Monetary
Policy
Submitted By:
Saujanya Sood (2K20/IT/131)
Richa Modi (2K20/IT/120)
Submitted To:
Prof. Bharat Singh
Department of Humanities
Delhi Technological University
Contents
Introduction
Macroeconomic overview of India
The Reserve Bank of India
Objectives of Monetary Policy
Tools of Monetary Policy - Quantitative and Qualitative
Impact of Monetary Policy on Businesses
Impact of Monetary Policy on Consumers
Introduction
What is Monetary Policy?
● Monetary policy is a set of measures and actions implemented by a country's central bank to regulate
the money supply, interest rates, and the overall financial conditions in the economy. It is a crucial
component of economic management aimed at achieving specific macroeconomic objectives.
● The central bank, such as the Federal Reserve in the United States or the Reserve Bank of India,
typically uses tools like interest rates, reserve requirements, and open market operations to influence
the level of economic activity.
Role in achieving economic growth
● Monetary policy plays a pivotal role in maintaining economic stability by addressing key variables
such as inflation, interest rates, and employment.
● Monetary policy is instrumental in pursuing broader economic objectives, typically defined by
central banks and governments.
Macroeconomic overview of India
● Gross Domestic Product
GDP is the total monetary value of all finished goods and services produced within a country's borders in a
specific time period. It is a comprehensive measure of a nation's economic performance and is often used to
assess the overall health and size of an economy. The GDP growth rate of India in 2021-22 was 8.1%.
● Inflation
Inflation is the rate at which the general level of prices for goods and services is rising, leading to a decrease in
purchasing power. Central banks often target a specific inflation rate to maintain price stability and support
economic growth. The inflation rate of India in 2021-22 was 5.13%, staying within the safe limits of 2-6% as set
by the RBI.
● Unemployment
Unemployment refers to the percentage of the labor force that is without a job and actively seeking employment.
It is a key indicator of economic health and can impact consumer confidence and spending patterns. The
unemployment rate in India as of 2021-22 is 7.71%.
Reserve Bank of India
● What is the RBI?
The RBI is the central banking institution of India, established to regulate and control the country's monetary and
financial systems. It functions as the sole issuer of currency and the custodian of the nation's foreign exchange
reserves.
● Roles and Responsibilities of the RBI
○ Monetary Policy Formulation: The RBI formulates and implements monetary policy by setting the
benchmark interest rates, such as the repo rate, to achieve the desired levels of inflation and economic growth.
○ Currency Issuer: The RBI is the sole issuer of currency notes in India and is responsible for the production,
distribution, and withdrawal of currency.
○ Anti-Counterfeiting Measures: The RBI implements measures to ensure the security and authenticity of the
currency, including incorporating advanced security features.
○ Exchange Rate Policy: The RBI influences exchange rates through interventions in the foreign exchange
market to support export competitiveness and maintain a stable external sector.
○ Government's Banker: The RBI acts as the banker, agent, and adviser to the central and state governments,
managing their accounts, conducting auctions of government securities, and facilitating government
transactions.
Objectives of Monetary Policy
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Price Stability: Maintain stable prices by controlling inflation, ensuring the purchasing power of the
currency remains consistent, and fostering confidence among consumers and businesses.
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Full Employment: Create conditions for maximum sustainable employment, minimizing unemployment
and providing opportunities for individuals seeking work.
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Economic Growth: Promote sustainable and balanced economic growth by influencing interest rates to
stimulate investment, consumption, and overall economic activity.
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Interest Rate Stability: Ensure stable interest rates to provide a predictable environment for borrowing,
lending, and investment decisions, supporting financial planning.
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Exchange Rate Stability: Maintain a stable exchange rate to promote predictability in international trade,
enhance the competitiveness of exports, and reduce uncertainties related to currency fluctuations.
Objectives of Monetary Policy
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Financial Stability: Safeguard the stability of the financial system by implementing regulations and
supervisory measures, preventing systemic risks, and maintaining the health of financial institutions.
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Balance of Payments Stability: Contribute to a stable balance of payments, ensuring equilibrium between
a nation's exports and imports to support overall economic stability.
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Enhancing Financial Inclusion: Promote financial inclusion by implementing policies that ensure
broader access to banking and financial services, reducing economic disparities.
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Facilitating Efficient Payment Systems: Ensure the efficiency, safety, and security of payment and
settlement systems to facilitate smooth financial transactions and maintain overall confidence in the
payment infrastructure.
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Supporting Government Objectives: Align with and support broader economic and social objectives set
by the government, ensuring a cohesive approach to economic management for the overall welfare and
development of the nation.
Tools of Monetary Policy
The RBI uses certain instruments to formulate the monetary policy of India. These are broadly divided into two
categories as follows:
Quantitative Instruments of Monetary Policy:
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Quantitative instruments refer to the tools employed by a central bank to directly impact the quantity of
money and credit in the financial system.
These measures are typically more straightforward and involve quantitative changes in the money supply
or interest rates.
Central banks use quantitative instruments to achieve specific targets related to inflation, interest rates, and
overall economic stability.
Common quantitative instruments include open market operations, the repo rate, reverse repo rate, cash
reserve ratio (CRR), and statutory liquidity ratio (SLR).
These tools involve numerical adjustments to influence the overall money supply, interest rate levels, and
liquidity in the financial system.
Tools of Monetary Policy
Qualitative Instruments of Monetary Policy:
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In contrast, qualitative instruments are more indirect and nuanced measures used by central banks to
influence the allocation of credit and shape the behavior of financial institutions.
Qualitative instruments are designed to impact the quality, flow, and distribution of credit rather than the
overall quantity of money.
Examples of qualitative instruments include selective credit controls, moral suasion, credit rationing,
margin requirements, and direct actions.
These instruments are often employed to target specific sectors or types of financial activities, providing a
more nuanced and targeted approach to achieving monetary policy objectives.
Quantitative Tools of Monetary Policy
Repo Rate
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The repo rate is the interest rate at which the central bank (in the case of India, the RBI) lends money to
commercial banks for a short-term period, usually against government securities.
When the central bank raises the repo rate, it effectively increases the cost of borrowing for commercial
banks, leading to higher interest rates across the economy. This, in turn, serves as a deterrent to excessive
borrowing and spending, contributing to the control of inflation.
Conversely, lowering the repo rate makes borrowing more affordable, stimulating economic activity by
encouraging investment and consumption.
Therefore, changes in the repo rate have a direct and cascading impact on interest rates, money supply, and
overall economic conditions, playing a pivotal role in achieving the central bank's objectives, such as price
stability, full employment, and sustainable economic growth.
The current repo rate set by the RBI is 6.5%, unchanged for the 6th time.
Quantitative Tools of Monetary Policy
Reverse Repo Rate
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The reverse repo rate is a vital monetary policy tool utilized by central banks to manage liquidity and
influence economic conditions. It represents the interest rate at which the central bank borrows funds from
commercial banks, usually against government securities.
An increase in the reverse repo rate encourages banks to park more funds with the central bank, as it offers
a higher return on these short-term investments. This has the effect of reducing the money supply in the
economy, contributing to the central bank's efforts to control inflation and stabilize financial conditions.
Conversely, a decrease in the reverse repo rate discourages banks from lending to the central bank,
fostering increased lending to businesses and consumers, thereby stimulating economic activity.
The reverse repo rate, when used in conjunction with other monetary policy tools, helps central banks
achieve their objectives of price stability, full employment, and sustainable economic growth.
Quantitative Tools of Monetary Policy
Credit Risk Ratio (CRR)
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The Cash Reserve Ratio (CRR) is a key monetary policy instrument employed by central banks to regulate
the amount of cash that commercial banks must maintain as reserves, expressed as a percentage of their
total deposits.
By adjusting the CRR, the central bank influences the liquidity available to commercial banks, impacting
their ability to lend.
An increase in the CRR requires banks to hold a higher proportion of their deposits in reserve, limiting
their lending capacity and reducing the overall money supply.
Conversely, a decrease in the CRR frees up more funds for lending, stimulating economic activity. The
CRR, as part of a central bank's toolkit, plays a crucial role in controlling inflation, managing liquidity, and
shaping the overall credit conditions in the economy.
It serves as a strategic lever for the central bank to achieve its broader monetary policy objectives,
contributing to price stability, full employment, and sustainable economic growth.
Quantitative Tools of Monetary Policy
Statutory Liquidity Ratio (SLR)
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The Statutory Liquidity Ratio (SLR) is a key component of monetary policy, mandating banks to maintain
a certain percentage of their net demand and time liabilities in specified liquid assets, such as government
securities.
The SLR acts as a prudential measure, ensuring that banks have a stable pool of liquid assets to meet
unforeseen demands and contribute to financial stability.
Adjustments to the SLR by the central bank have implications for the banking system's liquidity and credit
availability.
An increase in the SLR requires banks to hold a higher proportion of their deposits in liquid assets,
limiting funds available for lending and potentially slowing down economic activity.
Conversely, a reduction in the SLR releases more funds for lending, promoting credit expansion and
stimulating economic growth.
The SLR, as part of the monetary policy framework, plays a critical role in balancing financial stability
and credit creation, contributing to the central bank's broader objectives of price stability, full employment,
and sustainable economic development.
Quantitative Tools of Monetary Policy
Open Market Operations (OMO)
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Open Market Operations (OMO) form a crucial part of a central bank's monetary policy toolkit. In OMO,
the central bank buys or sells government securities in the open market to influence the money supply and
interest rates.
When the central bank buys securities, it injects money into the financial system, leading to increased
liquidity and potentially lower interest rates.
Conversely, selling securities withdraws money, reducing liquidity and putting upward pressure on interest
rates.
Through OMO, central banks aim to achieve their broader monetary policy objectives, such as controlling
inflation and supporting economic growth.
By manipulating the money supply and influencing interest rates, OMO serves as a versatile and effective
tool for central banks in navigating economic conditions and fostering stability in financial markets.
Qualitative Tools of Monetary Policy
Selective Credit Controls
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Selective Credit Controls are tools employed by central banks to regulate specific types of credit within
the financial system.
Unlike broad-based measures such as interest rates, selective credit controls target particular sectors or
activities to manage credit flows.
Examples include setting limits on lending to certain sectors, industries, or geographical areas.
These controls are used to address specific concerns, such as preventing the overheating of certain sectors
or curbing speculative activities.
By employing selective credit controls, central banks aim to fine-tune credit allocation without resorting to
more sweeping measures.
However, their usage is often limited, as they can distort market mechanisms and are less favored due to
their potential impact on market efficiency.
Overall, selective credit controls provide central banks with a nuanced approach to address specific
challenges while maintaining a degree of flexibility in their broader monetary policy framework.
Qualitative Tools of Monetary Policy
Moral Suasion
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Moral suasion is a non-binding approach used by central banks to influence the behavior of financial
institutions and guide their actions without resorting to formal regulations.
It involves persuasion, advice, and informal communication between the central bank and financial
institutions to encourage adherence to desired policies or practices.
This tool relies on the reputation and authority of the central bank to convince banks to act in accordance
with the broader monetary policy objectives.
While moral suasion does not carry the legal force of regulatory measures, its effectiveness lies in the
cooperative relationship between the central bank and financial institutions.
By leveraging trust and cooperation, central banks using moral suasion can encourage banks to voluntarily
align their activities with the central bank's goals, contributing to the overall stability and effectiveness of
monetary policy.
Qualitative Tools of Monetary Policy
Credit Rationing
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Credit rationing is a monetary policy tool involving the deliberate restriction of credit to certain sectors or
individuals.
Central banks may implement credit rationing to control lending in specific areas of the economy, ensuring
that the allocation of credit aligns with broader monetary policy goals.
This approach is often used to prevent excessive borrowing in sectors deemed vulnerable to economic
imbalances or speculative activities.
Credit rationing can take various forms, including setting limits on the amount of credit banks can extend
to particular borrowers or industries.
While it allows for a targeted and precise response to potential risks, credit rationing may also raise
concerns about market efficiency and equitable access to credit.
Central banks employ credit rationing cautiously, balancing the need for stability with the potential
drawbacks associated with restricting the flow of credit to certain segments of the economy.
Qualitative Tools of Monetary Policy
Margin Requirements
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Margin requirements are a monetary policy tool that involves setting the amount of cash or collateral that
individuals or institutions must deposit when engaging in certain financial transactions, particularly in the
realm of securities trading.
Central banks may adjust margin requirements to influence the level of borrowing and speculative
activities in financial markets.
By increasing margin requirements, the central bank can curb excessive borrowing for investment
purposes, reducing the potential for market bubbles.
Conversely, decreasing margin requirements can stimulate investment and market activity by making it
easier for investors to finance their positions.
Margin requirements play a crucial role in regulating market leverage and risk, contributing to the overall
stability of financial markets.
However, adjustments must be made cautiously to avoid unintended consequences, and central banks often
use margin requirements in conjunction with other tools to achieve balanced and effective monetary policy
outcomes.
Qualitative Tools of Monetary Policy
Direct Action
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Direct action is a monetary policy tool involving the central bank's direct intervention in financial markets
or specific sectors of the economy.
Unlike indirect tools such as interest rates or reserve requirements, direct action entails the central bank
taking immediate and targeted measures to address specific issues or imbalances.
This could involve direct purchases or sales of financial assets, direct lending to financial institutions, or
other interventions designed to achieve specific policy objectives.
While direct action can be a powerful tool for addressing urgent challenges, it is often reserved for
exceptional circumstances due to its potential market-distorting effects and the risk of unintended
consequences.
Central banks employ direct action when more conventional tools prove insufficient, emphasizing its role
as a responsive and decisive measure to address critical economic or financial situations.
Impact of Monetary Policy on Businesses
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Interest Rates and Borrowing Costs: Fluctuations in interest rates, controlled by monetary policy, directly
influence the expenses associated with business borrowing. When rates rise, businesses face higher costs for
loans, impacting their bottom line.
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Investment and Capital Spending: Monetary policy, especially when it involves raising interest rates, can act as
a deterrent to business investment and capital spending. The increased cost of financing makes companies more
cautious about expanding operations or initiating new projects.
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Inflation Expectations: Central banks often set inflation targets as part of their monetary policy. Predictable and
stable inflation rates provide businesses with a more reliable environment for making pricing decisions and
planning for the future.
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Consumer Spending: By manipulating interest rates, monetary policy affects the affordability of various loans,
such as mortgages and car loans, directly impacting consumers' disposable income. Changes in consumer
spending patterns subsequently affect businesses reliant on consumer demand.
Impact of Monetary Policy on Consumers
Interest Rates on Loans: Changes in interest rates, controlled by monetary policy, affect the cost of borrowing
for consumers. Higher interest rates can lead to increased mortgage payments, higher car loan costs, and more
expensive credit card debt.
Consumer Spending: Interest rate adjustments impact the disposable income of consumers. Lower interest rates
generally encourage spending by reducing the cost of borrowing, while higher rates can have the opposite effect,
potentially leading to decreased consumer spending.
Savings and Investments: Monetary policy influences the returns on savings and investments. Lower interest
rates may reduce the income from savings accounts and certain investments, affecting the ability of consumers to
grow their wealth.
Credit Availability: The overall stance of monetary policy can impact the availability of credit. Tightening
monetary policy may lead to stricter lending conditions, affecting consumers' ability to obtain loans for major
purchases like homes or cars.
Thank You!