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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 is referred to as either being an expansionary policy, or a contractionary
policy, where 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 stop unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates in order to stop inflation. Monetary policy is contrasted with fiscal
policy, which refers to government borrowing, spending and taxation.
Monetary policy rests on the relationship between the rates of interest in an economy, that
is the price at which money can be borrowed, and the total supply of money. Monetary policy
uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment. Where currency is
under a monopoly of issuance, or where there is a regulated system of issuing currency through
banks which are tied to a central bank, the monetary authority has the ability to alter the money
supply and thus influence the interest rate.
The beginning of monetary policy as such comes from the late 19th century, where it was
used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size
of the money supply or raises the interest rate. An expansionary policy increases the size of the
money supply, or decreases the interest rate.
Furthermore, monetary policies are described as follows: accommodative, if the interest
rate set by the central monetary authority is intended to create economic growth; neutral, if it is
intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
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On the external front, rupee value has been linked to the market forces. Current account
convertibility was achieved in August 1994. FERA was repealed and replaced by a new
legislation - Foreign Exchange Management Act (FEMA), in 1999. Further, the Exchange
Control Department of the Reserve Bank was renamed as Foreign Exchange Department.
Besides, a large number of innovative products and newer players have come to play active role
and new hedging instruments have been introduced, viz., foreign currency-rupee options, etc.
Authorized dealers could use cross-currency options, interest rate and currency swaps,
caps/collars and forward rate agreements (FRAs) in the international forex market.
In the context of monetary policy framework, there has been a greater focus on liquidity
management engendered by the growing integration of financial markets, domestically and
internationally. With the near total deregulation of interest rates, the Bank Rate has been
reactivated since April 1997 as a reference rate and as a signaling device to reflect the stance of
monetary policy. Following the recommendations of the Working Group on Money Supply:
Analytics and Methodology of Compilation (Chairman: Y. V. Reddy), the Reserve Bank has
commenced compilation and publication of four monetary aggregates [M0 (monetary base), M1
(narrow money), M2 and M3 (broad money)]; and introduced three new liquidity aggregates (L1,
L2 and L3) by incorporating deposits with post- office savings banks, term deposits, term
borrowings and certificates of deposits of term lending and refinancing institutions and public
deposits of non-banking financial institutions; broadening of the definition of credit by including
items not reflected in the conventional bank credit; redefining the net foreign assets of the
banking system to comprise banks holdings of foreign currency assets net of (a) their holdings of
FCNR(B) deposits and (b) foreign currency borrowings.
With the liberalization of the external sector, the monetary targeting framework came
under stress due to increasing liquidity mainly on account of increased capital inflows,
necessitating a review of the monetary policy framework and the Reserve Bank switched over to
a more broad-based "multiple indicators approach" since 1998 in monetary policy formulation.
The informal monetary policy strategy meetings review the monetary and liquidity conditions
and the process has been made consultative. The Financial Markets Committee (FMC) monitors
the developments in financial markets on a daily basis.
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Monetary and credit aggregates have witnessed deceleration since their peak levels in
October 2008. The liquidity overhang emanating from the earlier surge in capital inflows has
substantially moderated in 2008-09. The Reserve Bank is committed to providing ample liquidity
for all productive activities on a continuous basis.
In its mid- term review of monetary policy on October 24, 2008, the Reserve Bank had
indicated that it would closely and continuously monitor the liquidity and monetary situation and
respond swiftly and effectively to the impact of the global developments on Indian financial
markets. The Reserve Bank had also indicated that the challenge for the conduct of monetary
policy is to strike an optimal balance among preserving financial stability, maintaining price
stability and sustaining the growth momentum.
In response to emerging global developments, the Reserve Bank has taken a number of
measures since mid-September 2008. The aim of these measures was to augment domestic and
forex liquidity and to enable banks to continue to lend for productive purpose while maintaining
credit quality so as to sustain the growth momentum.
On a further review of the evolving developments, the Reserve Bank has taken the
following measures:
Enhancing Rupee Liquidity
The special term repo facility, introduced for the purpose of meeting the liquidity
requirements of mutual funds and non-banking finance companies would continue till end-march
2009. Banks can avail of this facility either on incremental or on rollover basis within their
entitlement of up to 1.5 per cent of net demand and time liabilities.
As the upside risks to inflation have declined, monetary policy has been responding to
slackening economic growth in the context of significant global stress. Accordingly, for policy
purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,
aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. The
growth in adjusted non-food credit, including investment in bonds/debentures/shares of public
sector undertakings and private corporate sector and CPs, is placed at 20.0 per cent.
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Interest Rates:
The bank rate is the minimum rate at which the central bank of a country as a lender of
last resort is prepared to give credits to the commercial banks. The increase in bank rate
increases the rate of interest and credit becomes dear. Accordingly, the demand for credit is
reduced and thus money power or purchasing power is reduced. This course of action is under
contractionary policy to handle inflation. On the other hand, decrease in the bank rate lowers the
market rate of interest charged by the commercial banks from their borrowers. Credit becomes
cheap and money becomes easily available to spend and thus demand in the economy for goods
and services increases and controls deflationary situation. Bank rate is the minimum rate. The
related interest rates which are controlled by the RBI is Repo Rate and Reverse Repo Rate.
Repo Rate
Repo Rate is the current rate, not the minimum rate. Funds are taken by the commercial
banks on the Repo Rate for overnight and fortnight requirements to maintain mandatory cash
reserves. The effect and operation of Repo Rate is same as Bank Rate in regard the monetary
policy. Effect of Repo Rate is generally not shifted to the public in general, it is absorbed, but as
it is dependent on Bank Rate, and Bank Rate is shifted to public through primary function of
advancing loan of the commercial banks.
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Cash Balances are high powered money on the basis of which commercial banks create
credit. Thus, through open market operations, if cash balances are increased, flow of credit will
increase many times more, and if cash balances are reduced, the flow of credit will decrease
many times more. Open Market Operations affects the quantity of money supply also by
increasing and decreasing VM (Velocity of Money), which is multiplier while calculating money
supply.
The above discussed were the quantitative measures of monetary policy. Sometimes, just
controlling the money supply or increasing supply does not result in price stability. The problem
with the monetary supply is that they cannot achieve price stability, if the inflation is in one
particular sector or part of the economy. It cannot do anything if one bank is not following the
guidelines, sometimes there have to be harsh actions taken by central bank.
QUALITATIVE CANTROL
Margin Requirements:
The margin requirement of loan refers to the difference between the current value of the
security offered for loans and the value of loans granted. Suppose, a person mortgages an article
worth ` 100 with bank and bank gives him loan of ` 70. In this case, 30 % is the margin
requirement. If the margin requirement is increased, it will decrease the availability of credit to a
person. If the margin requirement is decrease, it will enable this person to get more loan for his
assets value worth ` 100.
Rationing of Credit:
Rationing of credit refers to fixation of credit quotas for different business activities.
Rationing of credit is introduced when the flow of credit is to be checked particularly for
speculative activities in the economy. The central bank fixes credit quota for different business
activities. The commercial banks cannot exceed the quota limits while granting loans.
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