Monetary Policy

India is the management of a nation's money supply to achieve economic goals by a central bank or currency board. Monetary policy objectives can include control of inflation, control of exchange rates, or even simply economic stability. Monetary policy is contrasted with fiscal policy, which aims to achieve economic goals through taxation and government expenditure. The Federal Reserve, or Fed, handles monetary policy in the United States. The Fed controls the money supply through open market operations, and also sets interest rates between banks and reserve requirements. Tight monetary policy, also called contractionary monetary policy, tends to curb inflation by contracting the money supply. Easy monetary policy, also called expansionary monetary policy, tends to encourage growth by expanding the money supply. These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 which indicates the level (stock ) of legal currency in the economy. Besides, the RBI also announces norms for the banking and financial sector and the institutions which are governed by it. These would be banks, financial institutions, non-banking financial institutions, Nidhis and primary dealers (money markets) and dealers in the foreign exchange (forex) market.

When is the Monetary Policy announced?

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September ) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy.

What is Inflation?
Inflation is an increase in the total money stock resulting in a rise in the general level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the

economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer) over time. Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring central banks can adjust nominal (intended to mitigate recessions),] and encouraging investment in non-monetary capital projects.

Operations of monetary policy-Instruments

The RBI has multiple instruments at its command such as repo and reverse repo rates, cash reserve ratio (CRR), statutory liquidity ratio, open market operations, including the market stabilization schemes (MSS) and the liquidity adjustment facility (LAF), special market operations, and sector- specific liquidity facilities.

INSTRUMENTS OF MONETARY POLICY THAT RBI RECENTLY USED TO CONTROL INFLATIONARY TENDENCIES:

1.BANK RATE : Bank Rate is the rate at which central bank of the country (
Bank Rate in India is decided by RBI) allows finance to commercial banks. Bank Rate is a tool, which central bank uses for short-term purposes. Any upward revision in Bank Rate by central bank is an indication that banks should also increase deposit rates as well as Base Rate / Benchmark Prime Lending Rate. Thus any revision in the Bank rate indicates that it is likely that interest rates on your deposits are likely to either go up or go down, and it can also indicate an increase or decrease in your EMI. Bank Rate in India is decided by RBI. This is the rate at

which central bank (RBI) lends money to other banks or financial institutions. If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can said that if bank rate is hiked, in all likelihood, banks will soon hikes their own lending rates to ensure that they continue to make profit. Bank rate is a discount rate and thus technically it should always be more than the Repo Rate. However, for almost 9 years, RBI had not revised this rate as Bank Rate has not been in use. During all these years monetary policy signaling was done through modulations in the reverse repo rate and the repo rate under the Liquidity Adjustment Facility (LAF) (till May 3, 2011) and the policy repo rate under the revised operating procedure of monetary policy (from May 3, 2011 onwards). Moreover, under the revised operating procedure, marginal standing facility (MSF), instituted at 100 basis points above the policy repo rate, has been in operation, which in many ways serves the purpose of the Bank Rate.

However, now RBI realized that by not adjusting regularly the Bank Rate, it has been creating certain anomalies in the system. Bank Rate was still being used for arriving at the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio). Moreover, the Bank Rate continued to be used by several other organizations as a reference rate for indexation purposes.

Therefore, Reserve Bank consulted various organizations/stakeholders relying on the Bank Rate as a reference rate, and based on the feedback received, it i decided that the Bank Rate should normally stay aligned to the MSF rate. Accordingly, it has been decided that with effect from the close of business today (February 13, 2012), the Bank Rate will stand increased by 350 basis points, i.e., from 6.00 per cent per annum to 9.50 per cent per annum. This should be viewed and understood as one-time technical adjustment to align the Bank Rate with the MSF rate rather than a change in the monetary policy stance.

2. CASH RESERVE RATIO: CRR means Cash Reserve Ratio. Banks in

India are required to hold a certain proportion of their deposits in the form of cash. However, actually Banks dont hold these as cash with themselves, but deposit such case with Reserve Bank of India (RBI) / currency chests, which is

considered as equivalent to holding cash with RBI. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. Thus, When a banks deposits increase by Rs100, and if the cash reserve ratio is 6%, the banks will have to hold additional Rs 6 with RBI and Bank will be able to use only Rs 94 for investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be able to use for lending and investment. This power of RBI to reduce the lendable amount by increasing the CRR, makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system. Some non bankers also wrongly use CRR Ratio or CRR Rate instead of Cash Reserve Ratio ). It has been decided to: increase the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 5.75 per cent to 6.0 per cent of their net demand and time liabilities (NDTL) effective the fortnight beginning April 24, 2010. The CRR was 6% (as on 16th Sep 2010). This effectively means that banks have to keep 6% of their Time and Demand Deposits with the RBI. Out of every Rs 100 collected by banks as deposits, Rs 6 will have to be kept aside with the RBI. The RBI does not pay any interest on the CRR money of the banks. In times of high inflation the RBI increases the CRR. When the CRR is increased banks have to set more money aside with the RBI. Due to this banks have less money to lend to borrowers. This sucks out excess liquidity out of the markets. With less money in the financial system, there is less money to lend and less money with people to spend. This brings down the demand for goods and services. Low demand pulls down prices of goods and brings down inflation. RBI has announced reduction in CRR from 6.00% to 5.50% wef 28/01/2012 (announced on 24/01/2012 in the review of the third quarter monetary policy of 2011-12.

3. STATUTORY LIQUIDITY RATIO: SLR stands for Statutory Liquidity

Ratio. This term is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and some other approved securities to liabilities (deposits) It regulates the credit growth in India. Some non bankers also wrongly use SLR ratio or SLR Rate instead of Statutory Liquidity Ratio.

Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restrict the banks leverage position to pump more money into the economy. Presently the SLR is 25%. This effectively means that banks have to keep 25% of their Time and Demand Deposits either in cash or invest it in gold or in government bonds. Out of every Rs 100 collected by banks as deposits, they will have to invest Rs 25 in government bonds. When inflation is high the RBI increases the SLR. Due to this money is removed from the financial system. Banks lend less and the demand for goods and services come down resulting in lower inflation.

When the economy is going through a recession, the RBI lowers the SLR, thereby freeing up more money for banks to lend, which in turns results in higher demand and thereby revives the economy.

4. REPO RATE AND REVERSE REPO RATE: Repo (Repurchase)

rate is the rate at which the RBI lends shot-term money to the banks against securities. When the repo rate increases borrowing from RBI becomes more expensive. Therefore, we can say that 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. Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI. The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns. An increase in the reverse repo rate means that the RBI is ready to borrow money from the banks at a higher rate of interest. As a result, banks would prefer to keep more and more surplus funds with RBI. Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks.

Repo Rate has been decided to: increase the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.0 per cent to 5.25 per cent with immediate effect.

Reverse Repo Rate has been decided to:increase the reverse repo rate under the LAF by 25 basis points from 3.5 per cent to 3.75 per cent with immediate effect. The policy announcements on 03/05/2011, indicates that now repo rate has become the only independent variable policy rate, marking a shift from earlier method of calibrating various policy rates separately. The reverse repo rate -- the rate at which RBI borrows will be kept 100 basis points lower than the repo rate. On the other hand Marginal Standing Facility (MSF) rate will be kept 100 basis points higher than the repo rate.