Why in news:
The Reserve Bank of India’s surprise 50 basis points (bps) rate cut in early June 2024 has started showing its impact — with banks passing on the benefit to borrowers and loan growth picking up as a result. This development is important in the context of monetary policy transmission, bank credit availability, and economic recovery.
UPSC CSE Relevance:
UPSC CSE in prelims and mains examination has focused on Monetary policy committee , Tools of MPC, Impact on economy etc.
UPSC PYQ 2020:
Q: If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?
1.Cut and optimize the Statutory Liquidity Ratio
2.Increase the Marginal Standing Facility Rate
3.Cut the Bank Rate and Repo Rate
Select the correct answer using the code given below:
A) 1 and 2 only
B) 2 only
C) 1 and 3 only
D) 1, 2 and 3
UPSC PYQ 2017:
Q: Which of the following statements is/are correct regarding the Monetary Policy Committee (MPC)?
1. It decides the RBI’s benchmark interest rates.
2. It is a 12-member body including the Governor of RBI and is reconstituted every year.
3. It functions under the chairmanship of the Union Finance Minister.
Select the correct answer using the code given below :
A) 1 only
B) 1 and 2 only
C) 3 only
D) 2 and 3 only
About MPC:
Monetary Policy Framework Agreement:
- The Government of India and Reserve Bank of India signed a Monetary Policy Framework Agreement on 20th February, 2015 (Urjit Patel Committee recommendation).
- The objective of monetary policy framework is to primarily maintain price stability, while keeping in mind the objective of growth. The Monetary Policy Framework provides for inflation targeting to be set by GoI every 5 years. GoI uses CPI for the purpose of inflation targeting in India.
- The inflation target is Consumer Price Index (CPI) inflation of 4% (+/- 2%).
What if failure to maintain inflation target:
The Central Government has notified the following as the factors that constitute failure to achieve the inflation target: (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.
Where the Bank fails to meet the inflation target, it shall set out in a report to the Central Government:
a. the reasons for failure to achieve the inflation target;
b. remedial actions proposed to be taken by the Bank; and
c. an estimate of the time-period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial actions.
MPC:
- Monetary Policy Committee was constituted in 2016 as a statutory body under the RBI Act 1934.
- Composition: 6 Members (3 from the RBI side and 3 from the GOI side).
- RBI Governor – ex-officio chairperson
- RBI Deputy Governor
- One more member from RBI to be nominated by the Central Board of Directors.
- 3 other members are be appointed by the Central Government.
- Term of office: Members hold office for 4yrs.
- Eligible to reappoint: No
- Quorum: 4 members
- Decision based on the majority and binding on RBI.
- Meeting: At least four time in a year.
Tools of MPC:
Quantitative tools:
- Liquidity Adjustment Facility (LAF): The LAF refers to the Reserve Bank’s operations through which it injects/absorbs liquidity into/from the banking system. It consists of overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF and MSF.
- LAF Components:
- Repo Rate: 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: The interest rate at which the Reserve Bank absorbs liquidity from banks against the collateral of eligible government securities under the LAF. Following the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of the RBI for purposes specified from time to time.
- Standing Deposit Facility (SDF) Rate: The rate at which the Reserve Bank accepts uncollateralised deposits, on an overnight basis, from all LAF participants. The SDF rate is placed at 25 basis points below the policy repo rate.
- Marginal Standing Facility (MSF) Rate: 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.
- Bank Rate: The rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate acts as the penal rate charged on banks for shortfalls in meeting their reserve requirements (cash reserve ratio and statutory liquidity ratio). The Bank Rate is published under Section 49 of the RBI Act, 1934. This rate has been aligned with the MSF rate and, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
- Cash Reserve Ratio (CRR): 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 on 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): 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 on 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).
- Open Market Operations (OMOs): These include outright purchase/sale of government securities by the Reserve Bank for injection/absorption of durable liquidity in the banking system.
Qualitative Tools:
- Margin Requirement: It refers to difference between the securities offered and amount borrowed by the banks.
- Consumer Credit Regulation: Consumer Credit Regulation refers to issuing rules regarding down payments and maximum maturities of instalment credit for purchase of goods.
- Rationing of credit: It is a monetary policy tool used by the Reserve Bank of India (RBI) to regulate the total volume of credit in the economy by setting limits on the amount of loans and advances that banks can extend, and in some cases, by prescribing ceilings for particular sectors or categories of loans
- Moral suasion: It is a soft and informal method of credit control through which the Reserve Bank of India (RBI) appeals to or advises commercial banks to align their lending practices with the overall objectives of monetary policy. It does not involve any legal enforcement or penalties, making it a persuasive, rather than coercive, tool of selective credit regulation.
- Direct Action: It refers to the measures taken by the Reserve Bank of India (RBI) against commercial banks that fail to comply with its regulatory guidelines or violate the prescribed norms. It involves penal or corrective steps to ensure adherence to monetary policy directives.”
Strong Momentum Effect: “Strong momentum” refers to the continued strength and resilience in economic activity, especially after a revival or policy support. The Reserve Bank of India (RBI) uses this term to indicate that various sectors of the economy are growing steadily, and the growth trend is likely to persist.
Monetary Policy Stance:
| Policy Stance | Objective | Impact on Interest Rates | Effect on Economy | When is it Used? |
| Hawkish | To control inflation by discouraging excessive borrowing and spending | Increase in interest rates | Reduces credit demand and spending → Slows down economy → Helps reduce inflation | When inflation is high and price stability is priority |
| Dovish | To stimulate economic growth and boost demand | Decrease in interest rates | Encourages borrowing and spending → Boosts demand and investment → Leads to economic growth | When growth is weak and inflation is low |
| Neutral | To stay flexible and observe data before taking action | Rates can go up, down or remain same | Keeps options open → RBI reacts based on inflation-growth data | When economy is balanced and inflation is moderate |
| Accommodative | To boost economic activity by injecting more money into the system | Reduce interest rates progressively | Increases money supply → Cheaper loans → Higher spending → Promotes growth | When economy is in slowdown but inflation is not a threat |
Practice Question:
Q: With reference to Indian economy, consider the following.
1. Bank rate
2. Open market operations
3. Fine Tuning Operations
4. Consumer Credit Regulation
Which of the above is/are Qualitative and Quantitative component/ components of Monetary Policy?
A) 1 only
B) 2, 3 and 4 only
C) 1 and 2 only
D) 1, 2,3 and 4
