Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
Objectives of Monetary Policies are:-
- Accelerated growth of the economy
- Balancing saving and investments
- Exchange rate stabilization
- Price stability
- Employment generation
Monetary Policy could be expansionary or contractionary
- Expansionary policy would increase the total money supply in the economy
- contractionary policy would decrease the money supply in the economy.
RBI issues the Bi-Monthly monetary policy statement. The tools available with RBI to achieve the targets of monetary policy are:-
- Bank rates
- Reserve Ratios
- Open Market Operations
- Intervention in Forex market
- Moral suasion
Repo Rate– Repo rate is the rate at which the central bank of a country (RBI in case of India) lends money to commercial banks in the event of any shortfall of funds. In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.
Reverse Repo Rate is the rate at which RBI borrows money from the commercial banks. An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.
Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country. The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy.
CRR specifications give greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves. This is called fractional reserve banking.
Statutory liquidity ratio (SLR) is the Indian government term for reserve requirement that the commercial banks in India require to maintain in the form of gold, government approved securities before providing credit to the customers. It’s the ratio of liquid assets to net demand and time liabilities. Apart from Cash Reserve Ratio (CRR), banks have to maintain a stipulated proportion of their net demand and time liabilities in the form of liquid assets like cash, gold and unencumbered securities. Treasury bills, dated securities issued under market borrowing programme and market stabilization schemes (MSS), etc also form part of the SLR. Banks have to report to the RBI every alternate Friday their SLR maintenance, and pay penalties for failing to maintain SLR as mandated.
Inflation & Control Mechanism
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. It is the percentage change in the value of the Wholesale Price Index (WPI) on a year-on year basis. It effectively measures the change in the prices of a basket of goods and services in a year. In India, inflation is calculated by taking the WPI as base.
Formula for calculating Inflation=
(WPI in month of current year-WPI in same month of previous year)
————————————————————————————– ——– X 100
WPI in same month of previous year
Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products. When economy experiences inflation, i.e. when the price level of goods and services rises, the value of currency reduces. This means now each unit of currency buys fewer goods and services.
It has its worst impact on consumers. High prices of day-to-day goods make it difficult for consumers to afford even the basic commodities in life. This leaves them with no choice but to ask for higher incomes. Hence the government tries to keep inflation under control.
Contrary to its negative effects, a moderate level of inflation characterizes a good economy.
- An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy more and borrow more, because during times of lower inflation, the level of interest rate also remains low.
- Hence the government as well as the central bank always strives to achieve a limited level of inflation.
Various measures of Inflation are:-
- GDP Deflator
- Cost of Living Index
- Producer Price Index (PPI)
- Wholesale Price Index (WPI)
- Consumer Price Index (CPI)
There are following types on Inflation based on their causes:-
- Demand pull inflation
- cost push inflation
- structural inflation
Various control measures to curb rising inflation are:-
- Fiscal measures like reduction in indirect taxes
- Dual pricing
- Monetary measures
- Supply side measures like importing the shortage goods to meet the demand
- Administrative measures to curb hoarding, cartelization.