in government securities like government bonds.

Market Stabilization Scheme (MSS)

  • MSS was introduced when due to heavy inflow of US dollars by FlIs and purchase thereof by RBI created enormous liquidity.
  • As a response to the large-scale capital inflows and the consequent problems faced in managing liquidity, the Reserve Bank introduced the Market Stabilization after consulting the Government of India for mopping up liquidity of a more enduring nature in March 2004.
  • Under this scheme, the government would issue existing instruments, such as, Treasury Bills and/or dated securities by way of auctions under the MSS, in addition to the normal borrowing requirements, for absorbing liquidity from the system.
  • The intention of MSS is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilization from the day-to-day normal liquidity management operations.

Repo

  • Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive.
  • In case, RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Bank lending rates are determined by the movement of Repo Rate.

Reverse Repo

  • Rate at which banks park their short-term excess liquidity with the RBI. The RBI uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep their money with the RBI.
  • Repo Rate signifies the rate at which liquidity is injected in to the banking system by RBI, whereas reverse repo rate signifies the rate at which the central bank absorbs excess liquidity from the banks.

Open Market Operations (OMO)

  • Under the OMO, the RBI buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system.

Fiscal Policy

The fiscal policy is the policy relating to government expenditure and revenue collection, to influence the economic activity. The two main instruments of fiscal policy are government expenditure and taxation. The change in the level and composition of taxation and government spending can impact the following variables 

  • Aggregate demand and the level of economic activity;
  • The pattern of resource allocation;
  • The distribution of income.

FRBM ACT

  • Introduced on the recommendations of a committee headed by Dr. E.A.S. Sharma and Law was enacted in August 2003.

What the Act Requires

  • It requires the Government to place before Parliament three statements each year along with the Budget, covering Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework.
  • The Act lay down fiscal management principles, making it incumbent on the Centre to ‘reduce the fiscal deficit’ (no target is mentioned in the Act, but the Rules prescribe 3 per cent of GDP) and, more categorically, to ‘eliminate revenue deficit’ by 31 March 2008.
  • The Act requires the government to set a ceiling on guarantees (the Rules prescribe 0.5 per cent of GDP. The ceilings may be exceeded on grounds of “national security or national calamity or such other exceptional grounds as the Central Government may specify.”
  • The Act prohibits the Centre from borrowing from the Reserve Bank of India-that is , it bans ‘deficit financing’ through money creation. The RBI is also barred from subscribing to primary issues of Central Government securities. Temporary Ways and Means advances to tide over cash flow problems are permitted. Exceptions are also allowed whenever the Government declares an exceptional situation.
  • The Finance Minister is required to keep Parliament informed through quarterly reviews on the implementation, and to take corrective measures if the reviews show deviations. The Act provides that no deviation shall be permissible ‘without the approval of Parliament’
  • The main theme of FRBM Act is to reduce the dependence of the Government on borrowing and help to reduce the fiscal deficit in a phased manner.
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