Concept Clarifier: Monetary Policy
Monetary policy involves changes in the key interest rate to influence the growth of aggregate demand, money supply and price inflation.
Changes in short term interest rates affect the spending and savings behaviour of households and businesses and therefore feed through the circular flow of income and spending.
Although a change in interest rates affects the economy in several ways, there are inevitable time lags involved.
The impact of interest rate movements is not uniform throughout the economy. Some sectors are more affected by interest rate changes than others. For example, industries that export a high percentage of their output will be more exposed to movements in the exchange rate that might follow from a change in monetary policy. Similarly markets whose demand is sensitive to interest rate changes will be affected to a greater extent than other markets. Let’s consider as an example the effect of a 2 per cent rise in interest rates over a period of 6 months. The demand for basic foods and clothing is unlikely to be influenced much by this whereas the demand for new cars, expensive household durable goods and other “interest sensitive” products will probably experience a much greater change in demand from consumers.
Transmission of Monetary Policy
Monetary Policy Framework in India
The basic functions of the Reserve Bank of India are to:
- Regulate the issue of currency notes
- Keep reserves to provide monetary stability
- Centralise cash reserves of commercial banks
- Manage the credit system of the country
The RBI has the twin objectives of growth and price stability but the relative emphasis between the two tends to vary depending upon the broader economic outlook.
Monetary Policy Instruments
Repo Rate: The rate at which the RBI injects liquidity or lends overnight money to the banks. This instrument is the operational rate used for injections of liquidity.
Reverse Repo Rate: The rate at which the RBI absorbs liquidity or at which banks can lend excess cash to the RBI overnight. This instrument is used to absorb liquidity.
LAF Corridor: The LAF corridor is the difference between the repo and the reverse repo rates. The LAF corridor is used to reduce volatility in the overnight funding market. If the demand for money is lower than supply, then the average overnight funding rate for banks is typically closer to the reverse repo; similarly, if demand is higher than supply, then it is closer to the repo rate.
Cash Reserve Ratio (CRR): The cash reserve ratio is the proportion of deposits, which banks are required to hold in the form of cash with the RBI. The RBI uses the CRR to manage liquidity in the banking industry.
Statutory Liquidity Ratio (SLR): The statutory liquidity ratio is the minimum percentage of net demand and time liabilities (NDTL) that banks must maintain in the form of gold, cash or other approved securities such as government bonds. The RBI uses the SLR to regulate credit growth in India.
Marginal Standing Facility (MSF): The marginal standing facility is collateralized borrowing, designed to curb volatility in the overnight lending rates. The MSF allows banks to borrow overnight from RBI up to an additional 1 per cent of their NDTL at 100 basis points above the repo rate. This facility is used by banks as a last resort to raise money given the high interest rate associated with it.
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