ECONOMIC AND SOCIAL ISSUES (ESI)

CHAPTER
MONETARY POLICY

SUMMARY SHEET

FOR RBI GRADE B AND NABARD GRADE

A/B 2019

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Contents
1 Monetary Policy: What is it?................................................................................................................................. 3
2 Primary Objective of Monetary Policy:................................................................................................................. 3
3 Inflation Targeting Framework: ............................................................................................................................ 3
4 Monetary Policy Committee:................................................................................................................................ 3
5 Instruments of Monetary Policy: .......................................................................................................................... 4
5.1 Quantitative tools of RBI: ............................................................................................................................. 4
5.1.1 Cash Reserve Ratio (CRR)...................................................................................................................... 4
5.1.2 Statutory Liquidity Ratio (SLR) .............................................................................................................. 4
5.1.3 Liquidity Adjustment Facility (LAF): ...................................................................................................... 5
5.1.4 Repo Rate.............................................................................................................................................. 5
5.1.5 Reverse Repo Rate: ............................................................................................................................... 5
5.1.6 Marginal Standing Facility (MSF) .......................................................................................................... 5
5.1.7 Policy rate corridor: .............................................................................................................................. 5
5.1.8 Open Market Operations ...................................................................................................................... 6
5.1.9 Bank Rate .............................................................................................................................................. 6
5.1.10 To summarize: ...................................................................................................................................... 6
5.2 Qualitative Tools: .......................................................................................................................................... 6
5.2.1 Rationing of credit/ Priority sector lending .......................................................................................... 6
5.2.2 PSL Targets:........................................................................................................................................... 7
5.2.3 Loan to Value Ratio (LTV) / Margin Requirements: .............................................................................. 8
5.2.4 Moral Suasion ....................................................................................................................................... 8
5.2.5 Direct Action ......................................................................................................................................... 8
6 Open and Transparent Monetary Policy making: ................................................................................................. 8
7 Types of Monetary Policy followed by RBI: .......................................................................................................... 8
7.1 Accommodative Monetary Policy: ............................................................................................................... 8
7.2 Contractionary Monetary Policy:.................................................................................................................. 8
7.3 Neutral Stance of RBI:................................................................................................................................... 8
8 Quantitative easing by RBI: .................................................................................................................................. 9
9 Market Stabilization Scheme (MSS): .................................................................................................................... 9

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1 Monetary Policy: What is it?
Monetary policy is the process by which the monetary authority of a country, like the central bank
or currency board, controls the supply of money, often targeting an inflation rate or interest rate to
ensure price stability and general trust in the currency.

In India, The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary
policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.

2 Primary Objective of Monetary Policy:

In India, the primary objective of monetary policy is to maintain price stability while keeping in mind
the objective of growth. Price stability is a necessary precondition to sustainable growth.

3 Inflation Targeting Framework:

• In May 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 in the Official Gazette 4 per cent 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 per cent and the lower tolerance limit of 2 per cent.
• The Central Government notified the following as factors that constitute failure to achieve
the inflation target:
(a) The average inflation is more than the upper tolerance level of the inflation target for any
three consecutive quarters; or
(b) The average inflation is less than the lower tolerance level for any three consecutive
quarters.
• The framework aims at setting the policy (repo) rate based on an assessment of the current
and evolving macroeconomic situation.

The policy rate is the key lending rate of the central bank in a country. It is a monetary policy
instrument under the control of the Central Bank -Reserve Bank of India (RBI) - to regulate the
availability, cost and use of money and credit.

4 Monetary Policy Committee:

Before the amendment to the RBI Act, 1934, the policy rate was decided by the RBI Governor. But
the amendment to the RBI Act, 1934 in May 2016, provided for the formation of an empowered six-
member monetary policy committee (MPC).

Accordingly, the Central Government in September 2016 constituted the MPC as under:
• Governor of the Reserve Bank of India – Chairperson, ex officio;
• Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex

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 officio;
• One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex
officio;
• Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member;
• Professor Pami Dua, Director, Delhi School of Economics – Member; and
• Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad – Member

(Members referred to at 4 to 6 above, will hold office for a period of four years or until further
orders, whichever is earlier).

Note: Kindly refer EduTap’s ESI and Finance in news monthly Current Affairs magazine for any
updates related to the members of the MPC.

The MPC determines the policy interest rate required to achieve the inflation target. The first
meeting of the MPC was held on October 3 and 4, 2016 in the run up to the Fourth Bi-monthly
Monetary Policy Statement, 2016-17. (Every two months RBI comes out with the Monetary Policy
Statement).

What the RBI has to do?

RBI has to reduce/increase the money supply by reducing/increasing the policy rate. This will reduce
or induce inflation.

5 Instruments of Monetary Policy:

The instruments of monetary policy are of two types: first, quantitative, general or indirect; and
second, qualitative, selective or direct. They affect the level of aggregate demand through the
supply of money, cost of money and availability of credit. Quantitative tools are general and
Indirect in nature. Qualitative tools are specific and direct in nature.

Quantitative tools include Cash Reserve Ratio (CRR), Statutory Liquid Ratio (SLR), Repo rate, Reverse
Repo rate, Marginal Standing Facility, Bank Rate and Open Market Operations.

Qualitative tools include Loan to Value (LTV) ratio, Priority Sector Lending, Moral Suasion and Direct
Action.

5.1 Quantitative tools of RBI:

5.1.1 Cash Reserve Ratio (CRR)

It is the amount of money that the banks have to keep with RBI in cash form. The cash balance that
is to be maintained by scheduled banks with the RBI should not be less than 4% of the total NDTL,
which is the Net Demand and Time Liabilities. NDTL refers to the total demand and time liabilities
(deposits) that is held by the banks of public and with other banks.

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5.1.2 Statutory Liquidity Ratio (SLR)
It is the amount of liquid reserves that each bank has to keep with itself in the form of either cash,
gold or RBI approved securities (Government Securities, etc). In other words, it is nothing but the
share of NDTL that banks shall maintain in safe and liquid assets, such as, unencumbered
government securities, cash and gold. Changes in SLR often influence the availability of resources in
the banking system for lending to the private sector.

5.1.3 Liquidity Adjustment Facility (LAF):

LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF helps banks to
quickly borrow money in case of any emergency or for adjusting in their SLR/CRR requirements. LAF
consists of repo and reverse repo operations.

5.1.4 Repo Rate

Repo or repurchase option is a collaterised lending i.e. banks borrow money from Reserve bank of
India to meet short term needs by selling securities to RBI with an agreement to repurchase the
same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo
rate. Repo operations therefore inject liquidity into the system.

5.1.5 Reverse Repo Rate:

Reverse repo operation is when RBI borrows money from banks by lending securities. The interest
rate paid by RBI in this case is called the reverse repo rate. Reverse repo operation therefore
absorbs the liquidity in the system.

5.1.6 Marginal Standing Facility (MSF)

• It is a facility under which scheduled commercial banks can borrow additional amount of
overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR)
portfolio up to a limit (This is 2 percent of their net demand and time liabilities deposits
(NDTL) at a penal rate of interest, currently 25 basis points above the repo rate).

• This provides a safety valve against unanticipated liquidity shocks to the banking system.

Note: If there are changes with regard to the allowed percentage of NDTL for MSF and penal rate
of interest, they would be covered in the EduTap’s monthly Current Affairs magazine. Kindly refer
the same.

5.1.7 Policy rate corridor:

Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the
weighted average call money rate (Call money is the overnight funds that are lent by one bank to
another bank and call money rate is the rate at which this is done). LAF corridor is the difference
between the repo rate and the reverse repo rate.

RBI, in its first bi-monthly monetary policy review of 2017-18, decided to narrow the policy rate
corridor by 25 basis points. A narrow corridor is expected to check money flow into the banking
system and to drain out additional liquidity.

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So the correct decreasing order becomes:
MSF > REPO RATE > REVERSE REPO RATE

5.1.8 Open Market Operations

These include both outright purchase and sale of government securities for injection and absorption
of durable liquidity, respectively.

5.1.9 Bank Rate

In simple terms, Bank Rate is a rate at which RBI lends money to commercial banks without any
security. Impact: When bank rate is increased interest rate also increases which has a negative
impact on demand thus prices decrease.

5.1.10 To summarize:
Tool To Combat Inflation To induce inflation/ combat
disinflation/ combat
deflation
CRR Increase Decrease
SLR Increase Decrease
REPO RATE Increase Decrease
REVERSE REPO RATE Increase Decrease
MSF Increase Decrease
BANK RATE Increase Decrease
OPEN MARKET RBI sells Government Securities RBI buys Government
OPERATIONS Securities

5.2 Qualitative Tools:

5.2.1 Rationing of credit/ Priority sector lending

Priority sector refers to those sectors of the economy which may not get timely and adequate credit
in the absence of this special dispensation. It is aimed to provide institutional credit to those sectors
and segments for whom it is difficult to get credit.

Priority Sector includes the following categories:

Agriculture
Micro and Small Enterprises
Education
Housing
Export Credit
Others

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5.2.2 PSL Targets:
RBI has given specific targets for certain categories. The limits (sub-categories) and implementation
timelines are different for domestic banks, foreign banks having less than 20 branches in India and
foreign banks having 20 or more than 20 branches in India.

5.2.2.1 For Domestic Banks:

Thus, for domestic banks,

Categories Percentage of loans

Total Priority Sector 40%
Agriculture 18% (8% of this to small and marginal farmers)
Micro-Enterprises 7.5%
Weaker Sections 10%
Others 4.5%

The following chart gives the total priority sector target for foreign banks.

5.2.2.2 For Foreign banks:

5.2.2.3 Priority Sector Lending Certificates (PSLCs):

Priority Sector Lending Certificates (PSLCs) are a mechanism to enable banks to achieve the priority
sector lending target and sub-targets by purchase of these instruments in the event of shortfall. This
also incentivizes surplus banks as it allows them to sell their excess achievement over targets
thereby enhancing lending to the categories under priority sector. Under the PSLC mechanism, the
seller sells fulfillment of priority sector obligation and the buyer buys the obligation with no transfer
of risk or loan assets.

5.2.2.4 What happens if the PSL targets are not met by the banks?
Case 1: For Domestic banks and foreign banks having 20 and more than 20 branches in India: The
amount that is lagging in the target goes to the RIDF (Rural Infrastructure Development Fund) which
is managed by NABARD (National Bank for Agriculture and Rural Development).

Case 2: For Foreign banks having less than 20 branches in India: The amount that is lagging in the
target goes to SEDF (Small Enterprises Development Fund) which is managed by SIDBI (Small
Industries Development Bank of India).

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5.2.3 Loan to Value Ratio (LTV) / Margin Requirements:
It is the amount of loan that is given against a fixed value of collateral. For example: Suppose a
person wants to get a loan by mortgaging its gold worth Rs.1 lakh. The LTV is 60%, then the amount
of loan the person will receive is Rs. 60,000.

5.2.4 Moral Suasion

Moral Suasion is just as a request by the RBI to the commercial banks to take certain actions and
measures as per the trend of the economy. RBI may request commercial banks not to give loans for
unproductive purpose which does not add to economic growth but increases inflation.

5.2.5 Direct Action

This step is taken by the RBI against banks that don’t fulfill conditions and requirements. RBI may
refuse to rediscount their papers or may give excess credits or charge a penal rate of interest over
and above the Bank rate, for credit demanded beyond a limit.

6 Open and Transparent Monetary Policy making:

The MPC (Monetary Policy Committee) is required to meet at least four times in a year. 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. On the 14th day, the
minutes of the proceedings of the MPC are published which include: the resolution adopted by the
MPC; the vote of each member on the resolution, and the statement of each member on the
resolution adopted.

7 Types of Monetary Policy followed by RBI:

7.1 Accommodative Monetary Policy:

It is followed by RBI to increase the money supply in the economy. This is done by lowering of the
repo rate by the RBI (though there are other tools as well) so that borrowing money gets easier. It is
done to boost the economy when it is slowing. This type of policy is also called as Easy or
Expansionary Monetary Policy of the RBI.

7.2 Contractionary Monetary Policy:

It is followed by RBI to decrease the overall supply of money in the economy. This is done by RBI
with the help of increasing the repo rate. This is makes consumption difficult in the economy. This is
done in order to control inflation.

7.3 Neutral Stance of RBI:

A neutral stance of RBI provides it the flexibility to move in either of the directions. But, prevailing
risk of inflation may mean that the RBI won't cut down the interest rates.

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8 Quantitative easing by RBI:
Quantitative easing is an unconventional monetary policy in which a central
bank purchases government securities or other securities from the market in order to lower interest
rates and increase the money supply. Quantitative easing increases the money supply by flooding
financial institutions with capital in an effort to promote increased lending and liquidity.
Quantitative easing is considered when short-term interest rates are at or approaching zero, and
does not involve the printing of new banknotes.

9 Market Stabilization Scheme (MSS):

Market Stabilization scheme (MSS) is a monetary policy intervention by the RBI to withdraw excess
liquidity (or money supply) by selling government securities in the economy. The MSS was
introduced in April 2004. The issued securities are government bonds and they are called as Market
Stabilization Bonds (MSBs). Thus, the bonds issued under MSS are called MSBs. These securities are
owned by the government though they are issued by the RBI.

In the wake of demonetization, the government has increased the amount of MSBs to be issued to
Rs 6 lakh crores from just 0.3 lakh crores.

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