Monetary Policy of RBI

Prof. ISHA JAISWAL

Introduction

Free and unlimited credit creation by the commercial banks may create a serious threat in the economy, and therefore, it becomes necessary to regulate the credit money along with the legal money in the economy.

The central bank is having the authority to regulate the amount of money supply in the economy as and when required.

Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by its control over interest rates in order to maintain price stability and achieve high economic growth.

Monetary policy plays a crucial role in accelerating economic development by influencing the supply and uses of credit, combating inflation and maintaining balance of payments equilibrium.

Objectives or goals of the Monetary Policy

1. To maintain stability in the internal price level.2. To maintain stability in the exchange rate.3. To eliminate or to reduce the vagaries of business cycles by

controlling and regulating the supply of credit.4. To maximize income, employment and output in the economy.5. To meet financial requirements of the economy not only during

normal times but also during the emergency or war.6. To promote economic growth by providing finance for economic

development.

Objectives or goals of the Monetary Policy…..7.Monetary policy promotes capital formation by creating

conditions necessary to stimulate savings and investment.8. The existence of the unorganized sector reduces the effectiveness

of monetary policy. The aim of the monetary policy, therefore should be to co-ordinate the activities of different institutions working in the money market and bring about a well-integrated money market.

9. Greater equality in the distribution of income and wealth.

Targets of Monetary Policy

Money supply Bank credit Interest rates

Indicators of Monetary Policy

High powered money Money supply Bank credit Interest rates

Instruments of Monetary policy/Credit ControlA. General Methods / Quantitative methods of Credit Control1. Bank Rate Policy2. Open Market Operations3. Variation in Reserve Ratio

B. Selective Methods / Qualitative methods of Credit Control1. Fixation of Margin Requirements2. Consumer Credit Regulation3. Issue of Directives4. Rationing of Credit5. Publicity6. Direct Action

Quantitative and qualitative instruments Quantitative instruments are concerned with the

controlling and regulating the total volume of credit in the economy. It affect all the sectors of the economy.

Qualitative methods can be applied and used only for those sectors of the economy where it is most needed and can be withdrawn once the situation becomes normal.

A. General or Quantitative methods

1.Bank Rate Policy The rate at which the central bank is willing to discount the first class bills of exchange of the commercial banks is known as the Bank Rate.

In some countries it is also known as Discounting Rate.

The rate at which general public is given loans and advances and the bills of general public is discounted is known as market rate or Interest rate.

Bank rate…… When the commercial banks are continuously granting loans and

advances to the businessmen, then central bank may not treat this as good for Economy.

Now to control the lending activities of commercial banks, their capacity of lending must be reduced.

In the situation of Inflationary pressures, the RBI tends to increase the Bank rate.

This will increase the cost of discounting the bills to commercial banks.

The lending activity will be reduced by the commercial banks and therefore, the total supply of money in the economy will also reduce.

The reduction in the supply of money will also reduces the inflationary pressures.

On the contrary, reduction in the bank rate will have just the opposite effect.

Lowering of the bank rate will imply that commercial banks can borrow at a cheaper rate from the central bank and therefore, they too will reduce their lending rates.

This will make bank credit cheaper and encourages producers and traders to borrow and invest.

The level of economic activity will increase resulting in an general price level.

This will offset the deflationary pressures.

Bank rate:……

Bank rate:…… Limitations of the bank rate policy:1. Commercial banks may not raise their lending rates due to heavy surplus

cash.

2. In the optimistic atmosphere of inflation, the demand for credit by businessmen will be inelastic.

3. It makes credit costly for productive purposes and speculative demand may increase.

4. Lack of well developed and well organized money market, lack of banking habits etc. in underdeveloped and developing economies makes the bank rate policy ineffective.

5. Insensitivity towards the rate of interest, as it is a very small part of the cost of production.

6. Non banking financial intermediaries are not affected.

2. Open market operations Open market operation simply imply the purchase or sale by the

central bank of any kind of eligible paper like government securities or any other public securities or trade bills, etc.

When the central bank sells securities in the open market, other thing being equal, the cash reserve of the commercial banks decreases to the extent that they purchase these securities.

By this way the central bank can also reduce the amount of consumers deposits with commercial banks to the extent that these consumers acquire the securities sold by the central bank.

Open market operations…..

The sell of securities by the central bank in the open market ultimately contracts the credit in the economy.

Conversely, when the central bank purchases the securities from the commercial banks and general public, the credit expands up to the extent that they have sold their securities to the central bank.

In this way the central bank can either expand or contract the quantity of money in the economy and can control the deflationary or Inflationary pressures in the economy.

Limitations of the open market operation:1. Lack of well-developed securities market.2. Contradiction between bank rate and open market operation.3. Restricted dealings. (central bank have to be ready to incur

loses, and that’s why this measure is generally adopted for short run only to avoid the huge loses.)

4. Sale of securities by RBI may lead to an increase in the cash reserves with the commercial banks, but this does not mean that it would invariably lead to credit expansion.

Open market operations…..

3. Variations in Reserve Ratio: The commercial banks are required to keep a certain

proportion of their total demand and time liabilities as cash reserve with the central bank.

The central bank is also having a power to alter the quantum of this reserve according to the needs of the economy.

The increase in the customary reserve ratio leads to credit contraction and a lowering of the ratio leads to credit expansion.

The central bank changes the reserve amount according to the inflationary or deflationary situations of the economy.

Variations in Reserve Ratio……. Limitations of the Variations in the cash reserve ratio:1. This policy does not prove to be effective when the commercial banks happen

to have large cash reserves with them.

2. In times of depression producers and traders are not willing to borrow at any rate.

3. This policy is suitable only when it is desired to effect large changes in the reserves of the commercial banks.

4. Frequent changes in the cash reserve ratio creates a lot of uncertainty for the commercial banks.

5. Determination of bank credit policy: other things are considered at the time of deciding credit policies by the commercial banks.

6. Non-banking financial institutions remains outside its purview.

B. Selective or Qualitative methods:1.Fixation of Margin Requirements:

The practice of margin requirement is generally followed by all the financial institutions dealing in the loans and advances against the securities to the borrowers.

The loan value of the security = the market value of the security – The margin. The central bank is empowered to fix the “margin” and thereby fix the maximum

amount which the purchaser of security may borrow against that security. Effective enough without affecting actual credit capacity. To check the effect of inflation in certain spots of the economy without affecting

the Macro economic phenomenon. Diversified margins can be set for different loans. Easily administered.

2.Consumer Credit Regulation: This includes the laying down of rules regarding; Minimum down payments Minimum amount of installment Maximum period of payment, etc For certain type of consumer durable goods. This tool is extremely useful supplementary tool for controlling inflation

and maintaining economic stability. There is a problem of administration in developing countries like India.

3.Issue of Directives: The central bank is having the authority to issue some directions related to

the credit facilities provided by the commercial banks in the economy. The directives can be oral or written, statements, appeals or warnings, to the

financial institutions. The effectiveness of the “Directives” depends on the prestige of the central

bank. More successful in Branch banking as compared to Unit Banking System. But it is difficult to examine the effects of these Directives.

4.Rationing of Credit: The central bank may control or regulate the purposes for which the

credit is to be granted or not and up to which limit. It secure the diversion of financial resources in to the desired

channels of public authority in furtherance of the objectives of planning.

Credit rationing can be done in two ways:

a) Variable portfolio ceiling

b) Variable capital asset ratio. This method is justifiable in totalitarian economy as it expands

the responsibilities of the central bank.

5. Publicity: This includes request made by the central banks to the commercial

banks to co-operate with the general monetary policies of the central bank.

Central bank can also request the commercial banks for not to involve herself in any speculative finance of non essential activities.

This can secure good results only I the case of good cooperation by the commercial banks as there is no compulsion or threat on punitive actions.

This method is more suitable in expansion of credits rather contraction of credits.

6.Direct Action: This is the most extensively used selective method for credit control by the

central bank. These direct actions may be:

a) Refusing to rediscounting of bills to commercial banks.

b) Refusal of more credits to the banks who have already borrowed in excess to their reserves.

c) Charging penal interest rates on the credit demand over and above the prescribed limit.

It may affect the positive activities of the commercial banks. It is difficult to channelize the credits by the commercial banks. Its is not easy to demarcate the essential and non essential uses of the

credits.

Objectives of the Selective/Qualitative methods

1. To diversify the credits towards the more productive uses.2. To discourage excessive consumer demand for certain goods.3. To eliminate the limitations of the quantitative methods and to control all

types of credits. 4. To control a particular sector of the economy which shows undesirable

trends, without affecting the economy as a whole.5. To correct an unfavorable balance payment. This is sought to be done by

providing cheaper credit to export industries and by raising the discount rate on import bills.

Limitations of the Selective/Qualitative methods

1. The selective methods too excludes the non financial institutions.

2. The qualitative credit control can not be materialized in the real sense as the commercial banks can not watch over the utilization of the loans it has granted.

3. Commercial banks are having the profit motives at the centre, and that is why they may mischief by manipulating the accounts and sanctioning loans for forbidden uses.

4. If traders and businessmen decide to rely less on bank credit for carrying on their economic activities and resort more to trade credit, the efficiency of selective credit controls gets weakened to that extent.

Thank You

Types of Qualitative Instruments of Credit Control: Under the policy of moral persuasion the RBI

sends request letters to commercial banks in the form of ‘dos’ and ‘don’t dos’ to persuade banks to deliberately pursue certain policies as per RBI’s instructions.

Under the policy of margin over loans, RBI increases or decreases the margin to be maintained in the matter of sanctioning loans to various industries and uses of bank money.

The weapon of publicity is also used to prevent misbehaving commercial banks, not operating according to the norms of sound banking. RBI publishes the balance sheets, figures of deposit, lending and knowledge of the general public. This would expose banks to public scrutiny and deter from violating banking rules and norms.

RBI charges penalty interest from such non-co-operating banks to pressurize them to act in tune with its guidelines in the matters of disbursement of bank credit.