What is Monetary Policy?
Monetary Policy is a set of macroeconomic tools used by the Central Bank for influencing the money supply in the economy to achieve the macroeconomic goals decided. For sustainable economic growth, monetary policy is used by a nation’s central bank to control the overall supply of money.
Objectives of Monetary Policy
The major objectives of monetary policy are mentioned below:
- Boost the growth of the economy.
- Create employment.
- Finance price stability.
- Balance the exchange rates.
Differences between Monetary Policy and Fiscal Policy
These two policies differ in various aspects as mentioned below:
| Monetary Policy | Fiscal Policy |
|---|---|
| Definition | This policy can be defined as the regulation of money supply and the interest rates by the central bank. |
| Institutional Control | It is controlled by the Central Bank. |
| Primary Objective | Its primary objective is to control the stability within the economy. |
| Major Tools | Open market operations, discount rates, the interest in excess reserves, and reserve requirement. |
Types of Monetary Policy
There are basically two types of monetary policies:
- Expansionary Monetary Policy
- Contractionary Monetary Policy
What is Expansionary Monetary Policy?
- It is a type of macroeconomic monetary policy which aims at increasing the rate of monetary expansion to stimulate the growth of a domestic economy. Economic growth must be supported by an additional money supply.
- Also known as Accommodative Monetary Policy.
- The primary purpose of expansionary monetary policy is increasing the money supply in the economy through different measures mentioned below:
- By increasing the interest rates: This makes it less costly for consumers to borrow money, thus increasing the money supply in the market.
- By lowering the reserve requirements for banks: This leaves the commercial banks with more money for lending to the public, hence infusing more money into the economy.
- By purchasing government securities through central banks: The RBI buys government securities by paying cash to it, directly increasing the money available in the market.
- By stimulating business activities and consumer spending, it aims at fueling economic growth and also reducing the rate of unemployment.
- However, this may have an adverse effect of occasional hyperinflation.
What is Contractionary Monetary Policy?
- It is a monetary measure for reducing the government spending or rate of monetary expansion by the central bank.
- Its basic purpose is to reduce the amount of money supply in the economy through different measures mentioned below:
- By increasing the interest rate: This makes it more expensive for consumers to borrow money, hence reducing the money supply in the market.
- By raising the reserve requirements for banks: This leaves commercial banks with less money for lending to the public, hence reducing the money supply in the economy.
- By selling government bonds: Buyers of government securities pay cash to the RBI, meaning the money available in the market reduces.
- Its primary aim is to reduce inflation.
What is Monetary Policy in India?
In India, the RBI Act 2016 (Reserve Bank of India Act) directly mandates RBI with the responsibility of formulating monetary policy for the country. The process of this policy in India underwent a paradigm shift in 2016 as mentioned below:
PRE-2016
- In the year 2016, the Governor of Reserve Bank of India was responsible singularly for the formulation of monetary policy in India. Though the Governor was advised by a technical committee, he could veto the decisions.
POST-2016
- The Finance Act of 2016 amended the Reserve Bank of India Act of 1934 to set up the Monetary Policy Committee.
- Presently, the monetary policy in India is being formulated by this committee.
Monetary Policy and Inflation in India – FIT Framework
Background
- In 2015, the Reserve Bank of India and the government entered into the Monetary Policy Framework Agreement, which stipulated a primary objective for ensuring price stability, while keeping the objective of growth in mind.
- Similarly, the RBI Act, 1934 was amended and the Flexible Inflation Target (FIT) was adopted in 2016 to establish a liaison between the monetary policy and inflation in India.
Prominent Provisions
- The inflation target is set by the Central Government, in consultation with the RBI, once every 5 years.
- From 2021-2025, inflation is to be kept in the range of 4 (+/- 2) %.
- Headline Consumer Price Inflation is chosen as a key indicator.
Pros of Flexible Targeting (FIT)
- Rising prices create uncertainties and adversely affect savings and investments. By keeping inflation in check, it brings stability, transparency, and predictability in deciding major policies.
- Makes the RBI more accountable to the government if it fails in meeting inflation targets.
Cons of Flexible Inflation Targeting (FIT)
- It restrains the RBI from taking any tight policy stance.
Monetary Policy Committee (MPC)
- The idea of setting up MPC was proposed by an RBI-appointed Urjit Patel Committee.
- Under section 45ZB of the amended RBI Act of 1934, a 6-member empowered committee was established.
Major Provisions of MPC
- The committee should meet at least 4 times a year.
- It consists of 6 members.
- The members appointed in the MPC will hold the office for a period of 4 years and will not be eligible for re-appointment.
- The legal minimum for a meeting of MPC is 4 members.
- In case of a tie, the Governor of RBI will have a casting vote.
Composition of MPC
- Chairperson: The RBI Governor
- In charge of monetary policy: The Deputy Governor of RBI
- Three members appointed by the Central Government on the recommendations of a search-cum-selection committee comprising:
- Cabinet Secretary
- Secretary of the Department of Economic Affairs
- RBI Governor
- Three experts nominated by the central bank in the field of banking and economics.
Tools of Monetary Policy in India
There are different instruments used by the RBI for controlling the money supply, which can be categorized into two categories:
- Quantitative Tools: These tools aim at controlling the quantity and quality of credit.
- Qualitative Tools: These tools aim at controlling the direction and use of credit.
Drawbacks of Monetary Policy
- In India, people mainly prefer to use cash for transactions rather than banks, reducing the credit creation capacity of banks.
- The demand and supply of money do not remain constant due to black money, which is not recorded, as transactions are kept secret.
- Curbing inflation requires contractionary policy measures, whereas economic development requires expansionary policy measures.
- Influencing different kinds of interest rates in India becomes very difficult due to limitations in the available monetary policies.
