By Sravya Vemuri
The monetary policy in developing countries is mainly aimed at fostering economic growth while stabilising prices. For achieving stability, it is generally considered necessary to keep the growth of money supply in step with its demand, which is assumed to be uniquely related to the national income, at any rate over the medium-term.
The post-reform period
India saw an economic policy reform in 1991. The reforms of the liberalisation, which changed the economic face of the country, put an end to ‘red tapeism and several public monopolies. Foreign direct investments in a number of sectors started pouring in. Various types of Indian economic (monetary) indicators are used for different periods of time. These indicators are essential as they give us an accurate status of the Indian economy at different periods. Thus, these indicators help us analyse the Indian economy. An important economic indicator is the rate of inflation. The real gross domestic product (GDP), money supply, credit availability, interest rates, foreign trade & balance of payment (BOP) are some other key macroeconomic indicators.
Direct and indirect instruments of the RBI
The Reserve Bank of India has adopted various monetary policy instruments over time. Bank rate policy is an indirect method of influencing the volume of credit in the economy. It first influences the cost and availability of credit to the commercial banks and thereby, influences the willingness of the businesspersons to borrow and invest. Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are the most direct methods because they control the volume of credit by directly influencing the cash reserves of the commercial banks.
Open market operations is another instrument which controls the volume of credit by influencing the cash reserves of the commercial banks through the purchase and sale of securities. Therefore, the success of this policy depends on the existence of a well-developed securities market in the economy. Repo and reverse repo rates under the Liquidity Adjustment Facility (LAF) allow the Reserve Bank to manage market liquidity on a daily basis and transmit interest rate signals to the market.
A shift to indirect methods
During the 1990s, a shift from direct to indirect instruments of the monetary policy took place in consonance with the consistent preference for market-based instruments of the monetary policy. The process was reinforced by a switch, within the group of indirect instruments, from relatively less market-oriented instruments such as reserve requirements to relatively more market-oriented instruments such as open market operations.
With the initiation of financial sector reforms, monetary management in India has been increasingly relying on the use of indirect instruments like open market operations and fine-tuning of liquidity conditions through the Liquidity Adjustment Facility (LAF). The modulations in policy interest rates have emerged as a principal instrument of signalling monetary policy stance. Key monetary policy rates, such as the bank rate and the repo rate, have been reduced substantially since 1998 reflecting the countercyclical monetary policy stance. The bank rate was reduced from 11 percent in January 1998 to 6 percent by April 2003. The repo rate also witnessed a cut from 6 percent in January 1999 to 4.5 percent in August 2003.
With the changing framework of the monetary policy in India from monetary targeting to an augmented multiple indicators approach, the operating targets and processes have also undergone a change. There has been a shift from quantitative intermediate targets to interest rates, as the development of financial markets enabled the transmission of policy signals through the interest rate channel. At the same time, availability of multiple instruments such as CRR, OMO including LAF and MSS has provided the necessary flexibility to monetary operations.
Flexible inflation targeting network
In a historic monetary policy overhaul, the finance ministry and the Reserve Bank of India (RBI) have agreed to put in place a monetary policy framework to focus on flexible inflation targeting, something the central bank has been pressing for. The new framework makes RBI more accountable since now it will have to explain to the government if it fails to meet the inflation targets. Economists say the targets will restrain the RBI from taking any aggressive or accommodating monetary policy stance. This will put India at par with other nations in terms of flexible inflation targeting.
Price stability or economic growth?
The most controversial side of the monetary policy is that it reduces inflation by reducing economic growth. While various groups demand a decrease in interest rates, the RBI makes an independent decision which at times is not appealing to the government and other entities. This brings out the major conflict between stabilising prices and fostering economic growth. Studies have shown that price stability has to be the primary concern of central banks as in the long run, a higher inflation hinders economic growth.
There is a definite and remarkable economic impact of the monetary policy on Indian economy in the post-reform period. The importance of the monetary policy has been increasing year after year. Its role is very relevant in attaining monetary objectives, especially in managing price stability and achieving economic growth. Along with that, the use and importance of monetary weapons like bank rate, CRR, SLR, repo rate and the reverse rate have increased over the years. Repo and reverse repo rates are the most frequently used monetary techniques in recent years. The rates are varied mainly for curtailing inflation and absorbing excess liquidity thereby maintaining price stability in the economy. Thus, this short-time objective of price stability is more successful for the Indian economy rather than other long-term objectives of development.
Monetary policy rules can be active or passive. The passive rule is to keep the money supply constant, which is reminiscent of Milton Friedmans money growth rule. The second rule, called the price stabilisation rule, is to change the money supply in response to changes in aggregate supply or demand to keep the price level constant. The idea of an active rule is to keep the price level and hence, inflation in check. In India, this rule has been dominant, as a stable growth is a healthy growth.
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