In general, the Monetary Policy of a country is a regulatory policy that empowers the monetary authority of a country, like a Central Bank, to control the cost of money (interest rate), the supply of money, and the availability of bank credit.

In India, the monetary policy (MP) serves as a vital tool for the management of the Indian economy. The RBI (Reserve Bank of India) is the Central Bank of India. It controls the money supply as well as bank credit. It has the responsibility to ensure that the banking system of India meets genuine credit needs rather than any speculative or unproductive purposes.

Important objectives

• Growth with stability

Traditionally, the focus of the MP of India was to control inflation. This was done by following a policy of contraction of credit and money supply. But this led to poor growth of the economy.

Hence, the RBI adopted a new policy of growth with stability. Put simply, this implies that the RBI will offer adequate credit for the rising needs of the varied sectors of the economy. It will also strive to control inflation within a limit.

• Regulate, supervise and develop financial stability

Financial stability refers to the capacity of the economy to withstand shocks and ensure the faith of citizens in the financial system. Shocks maybe internal or external.

Hence, the RBI puts much value on financial stability via sufficient controls and regulations. It also ensures that there is no sacrifice for the objective of growth. Thus, the RBI strives to regulate, supervise and develop financial stability.

• Promotion of priority sector

The priority sector of the economy comprises the weaker section of the population, including small scale sector and farmers. RBI strives continually to offer adequate and timely credit to these at affordable interest rates.

• Generation of employment

The MP of a country has an impact on the rate of investment and how it is allocated among the various economic activities of the country with different intensities of labour. Thus, it helps in generation of employment.

• External stability

With the rise in global trade, India’s exports and imports are also rising. Conventionally, the RBI determines the rate of exchange and controls the foreign exchange market. But currently, the RBI has only indirect control over external stability by selling or buying foreign currencies in the open market.

• Investment and savings

RBI offers attractive interest rates to encourage the quantum of savings. High savings lead to high investments. Thus, monetary policy can be used to mobilize savings and investments in the economy.

• Redistributing wealth and income

By controlling inflation and deploying credit for weak sections of the country, the RBI can help redistribute wealth and income in the economy.

• Regulation of NBFI’s

Though the RBI cannot overtly control NBFIs (Non-banking Financial Institutions)of the economy like UTI or IFCI, it can use monetary policy to indirectly impact functions and policies of the latter.

Types of MP

In broad terms, there are two kinds of monetary policy: Expansionary and Contractionary policy.

• Expansionary MP

Also referred to as accommodative MP, its main objective is to boost the money supply in the economy by decreasing interest rates and reducing reserve requirements for commercial banks. 

By reducing interest rates, the RBI makes it easier for customers to borrow money and thus boosts the supply of money in the market.

Reducing reserve needs for banks leads to more funds with commercial banks to lend money to the public, thus instilling more money into the economy.

The RBI also buys government securities as part of MP, making more money available in the market. It aims to trigger economic growth by stimulating economic activities and consumer spending while reducing rates of unemployment.

 However, the con is that this policy could lead to hyper-inflation.

• Contractionary MP

This policy is aimed at reducing the money supply in the economy using measures such as increasing interest rates, raising reserve requirements of commercial banks, and selling government bonds.

By increasing interest rates, RBI makes it costlier for consumers to borrow money and, thus, reduces the money supply in the market.

By raising reserve requirements for banks, RBI leaves commercial banks with less cash to lend to people, thus lowering the money supply in the economy.

In the case of the sale of government bonds, buyers of such securities pay cash to the RBI, thus lowering the quantum of money in the market.

Applications

The RBI Act 1934 explicitly mandated that the RBI governor was solely responsible for formulating and implementing the MP of the country. But in 2016, there was a paradigm shift.

In 2015, the RBI and the Central government made an agreement that the main aim of the MP of India would be to ensure price stability while pursuing the aim of economic growth. The 1934 Act was amended to adopt the Flexible Inflation Target (FIT) in 2016 to connect the MP with inflation targeting.

The main provisions of this FIT are:

• The target for inflation is set by the Centre along with the RBI, once every 5 years.
• In case of the period 2021 to 2025, inflation is to be maintained at the range of 4 (plus or minus 2) percent.
• The key indicator of inflation will be the Consumer Price Index.

Benefits of FIT:

• When prices rise fast, they lead to uncertainties and impact saving and investment in an adverse manner. When inflation is kept in check, it aims to make the process of policy-making stable, predictable, and transparent.
• It makes the RBI more accountable when it fails to keep the inflation targets agreed with the government.

The detriment of FIT:

When targets for inflation are set tightly, they impede the RBI from taking any stance of tight MP.

MPC (Monetary Policy Committee)

The idea for setting up this committee was born by the findings of the Urjit Patel committee appointed by the RBI in order to oversee the tasks of inflation targeting.

Its six members include 3 members appointed by the RBI and 3 nominated by external agencies. The MPC is expected to meet at least 4 times a year. The RBI governor, who is a member, has a right to cast a vote in the event of a tie.

In sum, these are some of the main features of Monetary Policy in India.