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5 Things To Note About Monetary Policy

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5 Things To Note About Monetary Policy

Monetary policy is how central banks control the supply of money, manage inflation and influence the currency in an economy. This is useful in encouraging liquidity (or curbing it if required) and maintaining overall economic stability. Here we look at monetary policy in India.

1) The central bank reviews the monetary policy.

The monetary policy is formulated and announced and reviewed by the central bank of the country; in India’s case – the Reserve Bank of India, or RBI.

The RBI was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. Initially, the head office of the central bank was in Calcutta but got permanently shifted to Mumbai in 1937.

The RBI Governor has tremendous power vested in him and is the main authority for making decisions. He has veto power over interest rates.

Having said that, he does not work in isolation. The other board members assume advisory roles and internal discussions take place before the policy is finalised and made public. The governor also conducts meetings with the heads of major commercial banks and the country’s finance minister to get their views before making the announcements.

2) The monetary policy is reviewed bi-monthly.

The RBI used to announce its monetary policy twice in a financial year. The financial year starts on April 1 and ends on March 31 the following year.

After Bimal Jalan took charge as governor in 1997, he moved from two monetary policy reviews in a year to quarterly reviews. His successor Y V Reddy introduced a mid-quarter review, which resulted in an announcement every 45 days.

A panel headed by RBI deputy governor Urjit Patel had recommended that the central bank monetary policy committee conduct a bi-monthly review.

So while the RBI reviews its stance once in two months, it has the leeway to make changes to policy between the reviews if necessary.

3) The RBI Governor is appointed by the government.

The board of directors and the governor are appointed by the government in consultation with the Ministry of Finance.

The RBI has one governor and four deputy governors. The first governor of India’s central bank was Sir Osborne Smith. Chintaman Dwarkanath Deshmukh was the first Indian governor. Raghuram Rajan is the 23rd governor of the RBI.

The government also nominates 10 directors from various fields, one government official, and four directors from the local boards.

The RBI Governor is directly accountable to government of India and to the Parliament’s Standing Committee on Finance.

4) The RBI uses key rates to signal the direction of its monetary policy.

Monetary policy can be expansionary or contractionary, depending on the RBI’s stance.

An expansionary policy infuses money into the financial system. A contractionary policy takes money out of the financial system. One way to achieve this is by tinkering with the key rates. One of the main tools that a central bank uses to change money supply is changing the key rates. Other measures that a central bank can take include conducting open market operations and changing reserve requirements.

The key rates are reduced when economic growth slows or the economy is in a recession. Taking a cue from the RBI, other banks follow suit and lower their rates. This lowers rates on loans and encourages borrowing and spending. Conversely, rates are increased when there is greater volume of money in circulation and the economy is heating up or inflation needs to be in check.

By raising rates individuals are encouraged to save money and are deterred from taking loans.

5) What are the key rates the RBI employs?

The key policy or 'signalling' rates include the repo rate, reverse repo rate, cash reserve ratio and statutory liquidity ratio.

Repo rate is the rate at which RBI lends to banks for short periods. If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. If it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. The banks use this facility to deposit their short-term excess funds with the RBI and earn interest on it.

RBI can reduce liquidity in the banking system by increasing the rate at which it borrows from banks.

Cash Reserve Ratio, or CRR, is the amount of funds that banks have to park with RBI. If RBI decides to increase the cash reserve ratio, the available amount with banks would reduce. The central bank increases CRR to curb surplus liquidity.

Statutory Liquidity Ratio, or SLR, is the minimum percentage of deposits banks have to maintain with the RBI. It can be in the form of gold, cash, government bonds or other approved securities.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

DESIGNED BY : Indigo Consulting
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