Monetary Policy

• Monetary policy refers to the actions undertaken by a country's central bank—in India, the Reserve Bank of India (RBI)—to regulate the money supply, interest rates, and liquidity to ensure price stability and promote sustainable economic growth.

Legal Framework

• The monetary policy is governed by the Reserve Bank of India Act, 1934, which was amended in 2016 to institutionalize a Monetary Policy Committee (MPC) and set inflation targeting as the core objective.

Inflation Targeting Framework

• India follows a Flexible Inflation Targeting (FIT) framework. As per the current mandate, the Consumer Price Index (CPI) inflation target is:
  • 4%, with a tolerance band of ±2%,
  • Valid until March 2026,
  • Set jointly by the Government of India and the RBI.

Instruments of Monetary Policy

• Monetary policy tools are broadly classified into two categories:

Quantitative (General) Instruments

• These tools influence the overall level of credit and liquidity in the economy and are indirect in nature.
  • Repo Rate: Rate at which RBI lends money to commercial banks.
  • Reverse Repo Rate: Rate at which RBI borrows from banks.
  • Bank Rate: Long-term lending rate for RBI.
  • Cash Reserve Ratio (CRR): Percentage of deposits that banks must keep as cash with RBI.
  • Statutory Liquidity Ratio (SLR): Percentage of deposits to be kept in the form of liquid assets like gold or government securities.
  • Open Market Operations (OMO): Buying and selling of government securities by RBI to control liquidity.
  • Marginal Standing Facility (MSF): Emergency borrowing facility for banks.

Qualitative (Selective) Instruments

• These tools are aimed at regulating the direction and allocation of credit to specific sectors.
  • Credit Rationing
  • Margin Requirements
  • Moral Suasion
  • Direct Action
  • Regulation of consumer credit
• Through Sterilization, RBI neutralizes excess liquidity using CRR, OMOs, and Market Stabilization Schemes (MSS), particularly during capital inflows.

Types of Monetary Policy

Expansionary Monetary Policy

• Used to stimulate economic activity.
• RBI reduces Repo Rate, CRR, SLR, and Bank Rate.
• Conducts OMO purchases to inject liquidity.
• Loans become cheaper, encouraging borrowing and investment.
• Helps fight recession and low growth periods.

Contractionary Monetary Policy

• Used to control inflation and overheating of the economy.
• RBI increases Repo Rate, CRR, SLR, and Bank Rate.
• Conducts OMO sales to absorb excess liquidity.
• Loans become expensive, reducing consumption and investment.
• May increase unemployment in the short run but helps stabilize prices.

Monetary Policy Committee (MPC)

Composition

• As per the RBI Act (Amendment), 2016:
• 6 Members:
  • RBI Governor (Chairperson)
  • 1 RBI official (usually a Deputy Governor)
  • 1 RBI nominated official
  • 3 members nominated by the Government of India

Function

• Formulates monetary policy to achieve price stability while keeping in mind the objective of growth.
• Each member has one vote; in case of a tie, the Governor has a casting vote.
• The MPC meets at least 4 times a year, and decisions are published with minutes for transparency.