A well-sound economy is always backed by well-sound monetary policy. Instruments of Monetary policy are considered the backbone or engine of the economy. Monetary policy is controlled by the central bank which reflects or impacts the both micro and macro parameters of the economy.
In this article, we will discuss What is monetary policy, who formulates it, and what are monetary policy tools like repo rate, reverse repo rate, bank rate, CRR, SLR, MSF, etc.
► What is Monetary Policy?
Monetary policy is the macroeconomic policy of a nation that is laid down by the central bank of that nation. It contains the set of tools and activities that involve the management of the money supply, inflation, interest rate, and growth rate of an economy.
Monetary policy very is a crucial role in economic prosperity and welfare, employment generation, demand expenditure, and most importantly stability of the currency.
All the monetary policy tools are wisely used by the central bank because any change in interest rate will significantly impact the short-term supply of money in the economy and help in controlling the inflation rate.
◉ Monetary Policy in India
Monetary policy in India is formulated by Monetary Policy Committee (MPC). MPC was constituted in 2016 as a statutory body under the RBI Act 1934.
Currently, the monetary policy of India is undertaken in accordance with Monetary Policy Committee Framework Agreement (MFPA) Act 2015.
The monetary Policy Committee consists of 6 Members
RBI governor as chairman, RBI Deputy Governor, RBI member, and 3 other members appointed by the central government. MPC meets four times a year or every three months.
Objectives of Monetary Policy Price Stability Boost Economic Growth Equal income Distribution Stable Exchange Rate Inflation Control Better Standard of Living Balance of Payment (BOP) Promote Export and substitute imports
Also Read : Objectives of Monetary Policy
► Instrument of Monetary Policy
Monetary policy instruments are divided into two categories that are as follows;
- Quantitative Instruments
- Qualitative Instruments
1. Quantitative Instrument
- Repo Rate
- Reserve Rate
- Standing Liquidity Ratio
- Marginal Standing Facility
- Bank Rate
- Open Market Operation
2. Qualitative Instrument
- Credit Rationing
- Margin Requirement
- Moral Suasion
- Direct Action
► 1. Quantitative Instruments of Monetary Policy
The quantitative instruments are general tools that are related to the interest rates set by the RBI (Reserve Bank of India).
Quantitative instruments are related to the quantity and volume of money. It is designed to control the total volume/money of the bank credit in the economy of the nation.
✔ Repo Rate
Repo rate refers to the interest rate at which RBI provide loan to banks and banks submit their government securities to RBI as collateral.
Repo Rates are of many types
- Overnight Repo Auction
- Variable auction Repo
- Terms Repo – 7 days, 14 days, 21 days, 28days, 56 days
✔ Reserve Repo Rate
The reverse repo rate is the rate at which the RBI borrows money from commercial banks against collateral of eligible government securities
An increase in the repo rate means RBI wants to decrease the money supply or control inflation.
A decrease in the repo rate means RBI wants to increase the money supply.
✔ Standing Liquidity Ratio
SLR refers to the percentage of total deposits of a bank to keep with itself in the form of liquid assets such as cash, gold, government securities such as T-Bills, Dated Securities, etc.
If RBI increases the SLR then a higher proportion of funds is to be kept aside by banks hence it decreases the lending power of the bank rate which results in a high-interest rate, therefore, the money supply will decrease.
✔ Marginal Standing Facility
It is a tool through which banks can borrow from the RBI but banks can pledge securities held for SLR purposes and for using the MSL facility RBI charge a higher rate of interest to the bank than the repo rate.
✔ Bank Rate
The bank rate is a rate at which RBI provides long-term borrowings to not only banks but also state governments, financial institutions, cooperative banks, etc.
Any increase in bank rate by RBI will make borrowing from RBI expensive hence money supply will decrease
✔ Open Market Operation
OMO is a monetary tool that is frequently used by RBI in this RBI sale and purchase of government securities from the open market with the aim of influencing liquidity in the economy in the medium term.
► 2. Qualitative Instruments of Monetary Policy
Qualitative instruments are selective instruments of the RBI’s monetary policy. These instruments are used for differentiating between various uses of credit.
For example, many instruments in monetary policy can be used for favoring export over import or essential over non-essential credit supply. Such instruments are as follows;
✔ Credit Rationing
Rationing of credit is a method by which the RBI seeks to limit the maximum amount of loans and advances and, also in certain cases, fix a ceiling for specific categories of loans and advances that will be dispersed by RBI.
✔ Consumer Credit Regulation
RBI can issue rules to set the minimum/maximum level of down payments and periods of payments for the purchase of certain goods.
✔ Margin Requirement
Margin refers to the difference between the Loan and Collateral value. The RBI may lay down different margin requirements for different categories of loans (Vehicle, Home, Business, etc) to control credit to different sectors.
✔ Moral Suasion
Is a milder form of credit control in which the RBI can persuade commercial banks to cooperate with the general monetary policy.
Since it involves no administrative compulsion or threats of punitive action it is a psychological and informal means of selective credit control.
✔ Direct Action
This step is taken by the RBI against banks that don’t fulfill conditions and requirements.