Monetary Policy – Tools & Objectives
🟠 Topic 47: Monetary Policy – Tools & Objectives
📌 Introduction
Monetary policy is the process by which a central bank (RBI in India) manages money supply, interest rates, and liquidity to achieve specific economic objectives. It plays a crucial role in ensuring price stability, controlling inflation, and fostering economic growth. In India, RBI’s Monetary Policy Committee (MPC) sets the monetary policy stance.
🔹 What is Monetary Policy?
📖 Definition
Monetary policy refers to the regulation of the money supply and interest rates by the central bank to achieve macroeconomic objectives like inflation control, economic growth, employment generation, and external stability.
Key Objectives
| Objective | Explanation |
|---|---|
| Price Stability | Control inflation, ensuring stable purchasing power |
| Economic Growth | Ensure adequate credit flow to productive sectors |
| Employment Generation | Support economic activities that create jobs |
| Exchange Rate Stability | Manage volatility in currency markets |
| Financial Stability | Ensure overall stability of the banking and financial system |
🔹 Legal Framework – RBI Act Amendment (2016)
- Established Monetary Policy Committee (MPC).
- Mandated inflation targeting as primary goal.
- Inflation target: 4% (+/- 2%) under Flexible Inflation Targeting (FIT) framework.
🔹 Types of Monetary Policy
| Type | Explanation |
|---|---|
| Expansionary Policy | Increases money supply to stimulate growth |
| Contractionary Policy | Reduces money supply to control inflation |
🔹 Instruments/Tools of Monetary Policy
1️⃣ Quantitative Tools (Affect Money Supply)
| Tool | Description |
|---|---|
| Repo Rate | Rate at which RBI lends to commercial banks |
| Reverse Repo Rate | Rate at which RBI borrows from banks |
| Cash Reserve Ratio (CRR) | % of deposits banks must maintain with RBI |
| Statutory Liquidity Ratio (SLR) | % of net demand and time liabilities (NDTL) banks must invest in government securities |
| Open Market Operations (OMO) | RBI’s buying and selling of government securities to control liquidity |
2️⃣ Qualitative Tools (Affect Credit Flow)
| Tool | Description |
|---|---|
| Credit Rationing | Directing credit to priority sectors |
| Moral Suasion | Persuading banks to follow desired credit policies |
| Selective Credit Controls | Regulating loans for speculative activities |
🔹 Explanation of Key Tools
Repo Rate
- Key policy rate.
- Lowering repo rate makes borrowing cheaper, boosting investment.
- Raising repo rate makes borrowing expensive, controlling inflation.
Reverse Repo Rate
- Liquidity absorption tool.
- Higher reverse repo rate encourages banks to park surplus funds with RBI.
- Lower rate discourages parking, pushing banks to lend more.
CRR (Cash Reserve Ratio)
- Mandatory reserve maintained with RBI.
- Higher CRR reduces liquidity, lowering lending capacity.
- Lower CRR boosts liquidity, encouraging lending.
SLR (Statutory Liquidity Ratio)
- Ensures banks invest part of deposits in safe government securities.
- Used to control liquidity and ensure financial stability.
Open Market Operations (OMO)
- RBI buys government bonds to inject liquidity.
- RBI sells bonds to absorb excess liquidity.
🔹 Monetary Policy Committee (MPC)
Composition
| Member | Affiliation |
|---|---|
| RBI Governor | Chairperson |
| Deputy Governor (Monetary Policy) | Member |
| 1 RBI Official | Member |
| 3 External Experts | Nominated by Government |
Key Features
- Meets bi-monthly.
- Targets inflation with supporting focus on growth.
- Decisions by majority vote (Governor has casting vote if tied).
Inflation Targeting Framework
| Parameter | Target |
|---|---|
| Inflation Target | 4% |
| Upper Tolerance Limit | 6% |
| Lower Tolerance Limit | 2% |
✅ If inflation breaches limits for 3 consecutive quarters, RBI must explain to the government.
🔹 Transmission of Monetary Policy
- Policy changes (like repo rate cut) influence bank lending rates, impacting: ✔️ Consumer loans (home, vehicle, personal).
✔️ Corporate credit.
✔️ Bond yields.
Factors Affecting Transmission
1️⃣ Bank Health – High NPAs reduce rate cut transmission. 2️⃣ Liquidity in Banking System – Surplus liquidity improves transmission. 3️⃣ Market Sentiment – Business confidence affects investment despite rate cuts.
Case Study – Repo Rate Cuts during COVID-19
- To revive economic activity during COVID-19 lockdown, RBI: ✔️ Cut repo rate to historic lows (4%). ✔️ Provided liquidity support via Targeted Long-Term Repo Operations (TLTRO). ✔️ Offered moratorium on loan repayments.
✅ These steps prevented financial collapse, though economic recovery depended on fiscal stimulus and demand revival.
🔹 Role of RBI in Inflation Control
| Inflation Type | RBI Response |
|---|---|
| Demand-Pull Inflation | Raise repo rate to curb excess demand |
| Cost-Push Inflation | Limited impact – requires supply-side measures |
Example
- During 2022, rising global oil prices triggered imported inflation, limiting RBI’s effectiveness as it cannot control external factors.
🔹 Limitations of Monetary Policy
1️⃣ Lag Effect – Impact on economy takes time (6-12 months).
2️⃣ Supply-Side Inflation – RBI cannot directly address food price shocks, supply disruptions.
3️⃣ Credit Aversion – Even with lower rates, businesses may avoid borrowing during uncertainty.
4️⃣ Global Factors – External shocks (war, pandemic) limit policy effectiveness.
🔹 Coordination with Fiscal Policy
- Monetary Policy (RBI) controls money supply and rates.
- Fiscal Policy (Government) controls taxes, spending, public investment.
✅ Effective coordination ensures:
- Balanced inflation control and growth promotion.
- Complementary policies during crises (like COVID-19).
📚 Practice MCQ
1️⃣ Consider the following statements about Monetary Policy Committee (MPC):
- It is responsible for setting the repo rate.
- It has 6 members including 3 from RBI.
- Its primary goal is to maintain price stability while supporting growth.
Which of the above statements are correct?
✅ Options:
(a) 1 and 2 only
(b) 1 and 3 only
(c) 2 and 3 only
(d) 1, 2, and 3
2️⃣ Which of the following is a qualitative tool of monetary policy?
✅ Options:
(a) Repo Rate
(b) Open Market Operations
(c) Moral Suasion
(d) Statutory Liquidity Ratio
3️⃣ If RBI wants to increase liquidity in the banking system, which of the following steps can it take?
✅ Options:
(a) Increase CRR
(b) Sell government securities in OMO
(c) Lower repo rate
(d) Increase SLR
