Introduction to Monetary Policy
Monetary policy refers to the actions undertaken by a central bank (in India, the Reserve Bank of India - RBI) to manipulate the money supply and credit conditions to achieve macroeconomic objectives. It is a critical tool for managing an economy's aggregate demand, influencing variables like inflation, output, and employment.
The primary goal often revolves around price stability, while also balancing the needs for economic growth and financial system stability. In India, the monetary policy framework has evolved significantly, culminating in the adoption of flexible inflation targeting (FIT) and the establishment of the Monetary Policy Committee (MPC).
5.2.1. Objectives of Monetary Policy in India
The RBI Act, 1934, as amended in 2016, mandates the RBI to conduct monetary policy with the primary objective of maintaining price stability while keeping in mind the objective of growth. Additionally, financial stability is an increasingly recognized implicit objective.
1. Price Stability
- This is the primary and statutory objective of monetary policy in India, as per the amended RBI Act, 1934.
- Defined as maintaining a target inflation rate: CPI-Combined inflation at 4% with an upper tolerance limit of 6% and a lower tolerance limit of 2%. This is known as Flexible Inflation Targeting (FIT).
- Price stability creates a conducive environment for sustainable economic growth by reducing uncertainty, encouraging investment, and protecting the purchasing power of currency, especially for the poor.
- High inflation erodes real income, distorts resource allocation, and can lead to macroeconomic instability.
2. Economic Growth
- While price stability is primary, monetary policy must also support the objective of growth.
- This involves ensuring adequate availability of credit at reasonable costs to productive sectors of the economy.
- During economic slowdowns, an accommodative monetary policy (e.g., lowering interest rates) can stimulate demand and investment.
- There's often a short-run trade-off between controlling inflation and promoting growth (Phillips Curve concept, though its applicability in India is debated).
3. Financial Stability
- An implicit but crucial objective. Financial stability refers to the smooth functioning of financial markets and institutions, preventing systemic crises.
- Monetary policy tools can influence asset prices, credit growth, and leverage in the financial system.
- RBI uses macroprudential tools alongside monetary policy to address risks to financial stability. Examples: Regulating lending to specific sectors, capital adequacy norms for banks.
- The Global Financial Crisis of 2008 highlighted the importance of financial stability as a distinct objective.
5.2.2. Instruments of Monetary Policy
Monetary policy instruments are the tools used by the RBI to achieve its objectives. They are broadly classified into quantitative (general) and qualitative (selective) instruments.
A. Quantitative Instruments (General Tools)
These instruments influence the overall supply of money/credit in the economy.
1. Repo Rate (Repurchase Rate)
The key policy rate. It is the fixed interest rate at which the RBI provides overnight liquidity to commercial banks against the collateral of government and other approved securities under the Liquidity Adjustment Facility (LAF).
Mechanism: When banks face a shortage of funds, they can borrow from RBI at the repo rate by selling securities with an agreement to repurchase them at a predetermined date and price.
Impact: An increase in repo rate makes borrowing by commercial banks more expensive, leading them to increase their lending rates, thus reducing credit demand and money supply. A decrease has the opposite effect.
Current Repo Rate (as of Feb 2024 MPC): 6.50%
2. Reverse Repo Rate
The fixed interest rate at which the RBI absorbs liquidity, on an overnight basis, from commercial banks against the collateral of eligible government securities under the LAF.
Mechanism: When banks have surplus funds, they can park these funds with the RBI and earn interest at the reverse repo rate.
Impact: An increase in reverse repo rate incentivizes banks to park more funds with RBI, reducing liquidity in the system. A decrease disincentivizes this.
The reverse repo rate is typically set lower than the repo rate. With the introduction of the Standing Deposit Facility (SDF), the fixed-rate reverse repo has been largely superseded.
3. Marginal Standing Facility (MSF)
A facility under which scheduled commercial banks can borrow an additional amount of overnight money from the RBI by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit (currently 2% of Net Demand and Time Liabilities - NDTL), at a penal rate of interest.
Objective: To reduce volatility in the overnight inter-bank interest rates and provide a safety valve against unanticipated liquidity shocks.
Rate: The MSF rate is pegged above the repo rate, currently 6.75% (Repo rate + 0.25%). It forms the upper bound of the interest rate corridor.
4. Bank Rate
The rate at which the RBI is ready to buy or rediscount bills of exchange or other commercial papers.
Historical Significance: Traditionally, it was a key policy rate, but its direct role has diminished with the operationalization of LAF.
Current Relevance: The Bank Rate is currently aligned with the MSF rate (6.75%). It is primarily used for calculating penalties on banks if they fail to meet their CRR/SLR requirements. It also acts as a reference rate for various other financial transactions.
5. Liquidity Adjustment Facility (LAF)
A facility extended by the RBI to scheduled commercial banks (excluding RRBs) and primary dealers to avail liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of government securities.
Components: Repo auctions (for injecting liquidity), Reverse Repo auctions (for absorbing liquidity - largely replaced by SDF), Term Repo auctions (for longer tenors).
Corridor: The LAF operates within an interest rate corridor. The MSF rate acts as the ceiling, and the Standing Deposit Facility (SDF) rate acts as the floor. The repo rate is generally targeted to be in the middle of this corridor.
Standing Deposit Facility (SDF): Introduced in April 2022, the SDF allows banks to park their surplus funds with the RBI without any collateral. It replaced the fixed-rate reverse repo as the floor of the LAF corridor. SDF Rate: 6.25% (Repo Rate - 0.25%).
6. Cash Reserve Ratio (CRR)
The share of a bank’s Net Demand and Time Liabilities (NDTL) that it must maintain as cash deposits with the RBI.
Mechanism: Banks do not earn any interest on CRR balances.
Impact: An increase in CRR reduces the amount of funds available with banks for lending, thereby contracting credit and money supply. A decrease in CRR has the opposite effect, injecting liquidity.
It is a powerful tool but used sparingly as it directly impacts banks' profitability and lending capacity.
Current CRR (as of Feb 2024): 4.50% of NDTL.
7. Statutory Liquidity Ratio (SLR)
The share of a bank’s Net Demand and Time Liabilities (NDTL) that it must maintain in safe and liquid assets, such as unencumbered government securities, cash, and gold.
Mechanism: Banks earn interest on SLR holdings (as they are mostly government securities).
Impact: An increase in SLR restricts banks' ability to lend to the private sector as they need to hold more in approved securities. This can channel funds towards government borrowing. A decrease in SLR frees up funds for commercial lending.
Over the years, SLR has been progressively reduced to provide more funds to the commercial sector.
Current SLR (as of Feb 2024): 18.00% of NDTL.
8. Open Market Operations (OMOs)
The outright purchase and sale of government securities (G-Secs) by the RBI in the open market to inject or absorb liquidity of a durable nature.
Mechanism:
- Purchase of G-Secs: RBI buys G-Secs from the market, injecting liquidity (money flows from RBI to the sellers, i.e., banks/public).
- Sale of G-Secs: RBI sells G-Secs to the market, absorbing liquidity (money flows from buyers to RBI).
Impact: OMOs directly influence the level of reserves in the banking system and, consequently, the money supply and interest rates.
Types: Outright OMOs (PEMO) for permanent changes, Repo/Reverse Repo OMOs (LAF) for short-term, and Special OMOs like 'Operation Twist'.
What is 'Operation Twist'?
This involves the simultaneous purchase of long-term G-Secs and sale of short-term G-Secs by the RBI. Its aim is to bring down long-term interest rates (to boost investment) while managing short-term liquidity, thus 'twisting' the yield curve.
OMOs are a flexible and effective tool for managing systemic liquidity.
B. Qualitative Instruments (Selective Tools)
These instruments are used to regulate the flow of credit to specific sectors or for particular purposes. They are discriminatory in nature.
1. Margin Requirements
The margin is the proportion of the loan amount that the borrower has to finance from their own resources. RBI can prescribe different margins for loans against different commodities or securities.
Impact: By increasing the margin requirement for a particular sector, the RBI can discourage lending to that sector or for speculative activities. For example, a higher margin on loans against shares can curb speculative stock market activity.
2. Selective Credit Control (SCC)
Measures to influence the allocation of credit to particular sectors or for specific uses.
- Setting minimum margins for lending against specific securities.
- Ceilings on credit for certain purposes.
- Prohibition of credit for certain non-essential or speculative activities.
- Discriminatory interest rates for certain types of advances.
Note: Their use has declined significantly with financial liberalization, as they can distort market mechanisms. Priority Sector Lending (PSL) norms, while having a similar objective of directing credit, are more of a regulatory mandate than a typical SCC.
3. Moral Suasion
A psychological tool where the RBI uses persuasion, advice, and informal suggestions to induce commercial banks to follow its policy directives.
Mechanism: Through meetings, speeches, letters, and discussions, the RBI Governor or officials may urge banks to be cautious in their lending, to direct credit to certain priority sectors, or to maintain healthy financial practices.
Impact: Its effectiveness depends on the credibility of the RBI and the responsiveness of the banks. It is a non-coercive method.
5.2.3. Monetary Policy Committee (MPC)
The MPC was constituted in 2016, formalizing the monetary policy decision-making process and adopting a flexible inflation targeting framework. This was based on the recommendations of the Urjit Patel Committee.
Structure and Members
The MPC is a 6-member committee.
- RBI Governor: Chairperson, ex officio.
- Deputy Governor of RBI: in charge of Monetary Policy, Member, ex officio.
- One officer of the RBI: Nominated by the Central Board, Member, ex officio.
- Three external members: Appointed by the Central Government for 4 years, not eligible for re-appointment. Experts in economics, banking, finance, or monetary policy.
Voting Process
- Decisions are taken by majority vote.
- Each member of the MPC has one vote.
- In case of a tie, the RBI Governor has a second or casting vote.
- The MPC is required to meet at least four times a year.
- The quorum for a meeting is four members, with at least one external member and the Governor or Deputy Governor in charge of monetary policy present.
Accountability
- The primary mandate of the MPC is to achieve the inflation target set by the Government of India: 4% CPI-C inflation with a +/- 2% tolerance band (i.e., 2%-6%).
- Failure to meet the target: If average inflation is outside the 2%-6% range for three consecutive quarters, it constitutes a failure.
- In case of such failure, the RBI has to submit a report to the Central Government stating reasons, remedial actions, and estimated time to achieve target.
- The proceedings of the MPC meetings (resolutions and minutes) are published after 14 days, enhancing transparency.
The MPC Members: A Visual Overview
RBI Governor
(Chairperson)
Deputy Governor
(Monetary Policy)
RBI Officer
(Nominated)
External Member 1
(GoI Appointee)
External Member 2
(GoI Appointee)
External Member 3
(GoI Appointee)
5.2.4. Monetary Policy Transmission Mechanism
Monetary policy transmission refers to the process through which changes in the policy interest rate (repo rate) by the central bank work their way through the financial system to influence aggregate demand, and ultimately, inflation and output in the economy.
Channels of Transmission
1. Interest Rate Channel
- Changes in the policy rate directly impact short-term money market rates.
- Banks adjust their deposit and lending rates based on changes in their cost of funds.
- This affects borrowing costs for consumers and investment costs for businesses, influencing consumption and investment demand.
2. Credit Channel
Bank Lending Channel: Policy rate changes affect banks' reserves and liquidity, influencing their ability and willingness to lend. A rate hike might reduce bank liquidity, leading to a contraction in credit supply.
Balance Sheet Channel: Affects borrowers' net worth and collateral value. A rate hike can reduce asset prices, lowering collateral values and making it harder for firms/households to borrow. It also increases debt servicing burdens.
3. Exchange Rate Channel
- Changes in domestic interest rates relative to foreign interest rates can affect capital flows and the exchange rate.
- A policy rate hike might attract foreign capital, leading to currency appreciation.
- This can make exports costlier and imports cheaper, affecting net exports and aggregate demand. It also impacts the domestic currency prices of imported goods, thus influencing inflation.
4. Asset Price Channel
- Monetary policy can influence prices of assets like stocks, bonds, and real estate.
- Lower interest rates can make borrowing cheaper for asset purchases and increase the present value of future earnings, boosting asset prices.
- Changes in asset prices affect household wealth (wealth effect) and firms' investment decisions, influencing consumption and investment.
5. Expectations Channel
- Central bank actions and communication shape public and market expectations about future inflation and economic activity.
- If the central bank credibly commits to controlling inflation, it can anchor inflation expectations, making it easier to achieve price stability.
- Forward guidance by the MPC plays a key role here.
Impediments to Monetary Policy Transmission in India
- Dominance of fixed-rate deposits and loans: A significant portion of bank deposits and some older loans are at fixed rates, making transmission slower.
- Administered interest rates on small savings schemes: These offer competition to bank deposits and are not always aligned with monetary policy, affecting banks' ability to cut deposit rates.
- High Non-Performing Assets (NPAs): Stressed bank balance sheets can impair their ability to lend and transmit policy rate changes.
- Shallow financial markets: Limited depth in corporate bond markets means many firms rely heavily on bank credit.
- Information asymmetry and market imperfections.
- Fiscal dominance concerns: High government borrowing can put upward pressure on interest rates, counteracting monetary policy easing.
To improve transmission, RBI has mandated banks to link their new floating rate loans to an external benchmark like the repo rate (External Benchmark Linked Rate - EBLR system, since October 2019).
5.2.5. Recent Monetary Policy Stance
The monetary policy stance indicates the MPC's assessment of the macroeconomic situation and its likely future policy direction.
Types of Stances
1. Accommodative
Indicates a willingness to expand money supply and cut interest rates to boost growth. Usually adopted during economic slowdowns or when inflation is below target.
Recent Example: RBI maintained an accommodative stance for a prolonged period during and after the COVID-19 pandemic to support economic recovery.
2. Neutral
The central bank is monitoring the situation and could move in either direction (rate hikes or cuts) depending on incoming data. It implies a balance between inflation and growth concerns.
3. Withdrawal of Accommodation / Calibrated Tightening
Signifies that the central bank is focused on reining in inflation and will likely raise interest rates or reduce liquidity.
Recent Example: Starting May 2022, the RBI MPC shifted its stance and began raising the repo rate to combat rising inflation, initially moving to "withdrawal of accommodation."
4. Hawkish (Tight)
A strong signal that the central bank is determined to control inflation, even at the cost of some growth, through significant rate hikes.
5. Dovish
Opposite of hawkish, prioritizing growth over inflation control, signaling potential rate cuts.
Current Affairs Focus (as of February 2024 and recent past)
Latest MPC Announcements (February 2024):
- Policy Repo Rate: Kept unchanged at 6.50% (for the sixth consecutive meeting).
- Stance: Maintained as "withdrawal of accommodation" to ensure that inflation progressively aligns with the target, while supporting growth.
- Inflation Projection: CPI inflation for 2023-24 projected at 5.4%. For 2024-25, Q1 at 5.0%, Q2 at 4.0%, Q3 at 4.6%, Q4 at 4.7% (assuming normal monsoon).
- Growth Projection: Real GDP growth for 2023-24 projected at 7.3%. For 2024-25, projected at 7.0% (Q1: 7.2%, Q2: 6.8%, Q3: 7.0%, Q4: 6.9%).
RBI's Liquidity Management Operations: RBI has been actively managing system liquidity through various tools, including Variable Rate Repo (VRR) and Variable Rate Reverse Repo (VRRR) auctions, and increased use of the Standing Deposit Facility (SDF). The RBI aims to keep the weighted average call rate (WACR) – the operating target of monetary policy – close to the repo rate.
Impact on Lending Rates: Banks have largely transmitted the cumulative repo rate hikes (250 bps between May 2022 and Feb 2023) to their lending rates. The External Benchmark Linked Lending Rate (EBLR) system has ensured faster transmission to new floating-rate loans. Deposit rates have also increased, though often with a lag compared to lending rates.
Prelims-ready Notes
- Primary Objective (India): Price stability (CPI-C target 4% +/- 2%), while keeping in mind growth.
- Quantitative Instruments (affect overall money supply): Repo Rate, Reverse Repo Rate, MSF Rate, Bank Rate, LAF, CRR, SLR, OMOs, SDF Rate.
- Qualitative Instruments (affect specific sectors/uses): Margin Requirements, Selective Credit Control, Moral Suasion.
- Monetary Policy Committee (MPC): 6 members (3 RBI internal, 3 GoI external), RBI Governor is Chairperson (casting vote), meets at least 4 times/year, accountable for inflation target.
- Monetary Policy Transmission: Process of policy rate changes affecting economy (interest rates, credit, exchange rate, asset prices, expectations channels).
- Recent Stance (Feb 2024): Repo rate 6.50%, stance "withdrawal of accommodation."
Key Instruments & Rates (Feb 2024 Snapshot)
| Instrument | Current Rate (Feb 2024) | Purpose | Nature |
|---|---|---|---|
| Repo Rate | 6.50% | Inject liquidity (key policy rate) | Quantitative |
| SDF Rate | 6.25% | Absorb liquidity (floor of corridor) | Quantitative |
| MSF Rate | 6.75% | Emergency lending (ceiling of corridor) | Quantitative |
| Bank Rate | 6.75% | Penalties, reference rate | Quantitative |
| CRR | 4.50% | Control credit creation, reserve requirement | Quantitative |
| SLR | 18.00% | Control credit, ensure bank solvency | Quantitative |
| OMOs | N/A (Market determined) | Manage durable liquidity | Quantitative |
| Margin Reqs. | Varies | Control credit for specific purposes | Qualitative |
| Moral Suasion | N/A | Persuade banks | Qualitative |
Mains-ready Analytical Notes
Major Debates/Discussions
Inflation vs. Growth Dilemma: The classic trade-off. Aggressive inflation targeting might stifle growth, especially in a developing economy like India with supply-side constraints. The flexible inflation targeting (FIT) framework attempts to balance this.
- Pros of FIT: Anchors inflation expectations, provides policy credibility, transparency.
- Cons of FIT: May not adequately address supply-side inflation, potential neglect of growth in certain scenarios.
Effectiveness of Monetary Policy Transmission: Significant lags and incomplete pass-through remain challenges in India (Reasons: Bank balance sheet issues, small savings schemes, information asymmetry).
Role of MPC vs. Governor: While MPC decides collectively, the Governor's role as chairperson with a casting vote and as the face of RBI communication remains significant.
Coordination between Monetary and Fiscal Policy: Crucial for macroeconomic stability. Lack of coordination can lead to policies working at cross-purposes (e.g., loose fiscal policy with tight monetary policy).
Historical/Long-term Trends, Continuity & Changes
- Pre-1991: Monetary policy was subservient to fiscal policy, focus on financing government deficits (automatic monetization via ad-hoc Treasury Bills). Administered interest rate structure.
- Post-1991 Reforms: Phasing out of automatic monetization, deregulation of interest rates, move towards market-based instruments.
- Shift from Multiple Indicators Approach to FIT: Before 2016, RBI followed a multiple indicators approach. Adoption of FIT marked a significant shift towards a more focused, rule-based framework.
- Increasing Transparency: Publication of MPC minutes, detailed resolutions.
Contemporary Relevance/Significance/Impact
- Managing Global Spillovers: Indian monetary policy increasingly needs to factor in global shocks (e.g., US Fed rate hikes, commodity price volatility due to geopolitical events).
- Navigating Uncertainty: Events like pandemics, wars, and climate change create unprecedented uncertainty, making monetary policy formulation more complex.
- Financial Stability Concerns: Growth of NBFCs, digital currencies (private cryptocurrencies vs. CBDC like e-RUPI), and interconnectedness of financial markets necessitate a vigilant approach.
- Climate Change & Monetary Policy: Growing discussion on how central banks should incorporate climate-related financial risks.
Real-world/Data-backed Recent Examples
- India's response to COVID-19: RBI undertook significant rate cuts (repo rate down to 4%), liquidity infusions (OMOs, TLTROs), and regulatory forbearance to support the economy.
- Global Inflation Surge (2021-2023): Caused by supply chain disruptions, energy price shocks (Ukraine war), and strong demand recovery. Central banks worldwide, including RBI, responded with aggressive rate hikes (e.g., US Fed raised policy rate from near zero to over 5% in ~18 months).
- RBI's Handling of Inflation Post-2022: Repo rate increased by 250 bps from 4.0% to 6.5% (May 2022 - Feb 2023). Retail CPI inflation which peaked at 7.79% in April 2022, moderated to 5.10% in January 2024.
Integration of Value-added Points
- Financial Inclusion: Better financial inclusion (e.g., PM Jan Dhan Yojana) can improve monetary policy transmission by bringing more people into the formal financial system.
- Digital Payments: Growth in digital payments (UPI) can improve the velocity of money and efficiency of transactions, which has implications for monetary policy.
- FRBM Act: The Fiscal Responsibility and Budget Management Act, by limiting government deficits, provides a more stable environment for monetary policy.
UPSC Previous Year Questions
Prelims MCQs
1. Which of the following is not an instrument of monetary policy? (UPSC CSE 2012 - modified for context)
- (a) Repo Rate
- (b) Open Market Operations
- (c) Deficit Financing
- (d) Cash Reserve Ratio
Answer: (c) Deficit Financing
Explanation: Deficit financing is a fiscal policy tool related to government borrowing, not a monetary policy instrument used by the central bank.
2. The terms ‘Marginal Standing Facility Rate’ and ‘Net Demand and Time Liabilities’, sometimes appearing in news, are used in relation to (UPSC CSE 2014)
- (a) banking operations
- (b) communication networking
- (c) military strategies
- (d) supply and demand of agricultural products
Answer: (a) banking operations
Explanation: MSF is a rate at which banks borrow from RBI, and NDTL is the base for calculating CRR and SLR, both key banking terms related to monetary policy.
3. With reference to Indian economy, consider the following: (UPSC CSE 2015)
- Bank rate
- Open market operations
- Public debt
- Public revenue
Which of the above is/are component/components of Monetary Policy?
- (a) 1 only
- (b) 2, 3 and 4
- (c) 1 and 2
- (d) 1, 3 and 4
Answer: (c) 1 and 2
Explanation: Bank rate and OMOs are direct instruments of monetary policy. Public debt and public revenue are components of fiscal policy.
Mains Questions
1. Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments. (UPSC CSE 2019)
Direction: Assess the statement. Discuss recent GDP growth trends and inflation levels. Analyze if they truly indicate 'good shape' by considering other factors like employment, income inequality, fiscal health, and external sector stability. Link how monetary policy (inflation control) and fiscal policy have contributed or faced challenges.
2. The public expenditure management is a challenge to the Government of India in the context of budget making during the post-liberalization period. Clarify it. (UPSC CSE 2019 - relevant for fiscal-monetary interface)
Direction: While focused on public expenditure, this can be linked to how effective expenditure management (or lack thereof) impacts the fiscal deficit, which in turn influences the space for monetary policy and overall macroeconomic stability.
3. What is the mandate of the Monetary Policy Committee (MPC) of India? Discuss the tools it uses to achieve the mandate. (UPSC CSE 2017 - adapted)
Direction: Clearly state the mandate (price stability - 4% +/- 2% CPI target, while keeping in mind growth). Then detail the quantitative and qualitative tools (Repo, SDF, MSF, CRR, SLR, OMOs, etc.) and explain how each helps in achieving the mandate.
Original MCQs for Prelims
1. Consider the following statements regarding the Monetary Policy Committee (MPC) in India:
- It is a statutory body established under the RBI Act, 1934.
- All members of the MPC, including external members, are appointed by the Central Government.
- The MPC is mandated to set the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
Which of the statements given above is/are correct?
- (a) 1 only
- (b) 1 and 2 only
- (c) 3 only
- (d) 1, 2 and 3
Answer: (a) 1 only
Explanation: Statement 1 is correct. Statement 2 is incorrect; internal RBI members (Governor, Deputy Governor, one RBI officer) are ex-officio or nominated by RBI's Central Board, only external members are appointed by the GoI. Statement 3 is incorrect; while MPC decisions influence liquidity conditions that might necessitate CRR/SLR adjustments by RBI, the MPC's primary role is to set the policy repo rate. CRR/SLR are typically decided by the RBI, though informed by the MPC's stance.
2. If the Reserve Bank of India (RBI) conducts an 'Operation Twist', it implies:
- (a) A simultaneous increase in both repo rate and reverse repo rate.
- (b) Selling short-term government securities and buying long-term government securities simultaneously.
- (c) Injecting large amounts of liquidity through Long Term Repo Operations (LTROs).
- (d) Withdrawing liquidity by increasing the Cash Reserve Ratio (CRR).
Answer: (b) Selling short-term government securities and buying long-term government securities simultaneously.
Explanation: 'Operation Twist' is a type of Open Market Operation (OMO) where the central bank tries to influence the yield curve by simultaneously buying long-term securities (to bring down long-term interest rates) and selling short-term securities (which may push up short-term rates slightly or keep them stable).
3. Which of the following actions by the Reserve Bank of India (RBI) would most likely lead to an increase in liquidity in the banking system?
- An increase in the Marginal Standing Facility (MSF) rate.
- Outright purchase of government securities from the market.
- An increase in the Cash Reserve Ratio (CRR).
- Conducting a Variable Rate Reverse Repo (VRRR) auction.
Select the correct answer using the code given below:
- (a) 2 only
- (b) 1 and 3 only
- (c) 2 and 4 only
- (d) 1, 3 and 4
Answer: (a) 2 only
Explanation:
- Increasing MSF rate makes borrowing from RBI costlier, it doesn't inject liquidity.
- Outright purchase of G-Secs (OMO purchase) injects liquidity into the system.
- Increasing CRR mops up liquidity from banks.
- A VRRR auction absorbs liquidity from the banking system.
Original Descriptive Questions for Mains
1. "While the establishment of the Monetary Policy Committee (MPC) and the adoption of flexible inflation targeting have enhanced the credibility and transparency of monetary policy in India, challenges in policy transmission continue to hinder its full effectiveness." Critically analyze this statement. (15 marks, 250 words)
Structure/Key Points for Answering:
- Introduction: Briefly explain the shift to MPC and FIT framework and its objectives.
- Arguments for Enhanced Credibility/Transparency: Rule-based framework, collective decision-making, publication of minutes, accountability mechanism.
- Challenges in Policy Transmission: Bank-specific factors (sticky deposit rates, NPA burden), market-related factors (dominance of bank finance), administered rates (small savings schemes), fiscal dominance concerns.
- Steps taken to improve transmission: EBLR mandate, liquidity management by RBI.
- Critical Analysis: Acknowledge improvements but emphasize that transmission lags/gaps mean policy signals don't fully translate. Suggest further reforms.
- Conclusion: Reiterate importance of addressing bottlenecks.
2. Discuss the evolution of monetary policy objectives and instruments in India since economic reforms of 1991. How has the recent global economic environment, including the COVID-19 pandemic and geopolitical conflicts, reshaped the priorities and operational strategies of the RBI? (15 marks, 250 words)
Structure/Key Points for Answering:
- Introduction: State that monetary policy has evolved from supportive role to independent framework.
- Evolution of Objectives (Post-1991): Move from financing fiscal deficit to price stability, Multiple Indicator Approach, formal FIT adoption, growing emphasis on financial stability.
- Evolution of Instruments (Post-1991): Deregulation of interest rates, development of market-based instruments (LAF, Repo, OMOs), phasing out of ad-hoc treasury bills, introduction of MSF, SDF.
- Impact of Recent Global Environment: COVID-19 (unprecedented easing, liquidity infusion), Geopolitical Conflicts (supply chain disruptions, commodity price shocks, imported inflation, forcing rapid tightening), Global Monetary Policy Spillovers.
- Reshaping Priorities & Strategies: Greater focus on forward guidance, nimble liquidity management, heightened awareness of external sector risks, balancing inflation/growth.
- Conclusion: RBI's framework matured, but global shocks necessitate adaptability.
Conclusion & Way Forward
Monetary policy is an indispensable tool for macroeconomic management in India. The shift towards a flexible inflation targeting framework under the aegis of the MPC has brought greater clarity, transparency, and credibility to its operations. However, challenges related to policy transmission, balancing multiple objectives in a complex global environment, and ensuring financial stability remain pertinent.
Way Forward:
- Continued efforts to improve monetary policy transmission, including further development of financial markets.
- Strengthening the coordination between monetary and fiscal policies.
- Adapting the monetary policy framework to address emerging challenges like climate change-related financial risks and the rise of digital currencies.
- Enhancing data quality and analytical capabilities to support evidence-based policymaking.
Significance:
- Maintaining price stability, which protects the poor and fosters sustainable growth.
- Anchoring inflation expectations, reducing economic uncertainty.
- Supporting economic growth by ensuring adequate credit flow at appropriate costs.
- Preserving financial stability and preventing systemic crises.
- Managing external sector vulnerabilities and exchange rate stability.
The RBI's proactive and adaptive approach to monetary policy will continue to be vital for navigating India's economic trajectory amidst domestic and global uncertainties.