The Reserve Bank of India (RBI) regularly conducts meetings and announces changes in policy rates such as repo rate, reverse repo rate, etc. The RBI also releases broad commentary explaining the state of the Indian economy and the reasons behind its decision. The changes in policy rates are awaited keenly by bankers, investors and economic enthusiasts. However, the impact of these changes is widespread and affects not only the key stakeholders but also the entire economy and the common citizens indirectly. Let us understand the monetary policy and how it affects our lives.
What is the role of RBI in the Indian economy?
The Reserve Bank of India (RBI) is the central bank of India and plays a crucial role in the country’s economic development. RBI is responsible for formulating and implementing monetary policy in India. This includes setting interest rates, managing the money supply, and regulating credit. It regulates and supervises banks in India to ensure their safety and soundness. It issues licenses to new banks, monitors their activities, and takes corrective measures when necessary. RBI also manages the country’s foreign exchange reserves and regulates foreign exchange transactions. The apex bank is responsible to oversee payment and settlement systems in India, including electronic funds transfer, credit and debit cards, and online banking. Besides, the key economic roles, RBI also plays an important part in promoting financial inclusion by ensuring that banking services reach underserved and marginalized sections of society.
What is RBI Monetary Policy?
Monetary Policy refers to the actions taken by the central bank to regulate the supply of money and credit in the economy. It does so to achieve the country’s macroeconomic objectives such as GDP, Growth and Inflation. The key objective is to maintain price stability while balancing the economic growth. This monetary policy is formulated by its Monetary Policy Committee (MPC), which comprises six members, including three members from the RBI and three external members appointed by the government. The committee holds meetings every two months to review the current economic situation and decide on the appropriate policy stance. The policy statement issued after such meetings outline the key economic indicators, the rationale for the policy decision, and the future course of action.
In its meetings, the MPC discusses and implements various decisions in respect of the flow of credit in the economy. It has various tools available at its desk to do so –
- Bank policy rates – RBI uses the repo rate, reverse repo rate, and other interest rates to influence borrowing and lending rates in the economy. The repo rate is the rate at which banks can borrow money from RBI, while the reverse repo rate is the rate at which they can lend money to RBI. The change in repo rate affects the interest rates charged by banks on loans and deposits. When the repo rate is increased, the banks increase their lending and deposit rates, which makes borrowing expensive and saving lucrative. When the repo rate is decreased, the banks decrease their lending and deposit rates, which makes borrowing cheap and saving less attractive.
- Open market operations – RBI buys or sells government securities in the open market to increase or decrease the money supply in the economy. When the RBI buys government securities, it injects liquidity into the system, which can help in reducing interest rates and increasing borrowing and spending. When the RBI sells government securities, it reduces liquidity in the system, which can help in increasing interest rates and decreasing borrowing and spending.
- Reserve requirements – RBI mandates the amount of reserves that banks must hold with it. By changing these requirements, RBI can influence the amount of money that banks can lend. For example, it can increase the cash reserve ratio (CRR) or the statutory liquidity ratio (SLR) to reduce the lending capacity of banks. The CRR is the percentage of deposits that banks are required to keep with the RBI as a reserve. This means that banks cannot use this portion of their deposits for lending or other investments. The SLR is the percentage of deposits that banks are required to maintain in the form of liquid assets such as government securities, bonds, and other approved securities. This provides a cushion of liquid assets for banks to fall back on in case of financial emergencies.
- Selective credit controls – RBI can also change the margin requirements against assets such as raising the margin requirement to 30 per cent for a particular class of securities would mean the borrower will be given 70 per cent of the value of the asset as a loan, while the balance would have to be arranged by the borrowers themselves. Sometimes, RBI simply urges commercial banks to control the supply of money in the economy.
What is the objective of the RBI Monetary Policy?
The monetary policy of India has several objectives that aim to promote economic growth while maintaining stability in the financial system. Here are the objectives of India’s monetary policy explained in more detail:
Price Stability – The main objective of monetary policy is to maintain price stability. This means that the central bank aims to keep inflation low and stable, which is essential for a healthy economy. The focus is on creating an environment that allows for the swift execution of developmental projects while also ensuring reasonable price stability.
Desired Distribution of Credit – The monetary authority has control over the allocation of credit to the priority sector and small borrowers. This policy decides the specified percentage of credit that should be allocated to these sectors.
Equitable Distribution of Credit – The policy of the Reserve Bank aims for equitable distribution of credit to all sectors of the economy and all social and economic classes of people.
Controlled Expansion of Bank Credit – The RBI has the important task of controlling the expansion of bank credit and money supply, taking into consideration the seasonal requirements for credit without affecting output.
Promotion of Fixed Investment – The aim is to increase the productivity of investment by limiting non-essential fixed investment.
Restriction of Inventories – The RBI restricts inventories to prevent overstocking and idle money in the organization, which can lead to sickness in the unit.
Promotion of Exports and Food Procurement Operations – Monetary policy pays special attention to boosting exports and facilitating trade, which is an independent objective of monetary policy.
Promoting Efficiency – The central bank focuses on increasing efficiency in the financial system and incorporates structural changes such as deregulating interest rates, easing operational constraints in the credit delivery system, and introducing new money market instruments.
Reducing Rigidity – The RBI aims to bring about flexibility in operations that provide considerable autonomy. It encourages a more competitive environment and diversification while maintaining control over the financial system to maintain discipline and prudence.
How do changes in RBI policy rates affect us?
Changes in RBI policy rates can have a significant impact on common citizens in several ways. Here are some of how changes in RBI policy rates can affect common citizens:
Interest rates – When the RBI increases the repo rate, it makes it more expensive for banks to borrow money from the central bank. This, in turn, makes it more expensive for banks to lend money to customers. As a result, borrowing becomes more expensive for businesses and consumers, and this can lead to a decrease in spending and investment in the economy. On the other hand, when the RBI lowers the repo rate, it makes it cheaper for banks to borrow money from the central bank. This, in turn, makes it cheaper for banks to lend money to customers. As a result, borrowing becomes more affordable for businesses and consumers, and this can lead to an increase in spending and investment in the economy.
Inflation – When the RBI buys government securities from banks, it releases more money into the banking system, which increases the supply of money in the economy. This, in turn, reduces the cost of borrowing, making it cheaper for businesses and consumers to borrow money from banks. This can lead to an increase in spending and investment in the economy, which can boost economic growth. On the other hand, when the RBI sells government securities to banks, it reduces the money supply in the economy. This makes borrowing more expensive, which can lead to a decrease in spending and investment in the economy. This can help in controlling inflation by reducing demand in the economy and lowering the pressure on prices. The RBI also uses open market operations (OMOs) to influence liquidity in the economy. In OMOs, the RBI buys or sells government securities in the open market, which influences the liquidity in the banking system.
Exchange rates – When the central bank raises interest rates, it can make the currency more attractive to investors, which can lead to an increase in the value of the currency relative to other currencies. Conversely, when the central bank lowers interest rates, it can make the currency less attractive to investors, which can lead to a decrease in the value of the currency relative to other currencies.
Stock markets – Monetary policy changes can also impact the stock market. When the central bank raises interest rates, it can make borrowing more expensive for businesses, which can reduce their profitability and lead to a decline in stock prices. Conversely, when the central bank lowers interest rates, it can make borrowing cheaper for businesses, which can increase their profitability and lead to a rise in stock prices.
History of RBI’s Monetary Policy Decisions
Over the years, the RBI’s monetary policy framework has undergone several changes to meet the evolving needs of the economy. In the early years of RBI’s existence, the focus of monetary policy was on maintaining the exchange rate of the Indian rupee against the British pound. The RBI used the exchange rate as the anchor for monetary policy, and it aimed to maintain stability in the exchange rate by adjusting interest rates and credit availability. After India gained independence in 1947, the RBI’s focus shifted to promoting economic growth and development. The central bank continued to use interest rate policy to influence the economy and maintain price stability.
In the 1960s and 1970s, the RBI’s monetary policy was geared towards achieving social and economic objectives, such as reducing poverty and promoting employment. The central bank used credit rationing and direct lending to achieve these goals. However, this approach led to inefficiencies and distortions in the economy, and the RBI gradually shifted towards a more market-oriented monetary policy framework in the 1990s. The central bank started using indirect instruments of monetary policy, such as open market operations, to influence the money supply and credit availability. In the early 2000s, the RBI introduced a formal inflation targeting framework, which aimed to keep inflation within a specific target range. The central bank also began using a range of policy tools, such as repo rates, reverse repo rates, and the CRR, to influence the money supply and inflation. In recent years, the RBI has continued to refine its monetary policy framework to meet the changing needs of the economy. The central bank has introduced measures to enhance transparency, communication, and accountability in monetary policy, and it has also worked to align its policies with global best practices.