Context:

India will reclaim its position as the fastest growing major global economy this year, partly propelled by benefits from a new tax system and bolstered by an expected central bank interest rate cut.

Introduction:

  • The Reserve Bank of India (RBI) will announce monetary policy in less than two week’s time.
  • India’s annual retail inflation eased to 1.54 per cent in June, its slowest pace in more than five years, but is expected to begin rising again through to mid-2018.
  • With inflation currently well below its target, the central bank is expected to cut borrowing costs by 25 basis points at its next meeting. It last cut rates, by the same amount, to 6.25 per cent in October 2016
  • Having changed its monetary policy stance to neutral from accommodative at the start of the year, the Reserve Bank of India softened its position on policy in June in view of the sharp drop in retail inflation.
  • Movements in both the Consumer Price Index for all items (CPI) and Wholesale Price Index (WPI) show declines much below the average inflation target of 4%.
  • Low inflation with uncertainty about major output gains over the average growth rate in recent quarters will give relatively low nominal gross domestic product. This could result in lower tax revenues unless one expects sharp growth in the tax base to compensate for the revenue shortfall.

What is Monetary Policy?

  • Monetary policy is the macroeconomic policy laid down by the central bank of country. It involves management of money supply and interest rate and is the demand side economy policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
  • In India, monetary policy is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth.
  • The Reserve Bank of India (RBI) implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, and moral persuasion and through many other instruments.

Following are the main elements of the monetary policy of India:

 

  • It regulates the stocks and the growth rate of money supply.
  • It regulates the entire banking system of the economy.
  • It determines the allocation of loans among different sectors.
  • It provides incentives to promote savings and to raise the savings-income ratio
  • It determines the allocation of loans among different sectors.
  • It provides incentives to promote savings and to raise the savings-income ratio

Types of Monetary Policy

  • Monetary policy is referred to as either being expansionary or contractionary. Expansionary policy is when a monetary authority uses its tools to stimulate the economy. An expansionary policy increases the total supply of money in the economy more rapidly than usual. It usually diminishes the value of the currency, thereby decreasing the exchange rate.
  • The opposite of expansionary monetary policy is contractionary monetary policy, which slows the rate of growth in the money supply or even shrinks it. This slows economic growth to prevent inflation. It leads to increased unemployment and depressed borrowing and spending by consumer and businesses, which can eventually result in an economic recession.

Tools of Monetary Policy: Traditional tools:

The Reserve bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and bank’s reserves on deposit at the central bank. Central banks have three main tools of monetary policy:

  1. Open Market operations: This is the most commonly used tool by which the central bank can affect the monetary base. This entails managing the quality of money in circulation through the buying and selling of various financial instruments such as treasury bills, company bonds, or foreign currencies, in exchange for money on deposit at the central bank.
  2. The discount rate: Central bank can lower the interest rate it charges on discounts or overdraft. If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy.
  3. The reserve requirements. It refers to the proportion of total assets that banks must keep on hand overnight either in its vaults or at the central bank. Lowering the reserve requirement frees up funds for banks to increase loans or buy other profitable assets.

Objectives of monetary policy in India:

  • To Regulate Money Supply in the Economy:

Money supply includes both money in circulation and credit creation by banks. Monetary policy is farmed to regulate the money supply in the economy by credit expansion or credit contraction. By credit expansion, the money supply can be expanded. By credit contraction, money supply can be decreased.

  • To Attain Price Stability:

It implies Control over inflation. Price level, is affected by money supply. Monetary policy regulates money supply to maintain price stability.

  • To promote Economic Growth:

An important objective of monetary policy is to make available necessary supply of money and credit for the economic growth of the country. Those sectors which are quite significant for the economic growth are provided with adequate availability of credit.

  • To Promote saving and Investment:

By regulating the rate of interest and checking inflation, monetary policy promotes saving and investment. Higher rates of interest promote saving and investment.

  • To Control Business Cycles:

Boom and depression are the main phases of business cycle. Monetary policy puts a check on boom and depression. In period of boom, credit is contracted, so as to reduce money supply and thus check inflation. In period of depression, credit is expanded, so as to increase money supply and thus promote aggregate demand in the economy.

  • To Promote Exports and Substitute Imports:

By providing concessional loans to export oriented and import substitution units, monetary policy encourages such industries and thus help to improve the position of balance of payments.

  • To Manage Aggregate Demand:

Monetary authority tries to keep the aggregate demand in balance with aggregate supply of goods and services. If aggregate demand is to be increased than credit is expanded and the interest rate is lowered down. Because of low interest rate, more people take loan to buy goods and services and hence aggregate demand increases and vice-verse.

  • To Ensure more Credit for Priority Sector:

Monetary policy aims at providing more funds to priority sector by lowering interest rates for these sectors. Priority sector includes agriculture, small- scale industry, weaker sections of society, etc.

  • To Promote Employment:

By providing concessional loans to productive sectors, small and medium entrepreneurs, special loan schemes for unemployed youth, monetary policy promotes employment.

  • To Develop Infrastructure:

Monetary policy aims at developing infrastructure. It provides concessional funds for developing infrastructure.

  • To Regulate and Expand Banking:

RBI regulates the banking system of the economy. RBI has expanded banking to all parts of the country. Through monetary policy, RBI issues directives to different banks for setting up rural branches for promoting agricultural credit. Besides it, government has also set up cooperative banks and regional rural banks. All this has expanded banking in all parts of the country.

Challenges before monetary authority of India:

  1. Changing Global Economic Environment: An important challenge faced is brought about by the new environment characterized by increased financial globalization.
  2. Multiplicity of goals: There is also multiplicity of goals in the rapidly integrating economies like fixed exchange rate, free capital movement, and an independent monetary policy.
  3. Inelasticity of domestic supply: Limitations of the elasticity of aggregate supply domestically, impose an additional burden on monetary policy particularly in the short-term.
  4. Challenges originating from other sectors: Monetary policy has also to contend with the following challenges originating from other sectors.

(a) Fiscal imbalances remain large by international standards which need to be managed in a non-disruptive manner; (b) The enduring strength of foreign exchange inflows complicates the conduct of monetary policy. In the event of demand pressure building up, increase in interest rates may be advocated to preserve and sustain growth in a non- inflationary manner.

5-Inelasticity of domestic supply: Limitations of the elasticity of aggregate supply domestically, impose an additional burden on monetary policy particularly in the short-term. While open trade has expanded the supply potential of several economies, it does not seem to have had any significant short-term salutary effect on supply elasticities.

Solutions:

  • Fiscal authorities will have to do much more than indulge in excess expenditures.
  • Fiscal authorities could also pursue institutional policies to stimulate demand and match the expected gains in agricultural output on account of favourable monsoons.
  • The government’s institutional policies will have to address the terms of trade issue.
  • Agriculture prices cannot afford to move down further and hamper farmers’ incomes.
  • Prospects of private firms’ profits could improve once demand picks up.
  • If fiscal stimulus edges up prices somewhat, the pressure on the external value of the rupee which has already had an impact on exports to a noticeable extent, could soften.

Conclusion:

The world has changed immeasurably, and continues to.

Print Friendly, PDF & Email

Did you like what you read?

Enter your email address below to get all our updates in your inbox the moment it is published. Once you enter your email address, you will be subscribed immediately.


We do not spam you, so you can easily unsubscribe anytime, by clicking on unsubscribe link in the email.