Civil Services Study Centre

A d m i n i s t r a t i v e Tr a i n i n g I n s t i t u t e
Government of West Bengal
Saltlake, Kolkata-700106

Monetary Policy and

Role of Reserve Bank of India

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Le c t u re N o.: 4
D a t e: D ec embe r 21 , 2 01 4
S . M a i t ra
Associate Professor of Economics

Prices and Inflation

The Reserve Bank of India had adopted the

new Consumer Price Index (CPI) (combined)

as the key measure of inflation.
Earlier, RBI had given more weightage to
Wholesale Price Index (WPI) than CPI as the
key measure of inflation for all policy
purposes.
This has been done following
recommendations of Urjit R. Patel Committee.
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Urjit Patel Committee

Major Recommendations
An Expert Committee under the Chairmanship of Urjit Patel,

Deputy Governor of RBI to Revise and Strengthen the Monetary

Policy Framework was appointed on September 12, 2013.
The Choice of Nominal Anchor
Inflation should be the nominal anchor for the monetary policy
framework.
The Choice of Inflation Metric
The RBI should adopt the new CPI (combined) as the measure of
the nominal anchor for policy communication. The nominal
anchor should be defined in terms of headline CPI inflation,
which closely reflects the cost of living and influences inflation
expectations relative to other available metrics.
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Urjit Patel Committee

Major Recommendations
Numerical Target and Precision
The nominal anchor or the target for inflation should be

set at 4 per cent with a band of +/- 2 per cent around.

Price stability
Since food and fuel account for more than 57 per cent of
the CPI on which the direct influence of monetary policy
is limited, the commitment to the nominal anchor would
need to be demonstrated by timely monetary policy
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Urjit Patel Committee

Major Recommendations
Institutional Requirements
Consistent with the Fiscal Responsibility and Budget

Management (Amendment) Rules, 2013, the Central

Government needs to ensure that its fiscal deficit as a
ratio to GDP is brought down to 3.0 per cent by 201617.
Administered setting of prices, wages and interest
rates are significant impediments to monetary policy
transmission and achievement of the price stability
objective, requiring a commitment from the
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Government towards their elimination.

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Prices and Inflation

Measures to control

inflation:
(i)
Monetary measures
(ii) Fiscal measures
(iii) Other
measures
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Monetary Policy and its Objectives

Monetary Policy:
The term monetary policy refers to actions taken by central banks to
affect monetary magnitudes or other financial conditions. It is concerned
with the changing the supply of money stock and rate of interest for the
purpose of stabilizing the economy at full employment or potential output
level by influencing the level of aggregate demand.
Objectives of Monetary Policy:
To ensure the economic stability at full employment or potential level of
output.
To achieve price stability by controlling inflation and deflation.
To promote and encourage economic growth in the economy.
Promotion of a stable financial system which can avert crisis by absorbing
shocks is thus an important goal of a Central Bank.
Preventing sharp fluctuations in the value of the rupee so as to maintain
orderly conditions in the foreign exchange market is rightly counted as a
major goal of the RBI.

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Traditional and New Tools of Monetary Policy

Bank Rate Policy: Bank rate is the rate at which the central bank

of a country provides loan to the commercial banks. If the bank

rate is low, the banks are encouraged to borrow reserves against
which they can advance loans. This facilitates credit creation. An
upward revision of this rate discourages borrowing and exerts a
contractionary effect on money stock. When central bank raises
the bank rate, the commercial bank raises their lending rates, and
it results in less borrowings and reduces money supply in the
economy.
Open Market Operations: Open market operation consists of
purchase and sale of securities by the central bank of the country.
The sale of security by the central bank leads to contraction of
credit and purchase thereof leads to credit expansion.

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Traditional and New Tools of Monetary

Policy
Cash Reserve Ratio: Cash Reserve Ratio is a certain percentage of

bank deposits which banks are required to keep with RBI in the form
of reserves or balances. When CRR is increased, the loanable funds
at the disposable of commercial banks get reduced and the money
supply contracts. The opposite effect occurs if the CRR is reduced.
This increases the ability of the banks to create deposit money. Since
it is rather a drastic way to change the money supply, the variation in
CRR is not used very frequently.
Selective Credit Control: Selective Credit Controls are aimed at
regulating the distribution of credit amongst sectors or purposes. RBI
uses this measure to prevent speculative hoarding of essential
commodities and check undue rises in prices. Selective credit control
measures include fixing the margin requirements for loans, fixing the
maximum limit for advances and charging discriminatory interest
rates on selective advances. RBI may also instruct banks not to
provide loans for a specific purpose.
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Traditional and New Tools of Monetary Policy

Repo Rate: Repo (Repurchase) rate is the rate at which the RBI lends shot-

term money to the banks against securities. When the repo rate increases
borrowing from RBI becomes more expensive. Therefore, we can say that in
case,RBI wants to make it more expensive for the banks to borrow money,
it increases the repo rate; similarly, if it wants to make it cheaper for banks
to borrow money, it reduces the repo rate
Reverse Repo Rate: Reverse Repo rate is the rate at which banks park
their short-term excess liquidity with the RBI.The banks use this tool when
they feel that they are stuck with excess funds and are not able to invest
anywhere for reasonable returns.An increase in the reverse repo rate
means that the RBI is ready to borrow money from the banks at a higher
rate of interest. As a result, banks would prefer to keep more and more
surplus funds with RBI.
Thus, we can conclude that Repo Rate signifies the rate at which liquidity is
injected in the banking system by RBI, whereas Reverse repo rate signifies
the rate at which the central bank absorbs liquidity from the banks.

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Ty p e s o f M o n e t a r y P o l i c y

Expansionary or Easy Monetary Policy

(undertaken

during Recession and unemployment):

Measures:
(1) Central bank buys securities through open market
operation. (2) It reduces cash reserves ratio. (3) It lowers the bank rate
Mechanism:
Money
supply
increases

Investment
increasesAggregate demand increases Aggregate output increases
by a multiple of the increase in investment
Contractionary or Tight Monetary Policy
(undertaken
during Inflation):
Measures: (1) Central bank sells securities through open market
operation. (2) It raises cash reserve ratio and statutory liquidity (3) It
raises bank rate
(4) It raises maximum margin against holding of stocks of goods
Mechanism: Money supply decreases Interest rate raises
Investment expenditure declinesAggregate demand declines Price
level falls

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Operating Procedure of Monetary Policy

Liquidity Adjustment Facility:
Key element in the monetary policy operating framework

of the RBI.
On daily basis, the RBI stands ready to lend to or borrow
money from the banking system, as per the latter's
requirement, at fixed interest rates.
The primary aim of such an operation is to assist banks to
adjust to their day-to-day mismatches in liquidity, via
repo and reverse repo operations.
The interest rate on the LAF is fixed by the RBI from time
to time.
LAF operations help the RBI effectively transmit interest
rate signals to the market.

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Changes in the Operating Procedure of Monetary

Policy
Effective 3 May 2011, based on the recommendations of the

Working Group on Operating Procedure of Monetary Policy,

the operating framework of monetary policy has been refined.
The repo rate has been made the only independently varying
policy rate.
A new marginal standing facility (MSF) has been instituted,
under which SCBs have been allowed to borrow overnight at
their discretion, up to 1 per cent of their respective NDTL, at
100 bps above the repo rate. The revised MSF reverse repo
corridor has been defined with a fixed width of 200 bps with
the repo rate placed in the middle of the corridor.
The reverse repo rate has been placed 100 bps below and the
MSF rate 100 bps above the repo rate.

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Reserve Bank of India

The apex institution of our financial
system, the Reserve Bank of India, was
set up on 1 April 1935, under the
Reserve Bank of India Act. It was
nationalized on l January 1949.
RBI has a central board of directors
headed by the Governor.
The head office is in Mumbai with four
local boards at ATI-CSSC
Delhi, Kolkata, Chennai,
and Mumbai.

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Major functions of RBI

Currency authority: RBI is the sole authority for

the issue of currency other than one rupee notes and

coins and other small coins (which are issued by the
GOI). Controlling the supply of money and credit in
the economy is the responsibility of the RBI.
Banker to government: RBI is in charge of all
banking business of the central as well as state
governments. The governments maintain accounts at
RBI which makes loans and advances to them. RBI is
also the manager of the public debt, both internal
and external, of the country. Currently, GOI bonds are
auctioned through the public debt office (PDO) of RBI.

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Major functions of RBI

Banker's bank and supervisor: The RBI holds part of the cash
reserves of commercial banks, lends funds to them in times of
need, provides them clearing facilities, and keeps a close watch
on their activities. To banks, RBI is the lender of last resort. In
India the demand for funds increases, steeply during the months
of November to April to finance the marketing of major kharif
crops. RBI lends to banks generously to help them meet this
need.
Custodian of foreign exchange: RBI is entrusted with
managing the country's foreign exchange reserves and
maintaining the external value of the rupee. In the days before
economic reform, the exchange rate of the rupee was rigidly
controlled. Now the RBI intervenes in the foreign exchange
market only to keep the market-determined rate within
reasonable bounds.

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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM

PERIOD

In India, prior to 1991, interest rates and returns on all

types of financial investments were strictly regulated.

Banks had to operate under numerous restrictions
imposed by the Government of India.
There was virtually no competition in the banking
sector and the nationalised banks were required to
perform many social duties, like lending to priority
sectors at subsidised rates of interest.
Heavy regulation, lack of competition and
accountability along with emphasis on social
responsibility, at the cost of profitability, led to
cumulative rise in inefficiency and non-performing
assets (NPA) over the decades.

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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM

PERIOD

RBI did not have desired autonomy during pre-reform period

and monetary policy virtually played an accommodative role to

fiscal policy.
The central government could borrow without limit from the RBI
through ad hoc treasury bills (which were basically overdrafts on
the RBI).
In addition to CRR, commercial banks were statutorily required
to hold a specified per centage of their assets (statutory
liquidity ratio, SLR) in the form of government bonds. These
bonds had zero risk of default, but yielded very low returns.
SLR was the mechanism by which the banks were forced to lend
to the Government of India at interest rates that were kept
artificially low. In the early 1990s more than 60 per cent of
incremental bank deposits used to be allocated to meet the CRR
and SLR requirements.
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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM

PERIOD

The GOI used to fix interest rates on government bonds

at levels much lower than those on other assets with the

obvious intention of minimising its cost of borrowing. As
a result, general public did not show much interest in
these bonds. These bonds were held, under compulsion,
mostly by banks, provident funds, and nationalised
insurance companies.
In India, the process of economic reform began in 1991.
Banking reform has been an important component of
that process. On the recommendations of the
Narasimham Committee on Financial System (1991), the
GOI has adopted measures to restructure the banking
system.

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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD

The major steps include:

lifting of regulations on interest rates on deposits and
advances;
allowing entry of private banker;
liberalisation of branching regulations for both public
and private sector banks;
introduction of capital adequacy, income recognition,
and provisioning norms; and
reduction of the appropriation of loanable funds by the
GOI through gradual decrease in CRR and SLR. Banks
have now more funds at their disposal for lending on
commercial terms.
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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM

PERIOD

The monetary reform undertaken in

India was characterised by the move
from direct instruments (such as
administered interest rates, reserve
requirements, selective credit control) to
indirect instruments (such as open
market
operations,
purchase
and
repurchase of government securities) for
the conduct of monetary
policy.
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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD

The GOI no longer has the power to control

interest rates on government bonds and the SLR

has been progressively reduced.
SLR was as high as 38.5 per cent in 1992, but
gradually reduced to only 25 per cent in 2005.
Banks continue to hold a larger portion of their
portfolio in the form or such securities because
of these are of low risk and high liquidity, but
banks are no longer forced to do so.

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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM

PERIOD

Earlier, through the use of ad hoc treasury

bills the GOI used to enjoy unlimited access

to the RBI credit.
More than 90 per cent of the variations in
reserve money, on an average, during 1980s,
were due to the deficit financing or the RBI
credit to the central government.
This is known as automatic monetisation of
deficit. Such automatic monetisation of
deficit severely degraded the ability of the
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monetary authorities (RBI and Ministry of
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Finance)
to pursue
independent
monetary

CHANGES IN MONETARY POLICY IN INDIA DURING REFORM

PERIOD

As part of fiscal consolidation, issue of ad

hoc treasury bills has been abolished and a

system of Ways and Means Advances
(WMA), with a mutually agreed prior limit,
introduced to meet temporary mismatch
between receipts and expenditures of the
GOI.
Significantly, greater autonomy of the RBI
has been one of the major positive results
of financial reform in India.
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CHANGES IN MONETARY POLICY IN INDIA DURING REFORM PERIOD

With

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budget deficits not being automatically

monetised now, fiscal policy does not determine
reserve money any more.
On the contrary, it is increasingly reflecting the RBIs
assessment of market liquidity and absorptivecapacity (RBI, Annual Report, 2000-01).
The monetary authorities now have much more
discretionary control over the stock of reserve money.
In the pre-reform days, the yield on government bonds
was kept at such a low level that there was not much
demand for it. Since the market for government debt
was very narrow and undeveloped earlier, OMOs as an
instrument
of credit control
was ineffective. Situations
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are now changing.

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