Monetary Policy in India, Types, Objectives, Significance

Monetary Policy in India frames an important outline of the Indian economy as it helps the RBI as well as the government in controlling the supply of money, inflation and the stability of the Indian economy. In this article, we are going to cover all about the Monetary Policy in India, its types, important monetary tools and related concepts. 

Monetary Policy in India

Monetary Policy is a macroeconomic policy tool used by the Central Bank to manage the money supply in the Indian economy in order to achieve the macroeconomic goals of the country. The central bank uses various monetary instruments to manage the credit availability in the market to fulfil all the objectives of the economic policy. 

The Reserve Bank of India Act 1934 makes it necessary for the Reserve Bank of India to create monetary policies of India. Before 2016, the governor of RBI was responsible for formulating Monetary Policy in India and after 2016, the Finance Act of India 2016 was enacted that led to the creation of the Monetary Policy Committee. This committee is responsible for formulating the monetary policy of India. 

Monetary Policy Objectives 

The Monetary Policy of India has the following objectives: 

• Maintaining price balance
• Provide employment opportunities 
• Managing the exchange rates 
• Accelerating the growth of economy

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Monetary Policy Types 

There are two types of Monetary Policy- Expansionary Monetary Policy and Contractionary Monetary Policy

Expansionary Monetary Policy

Also known as Accommodative Monetary Policy, its primary objective is to increase the money supply in the economy to stimulate growth. The key measures include:

• Decreasing interest rates – Makes borrowing cheaper for consumers and businesses, encouraging spending and investment.
• Lowering reserve requirements for banks – Allows commercial banks to lend more, increasing liquidity in the market.
• Purchasing government securities – The RBI injects money into the economy by buying securities, thereby increasing available funds.

This policy is aimed at boosting economic activity, encouraging consumer spending, and reducing unemployment. However, if overused, it can lead to inflationary pressures or even hyperinflation.

Contractionary Monetary Policy

This policy is designed to reduce the money supply in the economy, primarily to control inflation. The key measures include:

• Raising interest rates – Makes borrowing costlier, discouraging excessive spending and investment.
• Increasing reserve requirements for banks – Limits the amount banks can lend, tightening liquidity in the market.
• Selling government bonds – Withdraws money from the economy as buyers pay the RBI for these securities.

The primary goal is to control rising prices and maintain economic stability.

Monetary Policy Committee (MPC)

Features of Indian Monetary Policy Committee include:

• The setting of MPC  was recommended by the Urjit Patel Committee. 
• Section 45ZB of amended RBI Act 1934, provides for the establishment of 6-member monetary policy committee. 
• MPC has to meet at least 4 times a year. 
• The committee consists of 6 members. 
• The MPC members can hold the office for a term of 4 years and are not eligible for re-appointment. 
• The RBI Governor has a casting vote in the case of a tie. 

Monetary Policy Tools in India 

Various instruments used by the RBI to control the money supply can be categorized into two categories:

• Quantitative Tools – Quantitative tools of monetary policy are aimed at controlling the cost and quantity of credit.
• Qualitative Tools – Qualitative tools of monetary policy are aimed at controlling the use and direction of credit.
  • The qualitative measures do not regulate the total amount of credit created by commercial banks. Rather, they make a distinction between good credit and bad credit and regulate only such credit which creates economic instability. Therefore, qualitative measures are known as the selective measures of credit control.

Monetary Policy Quantitative Tools

Major instruments coming in this category are explained below:

1. Bank Rate (Discount Rate) 

• Bank Rate is the rate at which the RBI buys or rediscounts Bills of Exchange or Commercial Papers from Scheduled Commercial Banks. 
• Higher Bank Rate means banks avoid borrowing money from RBI and the money supply decreases. 
• Lower Bank Rate means banks borrow more money and the money supply increases. 

1. Reserve Requirements

A regulation that specifies the minimum reserves banks must maintain.
Two components:

a) Cash Reserve Ratio (CRR)

• Percentage of a bank’s total Demand and Time Liabilities (DTL) deposited with RBI in cash.
• No interest is paid on CRR deposits.

• When CRR increases, there is less money available for lending and money supply decreases. 
• When the CRR decreases, money money is available for lending and the money supply in the economy increases. 

b) Statutory Liquidity Ratio (SLR)

• Percentage of Net Demand and Time Liabilities (NDTL) maintained by banks in cash, gold, SLR securities, or a combination.
• It is not mandatory to deposit SLR to the RBI. 
• Range prescribed by RBI: 0%–40%.
• When SLR increases, banks have less lending capacity and money supply decreases. 
• When SLR decreases, banks have more lending capacity and the money supply increases. 

3. Liquidity Adjustment Facility (LAF)

Helps banks manage daily liquidity mismatches via:

1. a) Repo Rate – Interest rate at which RBI lends short-term funds to SCBs against approved securities.
2. b) Reverse Repo Rate – Interest rate at which RBI borrows from SCBs (banks park excess funds with RBI).

4. Marginal Standing Facility (MSF)

• Introduced in 2011 by the Narasimhan Committee recommendation.
• Allows SCBs to borrow overnight loans (up to 1% of NDTL) from RBI at Repo Rate + 0.25%.
• Marginal Standing Facility is used when funds via LAF are exhausted.
• Minimum: ₹1 crore, in multiples thereof.

5. Open Market Operations (OMOs)

• Buying/selling of government securities by RBI.
• Buy securities in order toInject liquidity into the economy.
• Sell securities in order to withdraw liquidity from the economy.

6. Market Stabilization Scheme (MSS)

• RBI sells Market Stabilization Bonds (MSBs) to absorb excess liquidity.
• Mainly used for sterilization of surplus funds in the system.

7. Term Repos

• Introduced in Oct 2013 for tenors of 7, 14, or 28 days.
• Provides liquidity for longer than overnight.
• Helps develop the inter-bank money market and improve monetary policy transmission.

Monetary Policy Qualitative Tools

Major instruments coming in this category are explained below

1. Margin Requirements

• Margin Requirements is the difference between the value of securities offered as collateral and the actual value of the loan granted.
• Introduced to control credit flow to specific sectors.
• High margin leads to less loan sanctioned and reduced credit to that sector.

2. Consumer Credit Regulation

• Consumer credit regulation means loans given by banks in installments for purchasing consumer durables.
• RBI’s Control Measures:
  • Increase down payment required.
  • Reduce the number of repayment installments.
• Used when excess demand for consumer goods pushes prices upward.

3. Moral Suasion

• Moral Suasion means persuasion and requests by RBI to banks to follow monetary policy guidelines.
• Relies on cooperation rather than compulsion to maintain desired money supply levels.

4. Direct Action

• Direct Action means penal or restrictive measures against non-cooperative banks.
• Examples include: 
  • Refusal to rediscount bills.
  • Charging penal interest rates.

5. Rationing of Credit (Credit Ceiling)

• Rationing of credit means RBI sets a maximum limit on loans that Scheduled Commercial Banks (SCBs) can grant.
• This tightens lending and controls credit expansion.

6. Priority Sector Lending

• RBI mandates banks to allocate a specific portion of lending to sectors like:
  • Agriculture & allied activities
  • Micro & small enterprises
  • Housing for low-income groups
• Ensures credit availability to socially important but underfunded sectors.

Monetary Policy Significance

Introduction of Monetary Policy on India has the following significance: 

• Helps maintain price stability and economic growth of the country. 
• Helps in managing inflation. 
• Helps determine variables like consumption, savings, investment and capital formation. 
• Control over the money supply market helps in balancing the currency exchange rates.