The central bank’s macroeconomic policy is known as credit and monetary policy. Through monetary policies, the government manages the money supply, that is, inflation and deflation in the economy.
There are various economic policies that the government uses as per the requirement. All the policies help to manage the money supply, but their usage depends upon the need at that particular time.
In this law note, we will study the economic policies of the Reserve Bank of India (RBI) in detail.
Objectives of Monetary Policy
Monetary policies are introduced by the RBI to meet certain objectives, which are:
- To keep prices consistent.
- Assisting growth by ensuring an appropriate flow of credit to productive industries.
- Full-time employment arrangement.
- Credit facility expansion
- Equality and justice exchange rate stability
- Fixed deposit promotion.
- Fair credit distribution.
Types of Monetary Policy
There are two sorts of monetary policy instruments:
- Quantitative Policies of RBI
- Qualitative Policies of RBI
Let’s understand both the economic policies one by one.
What Are the Quantitative Policies of RBI?
Bank rate policy, open market operations, and variable reserve ratio are examples of quantitative or traditional credit control strategies.
Now, we will study the Cash Reserve Ratio, Bank Rate, Statutory Liquidity Rate, Repo Rate and more, which help the RBI in controlling the money flow in the market.
1. Cash Reserve Ratio (CRR)
Commercial banks are required to keep a specific percentage of their deposits with the RBI in the form of cash. The RBI uses Cash Reserve Ratio to drain surplus liquidity from the economy or release additional funds required for economic growth.
If the RBI lowers the CRR from 5% to 4%, commercial banks will be required to retain a smaller proportion of their total deposits with the RBI, allowing more money to be available for operations. In the same way, if the RBI decides to raise the CRR, the amount accessible to banks decreases.
2. Statutory Liquidity Ratio (SLR)
Before granting credit to consumers, commercial banks are required to have a certain quantity of gold or government-approved securities in hand as security or collateral.
The SLR is calculated and maintained by the RBI to regulate the expansion of bank lending. It is expressed as a percentage of total deposits available with a commercial bank.
3. Bank Rate
Bank Rate is the rate at which the RBI lends commercial banks long-term loans. The Bank Rate is a technique that the Reserve Bank of India employs to keep the money supply stable.
Any change in the Bank Rate by the RBI signals banks to change Deposit Rates and Prime Lending Rates (PLR) as well. (PLR is the rate at which banks lend to the bank customers).
4. Repo Rate
Repo Rate is the rate at which the RBI is willing to lend commercial banks short-term loans. When commercial banks run out of cash, they can borrow from the RBI in exchange for securities.
If the RBI raises the Repo Rate, commercial banks will find borrowing more expensive, and vice versa.
As a tool to control inflation, the RBI raises the Repo Rate, making it more expensive for banks to borrow from the RBI and therefore limiting the amount of money available. When the RBI wishes to boost growth in a deflationary environment, it will do the exact opposite.
5. Marginal Standing Facility (MSF)
For scheduled commercial banks, Marginal Standing Facility is a relatively short-term borrowing scheme. During a severe cash crisis or acute liquidity shortage, banks can borrow funds from the MSF.
Due to mismatches in deposit and lending portfolios, banks frequently experience liquidity shortages. Banks can borrow from the RBI for one day by submitting dated government securities.
The RBI established Marginal Standing Facility to reduce overnight lending rate volatility in the interbank market and ensure smooth monetary transmission throughout the financial system.
Borrowings by banks from other sources are represented by NDTL liabilities. Banks can borrow 1% of their Net Demand and Time Liabilities (NDTL) or total deposits and other liabilities overnight.
In July 2013, the RBI boosted the MSF rate to 300 basis points (or 3%) over the Repo Rate to stop the rupee from falling further. As a result, RBI can change the rate of borrowing and the percentage of borrowing allowed under MSF.
6. Base Rate
The Base Rate is the interest rate below which Scheduled Commercial Banks (SCBs) will not lend money to their customers.
7. Call Money Market
The call money market is a vital part of the money market where securities are borrowed and lent on an overnight basis. Scheduled Commercial Banks (SCBs), excluding regional rural banks, cooperative banks (other than land development banks), and insurance companies, are currently participants in India’s call money market.
The RBI sets prudential restrictions for each of these organisations in terms of outstanding borrowing and lending activities in the call money market.
What Are the Qualitative Policies of RBI?
Regulation of margin requirements, credit rationing, consumer credit regulation, and direct action are examples of qualitative or selective credit control strategies.
1. Setting Margin Requirements
The margin is the “part of the loan amount not covered by the bank.” Or, it is the portion of a loan that a borrower must raise to obtain funding for their purpose.
When a margin changes, the loan size changes as well. This strategy is used to boost credit supply for the poor while discouraging it for non-essential industries. This can be accomplished by boosting margin for non-essential sectors while decreasing margin for other vulnerable sectors.
For example, if the RBI believes that more credit should be distributed to the agriculture sector, the margin will be reduced, and a loan of 85-90 per cent may be granted.
2. Consumer Credit Regulation
This strategy regulates consumer credit supply by regulating consumer goods, hire-purchase and instalment sales. The down payment, instalment amount, loan period, and other factors are all determined in advance using this method. This can aid in monitoring credit usage and, as a result, inflation in a country.
3. Publicity
This is yet another type of credit control that is used selectively. The Central Bank (RBI) uses it to publish several reports that detail what is excellent and what is problematic about the system.
This publicly available information can assist commercial banks in targeting credit supply to specific industries. The information is made public through its weekly and monthly briefings, and banks can utilise it to achieve monetary policy goals.
4. Credit Rationing
The central bank sets the maximum amount of credit that can be given. The amount of credit accessible to each commercial bank is rationed.
Even bill rediscounting is controlled in this manner. A credit limit can be set for a specific purpose, and institutions are required to adhere to it. This can assist banks in reducing their loan exposure to unfavourable industries.
5. Control by Directions
The central bank uses this strategy to give frequent directives to commercial banks. Commercial banks are guided by these directives in developing their lending policies.
The central bank can use a directive to alter credit structures and limit credit supply for a specified purpose. The Reserve Bank of India (RBI) issues guidelines to commercial banks prohibiting them from lending money to the speculative sector, such as securities, over a specified amount.
6. Direct Action
The RBI can use this strategy to take action against a bank. The RBI may refuse to rediscount bills and securities if some banks do not follow RBI’s directives.
Second, the RBI has the authority to refuse credit to banks whose borrowings exceed their capital. A bank can be penalised by the central bank by adjusting some rates.
Finally, if a bank does not follow its orders and works against the goals of monetary policy, it may be barred from operating.
Conclusion
These are monetary policy’s different selection instruments. However, the availability of alternative sources of credit in the economy, the work of Non-Banking Financial Institutions (NBFIs), the profit motive of commercial banks, and the undemocratic nature of these tools restrict their success.
However, the appropriate combination of quantitative and qualitative monetary policy tools can provide the intended results in controlling the money supply in the economy.
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