Monetary policy in India

 Monetary Policy in India

What is monetary policy?

A monetary policy controls the size and growth rate of the money supply in an economy. Among its many uses, it can be used to control macroeconomic variables, including inflation and unemployment.

Types of monetary policies.

Contractionary: A contractionary monetary policy reduces the amount of money in the economy. Raising interest rates, selling government bonds, and increasing bank reserve requirements, can be achieved. Whenever the government wants to control inflation, it uses contractionary policy.

Expansionary: A monetary policy aimed at increasing the money supply in an economy by decreasing interest rates, purchasing government securities, and lowering reserve requirements for banks. As a result of an expansionary policy, unemployment is lowered and business activities and consumer spending are stimulated. Expansionary monetary policy is intended to promote economic growth. An expansionary monetary policy may also lead to an increase in inflation.

Objectives of monetary policies.

• Inflation: Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.

• Unemployment: There are many ways in which monetary policy can have an impact on the level of unemployment. For example, a contractionary monetary policy generally increases unemployment due to a reduced money supply in the market that hampers business activities leading to a reduction in the size of the job market.

• Currency Exchange rates: Reserve bank of India can regulate the exchange rates between domestic and foreign currencies by using its fiscal authority. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.

Instruments that can be used to control monetary policies: 

1. Interest rate adjustment: Reserve Bank of India can influence interest rates by changing the base rate, which is charged by RBI to banks for short-term loans. For example, if a central bank increases the Repo rate, the cost of borrowing for the bank increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease. Some key interest rates are:

• Repo Rate: (Presently at 4.90%) The interest rate at which the Reserve Bank provides liquidity under the liquidity adjustment facility (LAF) to all LAF participants against the collateral of government and other approved securities.

• Reverse Repo Rate: (Presently at 3.35%)  The interest rate at which the Reserve Bank absorbs liquidity from banks against the collateral of eligible government securities under the LAF. The fixed-rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time.

• Marginal Standing Facility(MSF): (Presently at 5.15%) The penal rate at which banks can borrow, on an overnight basis, from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a predefined limit (2 per cent). This provides a safety valve against unanticipated liquidity shocks to the banking system. The MSF rate is placed at 25 basis points above the policy repo rate.

2. Change reserve requirements: Reserve Bank of India usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients, and thus, the money supply decreases. Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).

• Cash Reserve Ratio (CRR): ( Presently at 4.50%) The average daily balance that a bank is required to maintain with the Reserve Bank as a per cent of its net demand and time liabilities (NDTL) as of the last Friday of the second preceding fortnight that the Reserve Bank may notify from time to time in the Official Gazette.

• Statutory Liquidity Ratio (SLR): (Presently at 18.00%)  Every bank shall maintain in India assets, the value of which shall not be less than such percentage of the total of its demand and time liabilities in India as of the last Friday of the second preceding fortnight, as the Reserve Bank may, by notification in the Official Gazette, specify from time to time and such assets shall be maintained as may be specified in such notification (typically in unencumbered government securities, cash and gold).

3. Open market operations: RBI can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.

Who decides on Monetary policies in India?

Before 1st August 2016, the Governor of the Reserve Bank of India made all significant interest rate decisions on his own based on the technical support from its members. Presently, Monetary Policy Committee(MPC) in India is responsible for maintaining price stability while keeping in mind the objective of growth. The Monetary Policy Committee has been entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level. As per the provisions of the RBI Act, out of the six members of the Monetary Policy Committee, three Members will be from the RBI and the other three members of the MPC will be appointed by the Central Government. The meetings of the Monetary Policy Committee shall be held at least 4 times a year and it shall publish its decisions after each such meeting. Monetary Policy Committee has an inflation target in terms of the Consumer Price Index (CPI) of  4 per cent with an upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. However, the annual inflation rate in India crossed the 6 per cent maximum limit target reaching 7.04 per cent in May 2022. As a result, the MPC was forced to raise interest rates in order to tame the inflation caused by high fuel and food prices.

Why there is a need to have a monetary policy?

When well-executed, monetary policy can have limited effects on real economic activity, and these effects are usually short-lived. monetary policy doesn’t affect growth in the long term. Inflation can be high and widely varying in instances of poor monetary policy, which can impede economic growth in several ways, including raising interest rates.

Usually, monetary policy is focused on achieving full employment, maintaining a high economic growth rate, and stabilizing prices and wages. RBI publishes Monetary Policy Report every six months to explain the sources and forecasts of inflation for the next fiscal two to six fiscal quarters.  

Way Ahead:

Monetary Policy instruments should be effectively used in order to ensure the money supply in the economy is such that the inflation rate is stabilized to realize economic growth.

Glossary:

NDTL: Net Demand and Time Liabilities (NDTL) show the difference between the bank's demand and time liabilities (deposits) and the bank's deposits in the form of assets held by the other institution.

CPI: Consumer Price Index (CPI) measures the aggregate price level in an economy. A CPI is made up of a set of goods and services that are commonly purchased.

Inflation & the Indian Economy

 Inflation & the Indian Economy

India has witnessed the annual inflation rate edged down to 7.04 per cent in May of 2022 from an 8-year high of 7.79 per cent in the month of April. The word inflation refers to a continuous rise in the general price level of goods and services in a given economy over a given period. The inflation rate is the percentage change in the price level from the previous period. Rate of inflation = [(Price in 2021 - Price in 2022) / Price in 2021]*100

Causes of Inflation in India:

1. Higher Fuel Prices due to an increase in International Crude Oil prices and an increase in taxes on Petroleum products.

2. Rising input cost 

3. Emerging Food Crisis due to Russian- Ukrainian war.

4. The easy money policy adopted by RBI to fuel growth in India contributed to rising inflation.

5. Inflation is mainly caused either by demand Pull factors or Cost-Push factors. Apart from demand and supply factors, inflation sometimes is also caused by structural bottlenecks and policies of the government and the central banks. Therefore, the major causes of inflation are: 

6. Demand-Pull Factors ( When aggregate demand exceeds Aggregate Supply at Full employment level). 

7. Cost Pull Factors ( When Aggregate supply increases due to an increase in the cost of production while Aggregate demand remains the same).

8. Structural Bottlenecks ( Agriculture prices fluctuations, Weak Infrastructure etc.) Monetary Policy Intervention by the Central Banks.

9. Expansionary Fiscal Policy by the Government.

10. Demand and Supply factors can be further subdivided into the following: 

11.  Demand-pull inflation is mainly caused by an increase in aggregate demand. The increase in aggregate demand mainly comes from either increase in Government expenditure or an increase in expenditure from Households and firms. The root cause of demand-pull inflation is Aggregate demand more than Aggregate supply.  The shortages of goods and services are due to an increase in demand-Pull inflation.

12.  Cost Pull Inflation: There exists a situation in an economy where inflation is fuelled up, not because of an increase in Aggregate Demand but mainly due to an increase in the cost of producing goods and services.  

Effect of Inflation on Employment: Inflation and unemployment have an inverse relationship according to the Phillips curve. As the Phillips curve shows, the lower a country's unemployment rate, the faster wages increase.

The Consumer Price Index is used to determine how the cost of living has changed over an extended period of time. As the CPI rises, families must spend more to maintain the same standard of living. Increasing prices of goods and services are considered inflation in economics. 

Wholesale Price inflation: The WPI is a measure of the cost of goods and services purchased by producers and firms rather than by the final consumer. WPI inflation captures factory-level price changes. 

The WPI and CPI are different indices and are used for different purposes.

The WPI and CPI use a different basket of goods to calculate inflation.

The weights assigned to food, fuel, manufacturing items etc. are different. For example, the weight of food in CPI is far higher at 46% than in WPI at 24%.

The WPI inflation does not capture price changes of services but the CPI does.

Different types of Inflation:

Stagflation: The situation of rising prices along with falling growth and employment is called stagflation.

Creeping Inflation: When prices are gently rising, it is referred to as Creeping Inflation. It is the mildest form of Inflation and is also known as Low Inflation. 

Chronic Inflation: If creeping Inflation persists for a longer period of time then it is often called Chronic or Secular Inflation. If it continues for a longer time without any downturn, then it may lead to Hyperinflation.

Walking Inflation: When the rate of rising prices is more than Creeping Inflation, it is known as Walking Inflation.

Moderate inflation: When prices rise by less than 10% per annum, it is known as Moderate Inflation. 

Running Inflation: A rapid acceleration in the rate of rising prices is referred to as Running Inflation. 

Hyperinflation: It is a situation when inflation rises at an extremely fast rate. 

Stagflation is a condition of slow economic growth and relatively high unemployment, or economic stagnation, accompanied by rising prices, or inflation.

Deflation: Deflation is when the overall price level in the economy falls for a period of time.

Disinflation: Disinflation is a situation in which the rate of inflation falls over a period of time. It is a fall in the inflation rate, not the overall price.

Headline Inflation: The headline inflation measure demonstrates overall inflation in the economy.

Core Inflation: The core inflation measures exclude the prices of highly volatile food and fuel components from the inflation index.

Central banks use inflation targeting to adjust monetary policy in order to achieve a specified annual inflation rate.

Steps to Control Inflation by RBI:

Inflation targeting is based on the belief that price stability and price stability are the keys to long-term economic growth. Currently, we are aiming for:

A target of 4% Consumer Price Index (CPI) inflation has been set by the Central Government, along with a tolerance limit of 6% and 2%, in consultation with the RBI.

In order to combat inflation, the Government of India took the following steps:

1. Decrease taxes on Fuel Prices.

2. Restriction on export of food items to tackle food price inflation as Prices of food rose 7.84 per cent, particularly vegetables (18.26 per cent), oil and fats (13.26 per cent) and spices (9.93 per cent). Additional upward pressure came from costs of transportation & communication (9.54 per cent); clothing (8.53 per cent) and health (5.49 per cent). 

3. Price control and wage control by the government.

4. Contractionary monetary policy is a more popular method of controlling inflation. The goal of a contractionary policy is to reduce the money supply within an economy by increasing interest rates.

Government interventions can put a cap on prices, but the broad price controls required to impact inflation don't have a great track record. In order to control inflation, the measures adopted by the government have a negative impact on the growth prospects of India. 

The way forward: According to experts, structural weaknesses in the Indian economy provide bottlenecks to long-term growth. A higher number of females joining the workforce, better educational outcomes, and improving the labour market are some of the bottlenecks in the labour market. By maintaining a balance between inflation and growth, the government can ensure sustained growth for many years to come.

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