Monetary Policy Types and Instruments

Monetary Policy Types and Instruments form an important topic in various UPSC and other competitive exams. One should have clear insight on the Monetary Policy Types and Instruments and Monetary Policy Committee.

Monetary policy is like a big policy made by a country’s main bank called the central bank. This plan helps manage the economy by using tools like interest rates and controlling how much money is available. The goal is to keep prices stable, encourage people to spend money, boost the economy, and make sure there’s enough money circulating.

In India, the Reserve Bank of India (RBI) is in charge of making and carrying out this plan. It’s a big deal because it’s a law—the Reserve Bank of India Act, made way back in 1934, says it’s their job. So, in simple words, monetary policy is all about how the central bank uses its tools to keep the economy running smoothly.

Monetary Policy Types

The way monetary policy is handled depends on how the economy is doing. Depending on that, we can put monetary policy into two categories.

1. Expansionary Monetary Policy Types

When a central bank adopts a loose monetary policy, it’s often called expansionary policy. This means they’re increasing the amount of money and credit available in the economy to try to make it grow. This type of policy is used during tough times to lower unemployment and boost growth and investment. The main aim is to get people spending and borrowing more. They do this by cutting interest rates, which makes loans cheaper and easier to get. According to economic theory, when there’s more money around and it’s cheaper to borrow, people and businesses tend to buy more stuff, which helps the economy grow.

2. Contractionary Monetary Policy Types

When a central bank adopts a tight or Contractionary monetary policy types it’s because they want to stop inflation caused by the economy growing too quickly, which is called “overheating”. They aim to do this by reducing the amount of money available in the economy, increasing interest rates, and making borrowing more expensive. This discourages businesses from borrowing money for investments because it becomes less profitable. Also, higher interest rates make it less appealing for consumers to borrow for big purchases like homes and cars. Overall, the goal of this policy is to slow down economic growth to prevent prices from rising too fast.

Strategies that central banks use to implement monetary policy types

Rule-Based Monetary Policy types: This approach follows a set of predetermined rules or formulas to guide policy decisions. The rule-based monetary policy types could be based on economic indicators like inflation rates, GDP growth, or money supply. The advantage of this approach is that it provides transparency and consistency, as decisions are based on clear guidelines rather than subjective judgment.

Discretionary Monetary Policy types: With discretionary monetary policy types, central banks have more flexibility. They make decisions based on their judgment of the current economic situation and their forecasts for the future. This approach allows central banks to respond quickly to changing circumstances but can be less predictable and may introduce uncertainty into the market.

Objectives of Monetary Policy Types

These are the main objective of Monetary Policy types of India:

Growth with Stability: The aim is to achieve economic growth while ensuring stability in prices and overall economic conditions.

Regulation, Supervision & Development of Financial Stability: Ensuring that the financial system operates smoothly and securely by regulating and supervising financial institutions, and promoting their development.

Promoting Priority Sector: Supporting and fostering growth in sectors of the economy that are considered important for development, such as agriculture, small businesses, and certain industries.

Generation of Employment: Implementing policies that encourage job creation and reduce unemployment levels.

External Stability: Maintaining stability in external economic factors such as exchange rates and balance of payments to safeguard the country’s financial health in international transactions.

Encouraging Savings and Investments: Encouraging individuals and businesses to save and invest their money, which contributes to economic growth and development.

Regulation of Non-Banking Financial Institutions: Supervising and regulating institutions that provide financial services but are not traditional banks, such as insurance companies and mutual funds, to ensure stability and consumer protection.

Monetary Policy Instruments (MPI)

Monetary policy instruments are tools used by the RBI to achieve its targets and objectives. They are categorized into direct and indirect instruments based on how they influence the goals set by the RBI. So, instruments are divided into:

• Direct instruments and
• Indirect instruments

Direct Instruments Monetary Policy Types

Direct instruments of monetary policy types allow the RBI to achieve monetary policy targets, such as controlling money supply and liquidity, without relying heavily on policy actions by others.

Cash Reserve Ratio (CRR)

The cash reserve ratio (CRR) is the percentage of demand and time deposits (known as Net Demand and Time Liabilities) that each scheduled commercial bank is required to maintain as cash reserves with the RBI.

Statutory Liquidity Ratio (SLR)

The Statutory Liquidity Ratio (SLR) mandates that commercial banks must hold a specific percentage of their demand and time deposits as liquid assets in their vault. Liquid assets, in the context of SLR, refer to cash, gold, and approved securities such as government bonds.

Refinance Facilities

Refinance facilities refer to specific lending programs provided by the RBI to banks, tailored for particular sectors. One prominent type is the support extended to the export sector through banks. These export refinance facilities encompass various offerings such as foreign exchange support and swap facilities, among others, which are administered by the RBI.

Indirect Instruments of Monetary Policy Types

Indirect instruments are tools used by the RBI where achieving targets and objectives requires responses or actions from institutions such as commercial banks, in addition to actions taken by the RBI itself.
Indirect instruments are:

Repo Rate

The repo rate is the interest rate at which the RBI lends money to commercial banks for short periods, typically overnight, as part of the Liquidity Adjustment Facility. It’s considered the most significant, potent, and favored monetary policy tool for the RBI.

The reverse repo rate

The reverse repo rate is the interest rate at which the Reserve Bank absorbs liquidity from banks on an overnight basis. In simpler terms, it’s the interest rate that the RBI offers to banks when it borrows funds from them for one day.

Liquidity Adjustment Facility (LAF)

The Liquidity Adjustment Facility (LAF) is a comprehensive framework established by the RBI to manage liquidity within the financial system. It comprises multiple tools that enable the RBI to both inject and absorb liquidity as needed. Through the LAF, the RBI can effectively control the flow of funds in the financial system by utilizing various instruments.

Open Market Operations (OMOs)

Open Market Operations (OMOs) involve the buying and selling of government securities by the RBI. When the RBI buys securities, it injects liquidity into the market, increasing the availability of funds. Conversely, when it sells securities, liquidity is withdrawn from the system, reducing the availability of funds. When securities are sold, financial institutions purchase them, providing funds to the RBI, which decreases the money supply or liquidity in the financial system.

Market Stabilisation Scheme(MSS)

Market Stabilization Scheme (MSS) is an open market operation by the RBI, aimed to sterilize or withdraw the excess money supply created out of the foreign exchange market intervention by the RBI.

Marginal Standing Facility (MSF)

Open Market Operations (OMOs) involve the buying and selling of government securities by the RBI. When the RBI buys securities, it injects liquidity into the market, increasing the availability of funds. Conversely, when it sells securities, liquidity is withdrawn from the system, reducing the availability of funds. When securities are sold, financial institutions purchase them, providing funds to the RBI, which decreases the money supply or liquidity in the financial system.

Term Repo

A Term Repo is a liquidity injection tool utilized by the RBI. In this process, the RBI auctions a predetermined amount of funds for a specified duration (ranging from one day to 13 days) to the entire banking system.

Long Term Repo Operations (LTROs)

Long Term Repo Operations (LTROs) are repo operations conducted by the RBI but for longer durations, typically ranging from one year to three years. Through LTROs, the RBI provides funds to banks at the prevailing repo rate, allowing them access to liquidity over an extended period.

Targeted Long-Term Repo Operations (TLTROs)

Targeted Long-Term Repo Operations (TLTROs) are specialized long-term repo operations conducted by the RBI to address specific liquidity needs in particular sectors. Under this program, the RBI provides funds to banks, which can then invest in securities of entities within designated sectors such as corporates, non-banking financial companies (NBFCs), and housing finance companies (HFCs).

Dollar Rupee Swap Facility

The Dollar-Rupee swap facility is a liquidity mechanism implemented by the RBI. Under this arrangement, the central bank offers either dollar liquidity or rupee liquidity to financial institutions by accepting the opposite currency in return.

Bank Rate

The Bank Rate (BR) is the rate at which the RBI re-discounts high-quality bills of exchange submitted by banks. Essentially, it represents the interest rate at which the central bank extends loans to commercial banks.

Corridor

The Corridor in the monetary policy types of the RBI refers to the range between the Marginal Standing Facility (MSF) Rate and the Reverse Repo Rate. Ideally, the call money rate, which represents the interest rate at which banks lend to each other overnight, should fluctuate within this corridor. This indicates a balanced liquidity situation in the financial system.

The Monetary Policy Framework (MPF)

The Government of India establishes the Flexible Inflation Targeting Framework, but it’s the Reserve Bank of India (RBI) that implements the Monetary Policy Framework for the country.

The amended RBI Act clearly mandates the RBI to oversee the country’s monetary policy framework. This framework focuses on determining the policy (Repo) rate based on an evaluation of the current and evolving macroeconomic situation. It also involves adjusting liquidity conditions to ensure that money market rates remain close to the Repo rate.

It’s important to note that changes in the Repo rate have a ripple effect throughout the financial system, influencing overall demand, which in turn affects inflation and growth rates.

Once the Repo rate is announced, the operating framework designed by the RBI involves managing liquidity on a day-to-day basis through appropriate actions. The goal is to keep the operating target, known as the weighted average call rate (WACR), aligned with the Repo rate.

Also read: Monetary Policy Committee of India

The Reserve Bank of India Monetary Policy Committee