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Monetary and Credit policy: Meaning and Importance

Monetary policy of   pertains to controlling and regulating money supply and cost borrowing with twin objectives of price stability and economic growth.  The monetary authority of all modern economies (countries), typically the central bank, targets an inflation rate or interest rate to ensure price stability and general trust in the currency. The other goals of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies.

Types of Monetary Policy

There are two types of monetary policy:

  1. Expansionary Monetary Policy and 2. Contractionary Monetary policy

Expansionary Monetary Policy

When an economy is undergoing recession, expansionary monetary policy is used to stimulate the economy.  The monetary authority in an expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to combat unemployment in a recession. A lower interest rate leads to increased borrowing (due to low cost of borrowing ) and investment  by  businesses This increases aggregate demand (the overall demand for all goods and services in an economy), which boosts short-term growth as measured by gross domestic product (GDP) growth. Expansionary monetary policy usually leads to depreciation of currency of the country in question . In other words it diminishes the value of the currency relative to other currencies (the exchange rate).

Contractionary Monetary Policy

In  contractionary monetary policy, the monetary authority increases short run interest rates or in other words maintains short-term interest rates higher than usual in order to reduce borrowing (as it becomes costlier) This in turn slows the rate of growth in the money supply or even shrinks it. This slows short-term economic growth and lessens inflation. The contractionary monetary policy is resorted to curb high level of inflationary expectations or “cool down” an “over- heated economy” due to much higher aggregate demand than aggregate supply.However, it can lead to increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.

Credit Policy

Credit is created on the basis of money supply. In a branch banking system operating with provision of a reserve ratio, every bank has to maintain an amount equal to reserve ratio out of its total time and demand deposits and the remaining part is lent out. This is how “reserve money” or “high powered money” creates “credit”. In economics, credit policy is government policy at a particular time on how easy or difficult it should be for people and businesses to borrow money and how much it will cost.

Money Multiplier or Credit Multiplier

Money multiplier or credit multiplier is a model that illustrates how banks can create money. The rate at which credit is created depends on the reserve ratio and the capital ratio for banks. The money multiplier or credit multiplier tells how the maximum amount the money supply could increase based on an increase in reserves within the banking system. Money multiplier closely related ratios of commercial bank money to central bank money (also called the monetary base) under a fractional-reserve banking system. In a fractional-reserve banking system, the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) when there are no leakages is equal to a multiple of the amount of reserves. This multiple is the reciprocal of the reserve ratio, and it is an economic multiplier.

In equations, writing M for commercial bank money (loans), R for reserves (central bank money), and RR for the reserve ratio, the reserve ratio requirement is that {\displaystyle R/M\geq RR;} {\displaystyle R/M\geq RR;}

 R/M{\displaystyle R/M\geq RR;} ≥ RR

the fraction of reserves must be at least the reserve ratio.

Taking the reciprocal,

M/R≤1/RR{\displaystyle M/R\leq 1/RR,}

 Which, yields {\displaystyle M\leq R\times (1/RR),}M≤R X (1/RR)

meaning that commercial bank money is at most reserves times (1/RR) which is the multiplier ignoring leakages into currency If banks lend out close to the maximum allowed by their reserves and there are no leakages into currency holdings, then the inequality becomes an approximate equality, and commercial bank money is central bank money times the multiplier. If banks instead lend less than the maximum, accumulating excess reserves, then commercial bank money will be less than central bank money times the theoretical multiplier.

High Powered Money

It is high powered money that creates overall money and credit supply in an economy. High powered money or powerful money refers to that currency that has been issued by the Government and Reserve Bank of India. Some portion of this currency is kept along with the public while rest is kept as funds in Reserve Bank. Base money or high powered money in a country is the total amount of bank notes and coins circulating in the economy. This includes:

  • the total currency circulating in the public,
  • plus the currency that is physically held in the vaults of commercial banks,
  • plus the commercial banks’ reserves held in the central bank .

The monetary base should not be confused with the money supply, which consists of the total currency circulating in the public plus certain types of non-bank deposits with commercial banks.

If a country’s gross domestic product is declining or growing sluggishly, monetary policy can offset this with open market purchases of bonds, which expand the monetary base. This expansion of the base in turn leads to expansion of the money supply and to downward pressure on interest rates, which makes it less expensive for consumers to buy consumer goods and for companies to purchase new physical capital; the increase in these types of expenditure gives an upward push to gross domestic product. On the other hand, if gross domestic product is growing at an unsustainably high rate, threatening to cause an increase in the inflation rate, contractionary open market operations can be used to slow the economy down.

Objectives of Monetary Policy

  • 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.
  • 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.
  • Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India of February 20, 2015.

Monetary Policy Framework

  • The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to operate the monetary policy framework of the country.
  • The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation; and modulation of liquidity conditions to anchor money market rates at or around the repo rate. Repo rate changes transmit through the money market to the entire the financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
  • Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.
  • The operating framework is fine-tuned and revised depending on the evolving financial market and monetary conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework was last revised significantly in April 2016.

Instruments of Monetary Policy

There are several direct and indirect instruments that are used for implementing monetary policy.

  • Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
  • Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.
  • Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.
  • Marginal Standing Facility (MSF): 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 at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.
  • Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
  • Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
  • Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.
  • Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to 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.
  • Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.
  • Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.

The Monetary Policy Process

  • Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. Accordingly, the Central Government in September 2016 constituted the MPC as under:
    1. Governor of the Reserve Bank of India – Chairperson, ex officio;
    2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex officio;
    3. One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio;
    4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) – Member;
    5. Professor Pami Dua, Director, Delhi School of Economics – Member; and
    6. 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.)
  • 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.
  • The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.
  • The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure that the operating target of the weighted average call money rate (WACR).
  • Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets and public finance advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in nature. With the formation of MPC, the TAC on Monetary Policy ceased to exist.

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