The central bank formulates monetary policy, and it is linked to the financial matters of the country. The policy suggests measures that should be taken for monitoring the money supply, availability and the cost of credit in the economy. These policies also supervise the distribution of credit among credit users across the country and borrowing and lending rates of interest. In a developing country like India, it is vital for promoting economic growth.
The different instruments of monetary policy include fluctuations in the bank and other interest rates, strict credit controls, the supply of currency, shifts in reserve requirements and Open Market Operations (OMOs).
|Reverse repo rate
|Marginal Standing facility rate
Objectives of Monetary Policy
The primary objective of the monetary policy is attaining a high level of economic growth, stabilizing the price and exchange rate. The other aspects of framing monetary policy are discussed below:
Promoting Saving and Investment
Since the monetary policy regulates the interest rate and inflation in the country, it can affect the savings and investment of people as well. A higher interest rate transmutes to a higher rate of investment and savings, thereby, sustaining a healthy cash flow within the economy.
Controlling the Imports and Exports
By helping industries secure a loan at a reduced rate of interest, the monetary policy supports the export-oriented units to exchange imports and boost exports which in turn helps in improving the condition of balance of payments.
Managing Business Cycles
The main stages of the business cycle are depression and boom. Monetary policy is the most excellent tool through which boom and depression of business cycles can be regulated by controlling the supply of money through credit. Inflation in the financial market can be regulated by reducing the money supply. On the other hand, when the money supply grows, demand in the economy will also increase.
Regulation of Aggregate Demand
Since monetary policy can regulate the demand in an economy, it can be used by the authorities to sustain a balance between demand and supply of goods and services. When credit expands, and the interest rate reduces, it enables more people to avail loans for the purchase of goods and services in the form of credit cards, personal loans, auto loans, etc. This drives an increase in demand. On the other hand, when the monetary authorities need to reduce demand, they can minimize credit and raise interest rates.
Generation of Employment
When the monetary policy reduces the interest rates, small and medium enterprises (SMEs) can easily secure a loan for their business expansion. This can motivate prominent employment opportunities.
Helping with the development of infrastructure
The monetary policy allows concessional funding for the development of infrastructure within the country.
Allocating more credit for the priority segments
Under the monetary policy, additional funds are allocated at lower rates of interest for the development of the priority sectors such as small-scale industries, agriculture, underdeveloped sections of the society, etc.
Managing and developing the banking sector
RBI controls the banking system. While RBI strives to make the banking facilities available across the nation, it also directs other banks through the monetary policy to stabilize the rural branches wherever it is necessary for agricultural development. Additionally, the Indian government has also set regional rural banks and cooperative banks to help the farmers in receiving the financial assistance that they require in no time.
Flexible Inflation Targeting Framework (FITF)
The Flexible Inflation Targeting Framework (FITF) was launched in India after the amendment of the RBI Act, 1934 in 2016. Under the RBI Act, the Government of India sets the inflation target every five years after having a consultation with RBI. While the inflation target for the period between 5 August 2016 and 31 March 2021 is determined to be 4% of CPI, the Central Government had announced that the upper limit for CPI would be 6% and the lower limit for CPI will be 2%.
In this structure, there are possibilities of not attaining the inflation target fixed over an amount of time. This could happen when:
- The average inflation is higher than the upper tolerance limit of the inflation target that is predetermined by the Central Government for three quarters in a row.
- The average inflation is less than the lower tolerance limit of the target inflation that is fixed by the Central Government already for three consecutive quarters.