Monetary Policy of Reserve Bank of India

In this project report we will discuss about:- 1. Introduction to the Monetary Policy of RBI 2. Objectives of the Monetary Policy of RBI 3. Critical Appraisal 4. Causes of Failure.

Introduction to the Monetary Policy of RBI:

Monetary policy in India is an adjunct of economic policy. As such, the objectives of monetary policy are not different from the objectives of economic policy. The three major objectives of economic policy in India have been growth, social justice, and price stability. The Government of India tries to manipulate its monetary policy through the Reserve Bank of India which is the monetary authority in the country.

The monetary (or credit control) policy of the Reserve Bank has been characterised as one of controlled monetary expansion. It aims at controlling inflation by restraining the secondary expansion of credit and regulating the supply of money in order to meet the requirements of different sectors of the economy to accelerate the pace of economic growth.

Objectives of the Monetary Policy of RBI:

Broadly speaking the following are the objectives of monetary policy which the Reserve Bank has been trying to achieve:

1. Price Stability:

The RBI tries to achieve price stability by controlling inflationary pressures in the area of aggregate demand through controlled monetary expansion and by facilitating allocation and effective utilisation of credit in relatively more productive channels.

2. Reduce Deficit:

It tries to reduce the monetised deficit (net RBI credit to the Government) in order to bring down Government’s gross fiscal deficit.

3. Encourage Exports:

It boosts exports in order to solve the problem of balance of payments deficit.

4. Growth:

It promotes growth through appropriate credit policy by promoting savings, mobilisation of resources and encouraging the requirements of different sectors of the economy according to plan priorities.

5. Social Justice:

It supports programmes of social justice (i.e. more equitable distribution of income) by influencing the cost, volume and direction of credit to priority sectors of the economy. Of these objectives, price stability is the dominant one.

It is price stability which provides the appropriate environment in which growth can take place and social justice can be ensured. Price stability is also required to augment our exports and to service our external debt. In the context of economic growth, price stability does not mean no increase in prices.

In fact, price stability refers to controlling inflation or keeping the general price level from rising by more than four per cent per year, as suggested by the RBI Chakravarty Committee (1985). For this the Committee advocated “monetary targeting with feed-back” in order to keep the growth of money supply in step with the demand for it. The monetary target is not fixed but may be revised on a mid-year assessment of the price situation.

Critical Appraisal of Monetary Policy of RBI:

The main aim of India’s monetary policy which is regulated by the RBI, is to have growth with stability. It is also known as the policy of controlled monetary (or credit) expansion. In pursuance of this policy, the RBI affects the quantity, availability and cost of credit by adopting both the quantitative and qualitative methods of credit control.

It increases the quantity of money and credit to meet the growing requirements of the developing economy, and at the same time imposes restrictions on the use of credit for non-essential and unproductive activities. In periods of recession, it follows the policy of easy credit or cheap money, and to control inflationary pressures, it follows the policy of credit squeeze or tight money.

It is contributing to the economic development of the economy in an important way by giving cheap and easy credit to the priority sector consisting of marginal and small farmers, artisans, unemployed, small traders, village and small industries, etc. At the same time, it also provides credit to large industries and to exporters to meet their expanding credit requirements so that production may increase and exports expand.

Causes of Failure of Monetary Policy of RBI:

Despite these achievements, the monetary policy of RBI has not been a success in bringing stability to the economy.

Some of the reasons are:

(1) Inflationary Pressures:

During the plans, the average growth rate of money supply has been 15 per cent per annum with the average growth rate of domestic product of 5 per cent per annum. The disproportionate and persistent increase in liquidity has been a significant factor contributing to inflationary pressures in the economy.

(2) Excessive Government Borrowing and Budgetary Deficits:

Another reason for the failure of monetary policy in India has been the impact of large and growing Government borrowing and budgetary deficits over the plans. The budgetary deficits have been virtually monetised (i.e. financed) by the RBI through the creation of ad hoc treasury bills.

Besides, the RBI has been providing support to the Government’s market borrowing programmes. Consequently, this has led to the phenomenal increase in reserve money contributed (i.e. created) by RBI credit to the Government. This has led to inflationary pressure in the economy.

(3) High CRR and SLR:

In order to contain the inflationary impact of monetisation of the budget deficits, the RBI has been continuously increasing the CRR and SLR. The reserve ratios in India are quite high being 45 per cent of the deposits, leaving 55 per cent for lending.

Out of these, 40 per cent go to priority sector advances at low rates of interest. Thus only a small portion of funds is available for deployment in non-food and trading activities at commercial rates of interest. This has tended to reduce the profitability of banks.

(4) Defective Interest Rate Policy:

The RBI has been following a policy of administered interest rates. The structure of these rates is complex and cumbersome. It conceals an element of arbitrariness. It fails to take into account the risk involved, the maturity period or the liquidity factor on individual instruments of credit: The interest rate structure is also not separate for the captive market and the borrowing public.

(5) Organised Sector Uninfluenced by Bank Credit:

With the introduction of commercial paper by the large organised sector, industries can raise money directly from the market at cheaper rates than bank credit. This has blunted the edge of monetary policy in controlling the activities of the organised sector.

(6) Other Sources for Banks:

Besides getting funds from NBFIs, commercial banks are able to maintain enough liquidity with them from the call money market, mutual funds and similar other sources. As a result, the RBI is not in a position to control the lending activities of the banks.

(7) Little Co-ordination between Monetary and Fiscal Policies:

There is little co-ordination between monetary and fiscal policies being pursued by the RBI and the Government. There is no co-ordination between the expansion in RBI credit to the Government and Central Government’s budgetary deficits. With increasing budgetary deficits from year to year, the RBI has to monetize them. Consequently, its power to regulate the volume of money is limited. This has made monetary policy less effective in India.

(8) Existence of Parallel Economy:

There is a large sector of unaccounted black money which is beyond the jurisdiction of RBI. The existence of this parallel economy makes a mockery of the credit policy of the RBI because individuals, traders and businessmen borrow, lend and spend money at their will.

(9) Government Policy:

There are some more weaknesses of monetary policy of the RBI due to Government policies. These are: (i) the government depends more on the public for borrowing outside the captive market, and (ii) yields on the Government securities are not fixed independently of the conditions in the capital market.

Conclusion:

We have seen above that one of the principal reasons for the failure of monetary policy in controlling inflationary pressures in India has been the growing budgetary deficits. Monetary policy at best can control the secondary effects of excessive budget deficits. It is, therefore, essential that monetary and fiscal policies should move in tandem.