MONETARY POLICY OF INDIA And how RBI controls Inflation
WHAT IS MONETARY POLICY?
Monetary policy is the process by which the
monetary authority of a country, like the central
bank or currency board, controls the supply of
money, often targeting an inflation rate or interest
rate to ensure price stability and general trust in
the currency.
The Reserve Bank of India (RBI) is vested with the
responsibility of conducting monetary policy.
OBJECTIVES OF THE MONETARY POLICY OF INDIA
Growth with stability
Regulation, Supervision & Development of Financial Stability
Promoting priority sector
Generation of Employment
External Stability
Encouraging Savings and Investments
Regulation of Non Banking Financial Institutions
MONETARY POLICY
IMPLICATIONS
DECISIONS
TOOLS OF MONETARY POLICY
Tools of Monetary Policy
Quantitative Measures Qualitative Measures
Open Variations in Change in
Market Credit Moral Direct
Operations Bank Rate Reserve Rationing Lending Suasion Control
(OMO) Ratios Margin
WHY RBI NEEDS TO CONTROL THE
MONETARY POLICY?
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WHY RBI NEEDS TO CONTROL MONETARY
POLICY?
Initially people used Barter System for trading. But the barter system
had many problems. Therefore, people switched to money system.
So, Financial Intermediates came into the picture.
Financial Intermediaries = Middlemen who help in the circular flow
of money between households and business firms.
There are two types of financial intermediaries: banking institution
and non-banking financial institutions.
• RBI controls (all) banks and (some) non-banking financial
institutions.
• RBI’s main job is to control Money supply in this game, and
thereby fight inflation and deflation.
WHY RBI NEEDS TO CONTROL MONETARY
POLICY?
• Inflation = price rise = bad for economy, you know that by
common sense.
• But Deflation = price decrease = we can buy things at a lower
price. Isn’t that good? Why is deflation bad for economy?
• Every business has ‘fixed cost of production’ say minimum light bill,
phone bill, office rent, staff salary etc. So, if prices keep falling and
falling (say of Nano car), then car marker will suffer losses. He has
no motivation to expand business. He wants to cut down his
production costs, by firing some of the employees= less new jobs
created= unemployment = social unrest.
• If prices of everything fall- then custom duty, VAT, excise duty,
service tax- their collection will also decrease. Then government has
less money to spend on education, healthcare, social sector, defense,
law and order = poverty, disease, crime.
SO, WHAT IS MONETARY POLICY?
• Policy made by the central bank.
• To control money supply in the economy. (and thereby fight both inflation and
deflation).
• RBI implements monetary policy using certain tools. Two types:
• Quantitative tool
• Qualitative tools
Let’s understand what that means…
QUANTITATIVE MEASURES OF
MONETARY POLICY
OPEN MARKET OPERATIONS
Open Market Operations or OMO refers to the purchase and/or sale of short term and long term securities by
the RBI in the open market.
OMO is used to wipe out shortage/excess of Money
in Money Market, to influence the term and structure
of interest rate and to stabilize the market for
government securities.
OPEN MARKET
OPERATIONS
OPEN MARKET OPERATIONS
When RBI sells securities in open market,
commercial banks and public buy it. This
reduces the existing money supply as
money gets transferred from the
Commercial Banks to RBI.
Individuals
RBI
Thus EXCESS
MONEY SUPPLY
Sells reduces
Securities
Controls Inflation
OPEN MARKET OPERATIONS
When RBI buys securities from
commercial banks in open market,
commercial banks sell it and get back
the money they had invested in them,
thereby increasing the existing money
supply.
Individuals
RBI
Buys
Securities
Thus SHORTAGE of
MONEY SUPPLY is
eased
Controls Recession
BANK RATE
Bank Rate or Discount Funds are provided either through
Rate is the MINIMUM lending directly or discounting or
rate at which RBI buying money market instruments
provides loans to the like commercial bills and treasury
Commercial Banks bills.
Pays Interest RBI
Gives Loan
BANK RATE
Bank Rate Increases
= Cost of Borrowing of Commercial Current Bank
Banks Rises Rate of RBI is
= Fall in Credit Volume to Banks 6.75%
= Reduction in Money Supply
Pays Interest RBI
Takes Loan
TEST YOUR KNOWLEDGE!!
Answer the following question:
Which of the following ratios are decided by RBI?
a) Cash Reserve Ratio
b) Statutory Liquidity Ratio
c) Repo and Reverse Repo Rate
d) All of the above
Let’s discuss each one of them in detail: