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- GS 3 || Economy || Banking & Financial Sector || RBI
Why in the news?
Reserve Bank of India (RBI) has announced the key monetary policy decision recently amid a surge in coronavirus cases and imposition of new restrictions to curtail the second wave of COVID-19 in India.
What is Monetary Policy?
- Monetary policy is the macroeconomic policy laid down by the central bank.
- It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
Monetary Policy Vs Fiscal Policy: The Difference
- Monetary policy and Fiscal policy both are broad macroeconomic tools to achieve the national socio-economic goals. However, there is a difference between both.
- While Monetary policy involves changing the interest rate and influencing the money supply, fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.
- Also, while monetary policy is operated by RBI in consultation with the government, fiscal policy is almost exclusively dealt by the Ministry of Finance.
- They are both used to pursue policies of higher economic growth or controlling inflation.
Monterey Policy in India
- The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy in India. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.
- The monetary policy of the Reserve Bank of India 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 RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments.
Objectives of Monetary Policy in India: Growth vs Price Stability?
- There has been endless debate over ‘growth vs price stability’ as the main objective of the monetary policy of the RBI.
- In its official version, the RBI has considered the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.
- Further, according to the RBI, Price stability is a necessary precondition to sustainable growth.
- In 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
- The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.
- Accordingly, the Central Government has notified 4% Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6% and the lower tolerance limit of 2%
- The Central Government notified the following as factors that constitute failure to achieve the inflation target:
- the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or
- the average inflation is less than the lower tolerance level for any three consecutive quarters.
- Prior to the amendment in the RBI Act in 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India.
Inflation Targeting and New Monetary Policy Framework (2016):
There were significant reforms introduced in the functioning of RBI in 2016. ‘Inflation Targeting (IT)’ was made the statutory goal of the RBI and a new ‘Monetary Policy Framework’ came into existence with some institutional changes.
What is ‘Inflation Targeting’?
- A central banking policy that revolves around meeting preset, publicly displayed targets for the annual rate of inflation. The benchmark used for inflation targeting is typically a price index of a basket of consumer goods, such as the Consumer Price Index (CPI).
Rationale For IT
- Reduce impact of inflationary shocks and the associated costs
- Targeting a low rate of inflation would lead to a more stable and lower long term rate of interest.
Monetary Policy Framework:
- Under inflation targeting, the RBI will target a fixed rate of CPI inflation — between 2 and 6%
- There would be a six-members Monetary Policy Committee (MPC) with representatives from RBI as well as the government to take key monetary decisions.
- The RBI will publish the operating targets as well as an operating procedure through which the target will be reached.
- The central bank will also prepare a document every six months explaining the sources of inflation and the forecast for the next six months.
Monetary Policy Committee (MPC):
Under the amended RBI Act, the monetary policy making is determined by the Monetary Policy Committee (MPC). It was introduced by an amendment in the RBI Act (amendment) 2016.
- The MPC is required to meet at least four times in a year.
- The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India.
- The committee comprises six members – three officials of the Reserve Bank of India and three external members nominated by the Government of India.
- The quorum for the meeting of the MPC is four members.
- Each member of the MPC has one vote, and in the event of an equality of votes, the Governor has a second or casting vote.
- The resolution adopted by the MPC is published after the conclusion of every meeting of the MPC.
- Once in every six months, the Reserve Bank is required to publish a document called the Monetary Policy Report to explain:
- the sources of inflation and
- the forecast of inflation for 6-18 months ahead.
- Governor of the Reserve Bank of India (RBI) is the ex-officio chairman of MPC.
Limitations of Monetary Policy in India:
The monetary policy is more of a formal tool to help the economy achieve its objective vis-a-vis balancing inflation, economic growth and price stability. In practice, unlike developed countries where financial institutions are more formal and well developed, the monetary policy in India often takes a long time to reflect the results on ground.
- Poor Monterey transmission: The reflection of the changes done by RBI in key policy rates such as Repo, Reverse Repo etc. on the common market is called ‘monetary transmission’. In India, the process of monetary policy transmission is rather inefficient. At no time in the past has monetary transmission been better than 50%.
- Undeveloped Money and Capital Markets: The money and capital markets are undeveloped. These markets lack in bills, stocks and shares which limit the success of monetary policy.
- Existence of Unregulated NBFCs: Non-bank financial intermediaries like the indigenous bankers operate on a large scale in such countries but they are not under the control of the monetary authority. The factor limits the effectiveness of monetary policy in such countries.
- High Liquidity with the banks: The majority of commercial banks in India possess high liquidity so that they are not influenced by the credit policy of the central bank.
- Unorganised sector: In India, a large section of economy runs in unorganised sector lacking formal transactions. This unaccounted monetary cash transactions also hampers the efficiency of the monetary policy.
- Monetary Policy Vs Fiscal Policy: High fiscal deficit leads to more market borrowing by the governments. This results in crowding out of the private investment. Also, government-determined purchase prices of agri-commodities, government subsidy levels on fuels and imperfections in agricultural markets, hinders the functioning of monetary policy. This creates a problem of non-coherence between the two policies.
- A Multi-Indicator Approach: Due to inherent weaknesses, the monetary policy takes a long time to reflect the impacts. Under such scenarios, RBI can consider taking a more comprehensive approach to set the target of monetary policy which includes other parameters like economic growth, stable exchange rate and financial stability, etc.
- Linking Cost of Funds with Market: In order to make the cost of funds flexible, both deposit and lending rates are linked to external benchmarks like the Mumbai Interbank Offer Rate (MIBOR). Linking small savings scheme interest rates to the market would be beneficial.
- Coordination Between Fiscal Policy and Monetary Policy: For monetary policy to yield its desired results, it needs support from fiscal policy. A diatonically opposite monetary and fiscal policy hampers the efficacy of each other. The constitution of MPC is a well intentioned step in this regard.
- Regulation of NBFCs: Given the increasing share of Monterey operations by NBFCs, there need to have comprehensive regulation for NBFCs. It will help in monetary transitions.
Model Mains Question:
- What do you understand by the ‘monetary transition’? Discuss the reasons of poor monetary transition in India?