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CHAPTER 1 1.1 INTRODUCTION Monetary Policy of the RBI: The liquidity or the money supply in the economy is controlled by the RBI. The RBI decides on this policy after taking into consideration the current economic scenario and the what the future economic scenario of the country should be. This is very important considering the fact that, the money supply in the economy has far reaching consequences than what a normal man thinks it has. The amount of money supply in the economy has its direct effect on the prices of the goods which are sold/bought in the economy. This is because of a very simple reason the money supply is actually the amount of money a person has. So if a person has a lot more money than his demands for goods and services will increase. Which is very essential for the economy to function but excess demand lead to rise in prices or in technical terms, inflation. If the money market transactions continue to feed the inflation, in the long run its very harmful for the economy as it results in very high prices, reduction in demand, fall in the value of money which in turn leads to more money supply which results in hyper-inflation and complete rundown of the economy. Definition: Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity. Description: In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth.

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The RBI implements the monetary policy through open market operations, bank rate policy, reserve system, credit control policy, moral persuasion and through many other instruments. Using any of these instruments will lead to changes in the interest rate, or the money supply in the economy. Monetary policy can be expansionary and contractionary in nature. Increasing money supply and reducing interest rates indicate an expansionary policy. The reverse of this is a contractionary monetary policy. For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the RBI is dependent on the monetary policy. By purchasing bonds through open market operations, the RBI introduces money in the system and reduces the interest rate.

1.1 What is monetary policy? Monetary policy is the process by which a central bank (Reserve Bank of India or RBI) manages money supply in the economy. The objectives of monetary policy include ensuring inflation targeting and price stability, full employment and stable economic growth. The money supply can be directly affected through reserve ratios or open market operations and can be indirectly affected by using key interest rates to influence the cost of credit.

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An easy or expansionary monetary policy is implemented by reducing statutory bank reserves or lowering key interest rates and improving market liquidity to encourage economic activity. A contractionary or tight monetary policy reduces liquidity and increases interest rates which has a negative impact on both production and consumption and therefore, economic growth.

1.2Monetary Policy Committee constitution under the Reserve Bank of India Act, 1934 notified. The Reserve Bank of India Act, 1934 (RBI Act) has been amended by the Finance Act, 2016, to provide for a statutory and institutionalized framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth. The Monetary Policy Committee would be entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level. A Committee-based approach for determining the Monetary Policy will add lot of value and transparency to monetary policy decisions. The meetings of the Monetary Policy Committee shall be held at least 4 times a year and it shall publish its decisions after each such meeting. The provisions of the RBI Act relating to Monetary Policy have been brought into force through a Notification in the Gazette of India Extraordinary on 27.6.2016. The factors constituting failure to meet inflation target under the Monetary Policy Committee Framework have also been notified in the Gazette on 27.6.2016. The Government, in consultation with RBI, has notified the inflation target in the Gazette of India Extraordinary dated 5th August 2016 for the period beginning from the date of publication of this notification and ending on the March 31, 2021, as under:Inflation Target:

Four per cent.

Upper tolerance level:

Six per cent.

Lower tolerance level:

Two per cent.

As per the provisions of the RBI Act, out of the six Members of Monetary Policy Committee, three Members will be from the RBI and the other three Members of MPC will be appointed by the Central Government. In exercise of the powers conferred by section 45ZB of the Reserve Bank of India Act, 1934, the Central 3

Government has accordingly constituted, through a Gazette Notification dated 29thSept 2016, the Monetary Policy Committee of RBI, with the following composition, namely:-

(a) The Governor of the Bank—Chairperson, ex officio; (b) Deputy Governor of the Bank, in charge of Monetary Policy—Member, ex officio; (c) One officer of the Bank to be nominated by the Central Board—Member, ex officio; (d) Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) —Member (e) Professor Pami Dua, Director, Delhi School of Economics (DSE) — Member

(f) Dr.RavindraH. Dholakia, Professor, Indian Institute of Management (IIM) Ahmedabad Member

1.3 INSTRUMENT OF MONETARY POLICY The Members of the Monetary Policy Committee appointed by the Central Government shall hold office for a period of four years, with immediate effect or until further orders, whichever is earlier.

 The instrument of monetary policy are tools or devise which are used by the monetary authority in order to attain some predetermined objectives. There are two types of instruments of the monetary policy as shown below.

(A)Quantitative Instruments or General Tools: The Quantitative Instruments are also known as the General Tools of monetary policy. These tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit control are also called as General Tools for credit control. They are designed to regulate or control the total volume of bank credit in the 4

economy. These tools are indirect in nature and are employed for influencing the quantity of credit in the country. The general tool of credit control comprises of following instruments.

1. Bank Rate Policy (BRP): The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central bank (i.e RBI) rediscounts bills and prepares of commercial banks or provides advance to commercial banks against approved securities. It is "the standard rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the RBI Act". The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit available to commercial banks. If the RBI increases the bank rate than it reduce the volume of commercial banks borrowing from the RBI. It deters banks from further credit expansion as it becomes a more costly affair. Even with increased bank rate the actual interest rates for a short term lending go up checking the credit expansion. On the other hand, if the RBI reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation. Thus any change in the bank rate is normally associated with the resulting changes in the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a tool of monetary policy depends on existing banking network, interest elasticity of investment demand, size and strength of the money market, international flow of funds, etc. 2. Open Market Operation (OMO): The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the RBI sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets 5

transferred from commercial banks to the RBI. Contrary to this when the RBI buys the securities from commercial banks in the open market,

commercial banks sell it and get back the money they had invested in them. Obviously the stock of money in the economy increases. This way when the RBI enters in the OMO transactions, the actual stock of money gets changed. Normally during the inflation period in order to reduce the purchasing power, the RBI sells securities and during the recession or depression phase she buys securities and makes more money available in the economy through the banking system. Thus under OMO there is continuous buying and selling of securities taking place leading to changes in the availability of credit in an economy. However there are certain limitations that affect OMO viz; underdeveloped securities market, excess reserves with commercial banks, indebtedness of commercial banks, etc.

3. Variation in the Reserve Ratios (VRR): The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities which commercial banks have to maintain with the central bank and SLR refers to some percent of reserves to be maintained in the form of gold or foreign securities. In India the CRR by law remains in between 3-15 percent while the SLR remains in between 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Thus by varying VRR commercial banks lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. RBI increases VRR during the inflation to reduce the purchasing power and credit creation. But during the recession or depression it lowers the VRR making more cash reserves available for credit expansion.

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(B) Qualitative Instruments or Selective Tools:

The Qualitative Instruments are also known as the Selective Tools of monetary policy. These tools are not directed towards the quality of credit or the use of the credit. They are used for discriminating between different uses of credit. It can be discrimination favouring export over import or essential over non-essential credit supply. This method can have influence over the lender and borrower of the credit. The Selective Tools of credit control comprises of following instruments. 1. Fixing Margin Requirements: The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non-necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given.

2. Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hire-purchase and instalment sale of consumer goods. Under this method the down payment, instalment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country.

3. Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy.

4. Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill 7

rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit expoursure to unwanted sectors.

5. Moral Suasion: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy. Under moral suasion central banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes.

6. Control through Directives: Under this method the central bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the central bank can influence credit structures, supply of credit to certain limit for a specific purpose. The RBI issues directives to commercial banks for not lending loans to speculative sector such as securities, etc beyond a certain limit.

7. Direct Action: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are in excess to their capital. Central bank can penalize a bank by changing some rates. At last it can even put a ban on a particular bank if it does not follow its directives and work against the objectives of the monetary policy.

1.4 Concept of Monetary Policy: Monetary policy seeks to influence the rate of aggregate spending by varying the degree of liquidity of various constituents of the economy including banks, firms, business houses and households. In a recession, monetary policy raises the level of expenditure by increasing the amount of cash and other liquid assets (e.g., short and long-term government 8

securities) at the disposal of the community and by making borrowing conditions easier through lower rates of interest. In an inflationary situation monetary policy seeks to restrict aggregate spending by reducing the total amount of liquid assets with the community and by making borrowing more costly.

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CHAPTER: 2 RESEARCH METHODOLOGY 2.1 TYPES OF MONETARY POLICY: 1. Expansionary Monetary Policy 2. Contractionary Monetary Policy 3. Unconventional Monetary Policy

Expansionary Monetary Policy: Expansionary monetary policy is the monetary policy which seeks to increase aggregate demand and economic growth in the economy. It involves increasing the money supply and lowering the interest rates. The lower interest rate encourages the borrowers to buy more which increases the economic activity. The increased economic activity leads to more employment opportunities thus decreasing unemployment. It also increases the inflation as more money is available to buy goods and services. It is also known as central banks seeks to increase the money supply by lowering the interest rates.

Contractionary Monetary Policy: Contraction monetary policy is the monetary policy which is used to fight the inflation in economy. It involves decreasing the money supply and increasing the interest rates. As reduction in money supply increases the interest rates, the borrowers will be reluctant to borrow the money due to higher borrowing cost which ultimately reduces the economic activity. It leads to decrease in inflation, increase in unemployment and slowdown in economy. It is also known as tight money policy as central banks seeks to reduce the money supply by restricting credit by increasing interest rates.

Unconventional Monetary Policy: Unconventional monetary policy is pursued by central banks when their traditional instruments of monetary policy cease to achieve their goals. The one such 10

unconventional monetary policy was employed us United States after the financial crisis of 2007 in the form Quantitative Easing (QE). Monetary Policy in India: The Reserve Bank of India employs various instruments of monetary policy in India to achieve the objectives of price stability and higher economic growth. Some of the important instrument or tools of monetary policy in India are: 

Open Market Operations (OMO)

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Cash Reserve Ratio (CRR)

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Statutory Liquidity Ratio (SLR)

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Liquidity Adjustment Facility (LAF)

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Selective Credit Control 

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Moral Suasion Open Market Operations (OMO):

It is the process of buying and selling of government securities, bond or Treasury Bills (T-Bills) to regulate the money supply in economy. If government wants to reduce money supply, it issues these bonds. The money is consumed to buy these bonds thus it reduced the monetary base of the economy. Similarly to increase the money supply, the government sells these bonds thereby increasing the monetary base of the economy. In India, the open market operations are conducted by Reserve Bank of India through its core banking solution e-Kuber. Cash Reserve Ratio (CRR): It refers to the cash which banks have to maintain with the Reserve Bank of India as percentage of Net Demand and Time Liabilities (NDTL). An increase in CRR makes it mandatory for banks to hold large portion of their deposits with the RBI. Therefore it reduces their deposit available for credit and they lend less which affect their profitability and also reduces the money supply in economy.

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Statutory Liquidity Ratio (SLR): Apart from CRR, the banks in India are required to maintain liquid assets in the form of gold, cash and approved securities. The increase/decrease in SLR affects the availability of money for credit with banks. Liquidity Adjustment Facility (LAF): Under Liquidity Adjustment Facility (LAF) the banks purchase money from RBI on repurchase agreements. 

Repo Rate: It is the interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF)

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Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.

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Marginal Standing Facility

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Under SF, the scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.

Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. Selective Credit Control: Under this method, the central influence the credit growth in country through following techniques: 

Specifying the margin requirements and differential rate of interests

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Regulating the credit for consumer durables

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Moral Suasion: The central persuades the commercial banks to regulate the credit growth through oral and verbal communication.

 Why monetary policy is ineffective in India? There are many reasons for monetary policy not able to achieve its intended objectives. Some of the reasons are: 

Higher proportion of Non-Bank Credit The credit market in India is largely occupied by non-bank credit providing institutions like money lenders, cooperatives, relatives, friends etc. This large segment is not affected by monetary policy instrument. Introduction of new financial instruments Mutual Fund, Venture Capital, IPO etc. have influence on overall liquidity in the economy. The monetary policy intervention by Reserve Bank of India is insignificant in these segments of financial system High currency-deposit ratio The rural economy in India has more inclination towards the usage of cash. Thus there is high currency-deposit ratio. The monetary policy only touches the deposit section. Thus any intervention by way of monetary policy has meagre effect on economy.

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2.1 THE FOLLOWING POINTS HIGHLIGHT THE SIX MAIN OBJECTIVES OF MONETARY POLICY IN INDIA. 1. High employment 2. Economic growth 3. Price stability 4. Interest-rate stability 5. Stability of financial markets 6. Stability in foreign exchange markets.

1. High employment: Any modern government is committed to promote high employment. High employment is a desirable goal of monetary policy for two main reasons: (1) high unemployment causes much human misery, with families suffering financial distress and loss of personal self- respect, (2) secondly, when unemployment is high, the economy has not only idle workers but also idle resources (closed factories and unused equipment), resulting in a loss output At first, it might seem that full employment is the point at which no worker is’ out of a job, that is, when unemployment is zero. But, this definition ignores the fact that some unemployment, called fractional unemployment, is beneficial to the economy. For example, a worker who decides to look for a better job might be unemployed for a while during the job search Workers often voluntarily decide to leave work temporarily to pursue other activities (raising a family, travel, returning to school), and when they decide to re-enter the job market, it again takes some time for them to find the right job.

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The goal for high employment should, therefore, not seek an unemployment level of zero, but rather a level above zero consistent with full employment at which the demand for labour equals the supply of labour. Economists call this the natural rate of unemployment. 2. Price stability: Over the past two decades, macroeconomists have become more aware of the social and economic costs of inflation and more concerned with a stable price level as a goal of economic policy. Price stability is desirable in a developing country like India, because a rising price level (inflation) creates considerable uncertainty in the economy. For example the information conveyed by the prices of goods and services is harder to interpret when the overall level of prices is changing, which complicates decision making for consumers, businesses and governments at different levels. Inflation also makes it difficult to plan for the future. For example it is more difficult to decide how much funds should be put aside to provide for one’s children’s college education in an inflationary environment. Furthermore inflation may strain a country’s social fabric. Conflict may result because each group in the society may compete with other groups to make sure that its wages keep up with the rising level of prices. 3. Interest-rate stability: Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it more and more difficult to plan for the future. Fluctuations in interest rates also affect consumers’ willingness to buy durable goods, such as houses, motor cars, refrigerators, washing machines or even personal computers.

4. Stability of financial markets:

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A major reason for the creation of the central bank is that it can promote a more stable financial system. One way in which the central bank promotes stability is helping prevent financial panics (particularly bank failure) through its role as lender of last resort. The central bank is the ultimate source of funds in the moneymarket. 5 Stability in foreign exchange markets:

With the increasing importance of international trade to the Indian economy, the value of the rupee relative to other currencies has become a major consideration for the RBI. A rise in the value of the rupee makes Indian industries less competitive with those abroad, and declines in the value of the rupee stimulate inflation in India. In addition, preventing large changes in the value of the rupee makes it easier for firms and individuals purchasing or selling goods abroad to plan ahead. Stabilising extreme movements in the value of the rupee in foreign exchange markets is thus viewed as a worthy goal of monetary policy. 6. Economic growth: The goal of steady economic growth is closely related to the high employment goal, because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. Conversely, if unemployment is high and factories are idle, it does not pay for a firm to invest in additional plants and equipment. Although the two goals are closely related, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. Monetary policy tools are used by currency boards, central banks, or even governments to control currency supplies. Consumer access to cash, along with the interest rates charged by lending institutions, create economic foundations for businesses to build upon. The tools used to regulate those base needs dictate how much stability is found in the financial markets. There are numerous ways for monetary policy tools to be used as a benefit to society. They maintain a balance of value with currency exchanges, stabilize economies, and can even address debt or 16

unemployment issues. The Federal Reserve is tasked with the implementation of monetary policy tools that promote expansion or limit recession at the national level. Based on the rates they set, local banks and credit unions create offers for their customers which encourage an expansion of borrowing. People then purchase homes and vehicles, or use their credit cards, to generate economic activities. The advantages and disadvantages of monetary policy tools look at how these artificial structures compare to what a natural free-market system would dictate for each person. 2.2 List of the Advantages of Monetary Policy Tools: 1.They encourage higher levels of economic activity: Monetary policy tools encourage consumer activities based on the current status of the economy. When a stimulus is necessary to keep growth happening, then banks can lower their interest rates on lending products to encourage additional spending. Lower interest rates create price reductions, which help keep spending at a consistent level. People have more incentive to buy low, even if their wages are under the national median, which means their spending gives strength to the local community.

2. They encourage a stable global economy: Most countries operate with currencies which are traded in value against others. There is no “gold standard” in use by the most influential financial nations in the world today. Thanks to monetary policy tools, there is greater consistency in the financial markets because there are known factors of scarcity. That’s why a government which decides to print more money will devalue their currency. It also creates opportunities to purchase bonds, increase reserves, or invest in the debt of other nations to generate multiple revenue lines.

3. They promote additional transparency: Monetary policy tools create predictable results when used as intended. Everyone involved in the financial sector understands what happens when movement occurs in either direction or if the status quo is maintained instead. These design of the tools forces those who use them to do so in ways that are understood by the general public, allowing organizations and consumers to make decisions about their future now instead of waiting for the tools to create a measurable effect. 17

4. They promote lower inflation rates: One of the most significant advantages that monetary policy tools offer is price stability. When consumers know how much their preferred goods or services cost, then they are more likely to initiate a transaction. That process keeps pricing structures stable because the value of the money used is also consistent. These tools make it possible to keep the value of money close to what it tends to be. Between 2009-2018, the inflation rate in the United States was under 10%. That means $1 in 2009 was worth $1.09 in 2018, maintaining the wealth earned by households.

5. They create financial independence from government policies: Monetary policy tools are kept separate from centralized governments, implemented by a central bank or similar institution instead. The government might try to influence these tools by passing targeted legislation against them, but it cannot control them outright. By keeping the economic decisions separate from the political decisions, there is a reduction of risk for the average person that the government will impact their vote, life, or choices by limiting the value of their overall income.

6. They are implemented with relative ease: When a central agency indicates that it will use a monetary policy tool in specific ways, then the market shifts automatically to account for the announced changes. Results are often produced well before the effect of the tools begin to occur. That allows for rapid results in some sectors, allowing the government and agencies involved to find tangible evidence that the tool used will create meaningful outcomes.

7. They can boost exports: When the money supply increases at a national level, or interest rates are lowered deeply compared to the global market, then the currency in question becomes devalued. Weaker currencies sometimes benefit from a worldwide perspective because exports receive a boost thanks to purchases from those in stronger economies. Foreigners find that the products are less expensive, so they buy more of them.

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2.3 List of the Disadvantages of Monetary Policy Tools 1. They do not guarantee economic growth: The implementation of monetary policy tools does not guarantee results. People and businesses have free will. They can choose to initiate more spending when rates are lowered, or they might choose to hold onto their cash. Consumers don’t take out loans because the interest rates are down all the time. 100% of households don’t buy or refinance their home. There will always be outliers in every economy which respond in unpredictable ways. If enough entities do this, then the results of the monetary policy tools could be different than what was expected.

2. They take time to begin working: The United States operates on budget estimates which account for 10 years of activity. Some countries can evaluate changes in half that time, while others use cycles that last for 20-40 years instead. Because currencies are not based on the scarcity of precious metals at this time, the tools must change the overall market to initiate economic shifts instead. Some changes take several years to start creating positive results. There can still be negative experiences in the initial days of a tool being implemented too.

3. They always create winners and losers: Monetary policy tools try to give everyone the same chance at success. The reality of any financial market, however, is that any shift in policy will create economic winners and losers. These tools try to limit the damage to the people who struggle under the changes made while enhancing the benefits of those who see currency gain.

4. They create a risk of hyperinflation: Small levels of inflation within an economy are not a bad thing. They encourage investments, allow workers to expect a higher wage, and stimulate growth at all levels of society. Having all items cost a little more over time can slow growth when necessary. If the interest rates are set too low, then artificially low rates happen. That creates speculative bubbles where prices increase too quickly, often to levels which create

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barriers to access for the average person. Venezuela experienced devastating hyperinflation in 2018 to the tune of 1.29 million percent.

5. They create technical limitations: The lowest an interest rate can go under current economic structures is 0%. If the central agency sets rates at this level, then there are limits to what monetary policy tools can do to continue limiting inflation or stimulating economic growth. Prolonged low interest rates also create a liquidity trap, creating a high rate of savings which renders the policies and tools ineffective. They affect bondholder behaviours, consumer fear, and a lack of overall economic activity.

6. can hurt They imports: When the monetary policy tools reduce the value of the national currency, then fewer imports occur. That happens because international purchases become more expensive for consumers using the currency in question. This effect was seen in earnest when the U.S. Dollar was worth less than a Canadian dollar from 2010 to 2013. Instead of U.S. consumers going over the border to purchase cheaper Canadian goods, the reverse happened. Canadians came to the United States to purchase cheaper American goods.

7. They do not offer localized supports or value: Monetary policy tools are only useful from a general sense. They affect an entire country with the outcomes they promote. There is no way for them to generate a local stimulus effect. If a community struggles with unemployment, they might need more stimulus to counter the issue. The current design of monetary policy tools doesn’t allow this to happen. The tools are unable to be directed at specific problems, boost Individual industries, or apply to regions within the national footprint. 8. They can slow production. Economies are fuelled by production. When more of it becomes available, then the chances for growth increase. If fewer activities occur, then production levels slow, and it could be several years before they can restore themselves to previous levels. The in-ground swimming pool industry encountered this effect during the 2007-2009 recession years, with total U.S. installations dropping 70%. The industry has still not 20

reached the installation rates seen in the 1990s yet because of how the monetary policy tools were used before the global recession took place. The advantages and disadvantages of monetary policy tools promote economic stability, which then encourages growth. There aren’t guarantees with any tools like this, however, because individuals are unpredictable. People can choose to do the opposite of what the tool anticipates, creating unexpected outcomes which are sometimes damaging to society. There are those who benefit and those who do not, but the goal of the tools is the same: to help the most people possible with what they do. 

Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Act.

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The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.

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Section 45ZB of the amended RBI Act, 1934 also provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government by notification in the Official Gazette. Accordingly, the Central Government in September 2016 constituted the MPC as under: 1. Governor of the Reserve Bank of India – Chairperson, ex officio; 2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, exofficio; 3. One officer of the Reserve Bank of India to be nominated by the Central Board – Member, exofficio; 4. Sheri Cretan Gate, Professor, Indian Statistical Institute (ISI) – Member; 5. Professor Pamir Due, Director, Delhi School of Economics – Member; and

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6. Dr. Raindrop H. Dholakia, Professor, Indian Institute of Management, Ahmadabad – Member. (Members referred to at 4 to 6 above, will hold office for a period of four years or until further orders, whichever is earlier.) 

The MPC determines the policy interest rate required to achieve the inflation target. The first meeting of the MPC was held on October 3 and 4, 2016 in the run up to the Fourth Bi-monthly Monetary Policy Statement, 2016-17.

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The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.

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The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure that the operating target of the weighted average call money rate (WACR).

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Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets and public finance advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in nature. With the formation of MPC, the TAC on Monetary Policy ceased to exist.

Read this article to learn about Monetary Policy of a Country – explained with Diagram)! Several economists have defined monetary policies differently. According to Harry Johnson, monetary policy can be defined as, “A policy employing central bank’s control of the supply of money as an instrument of achieving the objectives of general economic policy,” 22

According to Shaw, monetary policy can be referred as, “any conscious action undertaken by the monetary authorities to change the quantity, availability or cost… of money.” Monetary policy can be defined as a policy in which the monetary authority of a country, generally the central bank, controls the demand and supply of money. The main objective of the monetary policy is to achieve economic growth, maximize employment, maintain price stability, and attain balance of payment equilibrium. The monetary policy can be maintained by changing the rates of interests, such as Cash Reserve Ratio (CRR) and bank rate. The effectiveness of monetary policy can be influenced by two factors, namely, level of monetized economy and level of capital market development. In monetized economy, the monetary policy covers all economic activities. Moreover, in this type of economy, money serves as the medium of exchange for all economic transactions. Therefore, in such an economy, monetary policy can be implemented by changing the price level. Monetary measures can directly or indirectly affect the economic activities, such as production, consumption, saving, investment, and employment.

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The other important factor that influences the effectiveness of monetary policy is the development of capital market. A capital market can be defined as a market in which both, public and private sectors, sell financial securities to raise funds. Some of the instruments of monetary’ policy, such as CRR and bank rate, work through the capital market. Monetary policy influences the economic activities by making certain changes in the capital market. Therefore, for effective monetary policy, it is necessary that the capital market should be well developed. A developed capital market involves the following features a. Large number of financial institutions, commercial banks, and credit organizations b. Large number of financial transactions c. Inter-linkage and inter-dependence of capital submarkets

2.4 Tools of Monetary Policy: The tools of monetary policy are the monetary variables, which are used by the central bank to control and regulate the money supply and monitor the availability of credit in an economy. The tools of monetary policy are also termed as weapons of monetary control. Samuelson and Nordhaus have termed these tools as the nuts and bolts of monetary policy. Quantitative Measures: Quantitative measures are the measures that can be used for controlling and regulating the demand and supply of money. In addition to the quantitative measures of monetary policy, the nations can also adopt some direct measures for regulating the demand and supply of money. For example, in India, all the major banks are nationalized; therefore, the central bank (Reserve Bank of India) uses direct measures to cope with various economic problems, such as inflation.

Some of the important quantitative measures are shown in Figure-3:

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The different quantitative measures (as shown in Figure-3) are explained in detail. Open Market Operations: Open Market Operations (OMO) of a government involve the sales and purchase of government securities and treasury bills by the central bank. If the central bank wants to increase the supply of money with the public, it purchases government securities and treasury bills. On the other hand, if the central bank wants to decrease the supply of money, it sells the government securities and treasury bills. OMO is the most important and frequently adopted measure of the monetary policy. These operations are performed by the central bank with the help of commercial banks. The central bank is not involved in the direct dealing with the public. Government securities are purchased by commercial banks, financial institutions, large businesses, and individuals having high income. All these customers of government bonds have their accounts in commercial banks. When the customers purchase these bonds, the money is transferred from their bank accounts to the central bank account. In this way, when the central bank conducts operations in the open market, the bank deposits and reserves of commercial banks and their potential to generate credit get affected. For example, to reduce the chances of inflation, the central bank decrease the supply of money in the market. In such a case, commercial banks sell government securities in the market. This operation can be made easier when the commercial banks are under the direct control of government.

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However the supply of money can be adversely affected in certain situations. For example,, when customers purchase government securities they draw checks from their commercial bank accounts in favour of the central bank. In this way the money is transferred from commercial banks to the central bank account. This results in the reduction of deposits and reserves held by commercial banks which further decreases their credit creation capacity. As a consequence to this, the flow of credit from commercial banks to general public decreases. Apart from this, in case commercial banks themselves purchase government securities, their cash reserves decrease. As a result, the credit creation capacity of commercial banks decreases. This eventually results in reduction in the credit flow from commercial banks to the public. However, in case the central bank wants to increase the supply of money in economy, it purchases government securities from commercial banks and other purchasers of government securities. In such a case, money moves from the central bank account to individuals’ accounts. This leads to an increase in deposits and reserves of commercial banks. Consequently, the credit creation capacity of commercial banks increases, which raises the flow of credit to the public.

Limitations of the bank rate policy:

(a) Self-efficiency of commercial banks: Implies that the bank rate policy is based on variation in bank rate. This variation only works in situations when commercial banks borrow money from the central bank. However, in present times, commercial banks are self-efficient in terms of financial resources. Therefore, the changes in bank rate by the central bank do not affect the discount rate of commercial banks. (b) Growth of capital market: Refers to one of the most important limitation of the bank rate policy. Over the years, the capital market has expanded rapidly with the growth of financial institutions and credit organizations. 26

This has reduced the scope of bank credit. Therefore, variations made by the central bank in the discount rate, particularly in case of increase in the discount rate, have very less impact on credit market. (c) Elasticity of interest: Implies that fluctuation in the discount rate effective only when the demand of money is interest elastic. Generally, in less developed or underdeveloped countries, the interest rates in the credit market are sticky. Therefore, in these countries, the changes in discount rate have not been proved very effective.

Cash Reserve Ratio: CRR refers to the percentage of credit that needs to be maintained by commercial banks in the form of cash reserve with the central bank. The main aim of CRR is to avoid any kind of shortage of money in meeting the demand of money of depositors. CRR is usually determined by the previous experience of banks related to the extent of cash demanded by depositors. Commercial banks always retain their reserves beneath the safe limits. This is because of the reason that cash reserves are noninterest bearing in nature. This situation may result in financial crunch in banking sector. Therefore, CRR has been made obligatory by the central bank for commercial banks. In addition, it has become an important measure for the central bank to control the supply of money. CRR IS also termed as Statutory Reserve Ratio (SRR). The central bank possesses the power of changing the rate of CRR depending on economic situations. When there is a need of contractionary monetary policy in the economy, CRR is increased by the central bank. In this case, commercial banks need to reserve a-large amount of their total deposits with the central bank. As a result, the credit creation capability of commercial banks reduces, which further decreases money supply in the market. On the other hand, in case there is a requirement of increasing supply of money in the economy, the rate of CRR is

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decreased by the central bank. In such a case, the credit creation capability of commercial banks increases. Consequently, there would be increase in money supply. The effect of changes in CRR on money supply can be understood with the help of an example. Suppose commercial bank A has total money deposits of Rs.200 million with 20% of CRR. This implies that the bank can provide loans on the remaining amount, which is Rs.160 million. On the other hand if the rate of CRR increases to 25%, then the bank would be able to provide loans on the amount Rs.150 million. CRR is the most effective tool then the other tools of quantitative measures of monetary policy. It is the most popular instrument in developed countries where banking system is highly developed and had a greater stake in the capital market. However, CRR is restricted by its dependency on the bank credit system in the credit market. Statutory Liquidity Requirement: Apart from CRR, another reserve requirement imposed by the central on commercial banks is Statutory Liquidity Requirement (SLR). SLR is the amount of money that commercial banks need to keep with them in the form of liquid assets, besides CRR. The liquid assets can include cash reserve, gold, and government securities. In India, SLR was proposed by RBI to prevent the selling of government securities by commercial banks in case of increase in CRR. Before SLR was introduced, commercial banks were involved in the practice of selling government securities, in case of increase in CRR, to overcome a fall in their loanable funds. In India, RBI has continuously increased SLR from 25% in 1970s to 38.5% in 1991. However, SLR has been reduced to 30% on additional deposits in 1992. Now, the rate of SLR is 25% for commercial banks. However, it keeps on changing depending on the economic conditions.

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Selective Credit Controls: The quantitative measures of monetary control have uniform effect on the whole credit market. In simple terms, these measures have an even effect on all the sectors of an economy. However, this situation may not always wanted by policymakers for the formulation of policies. This is because of the reason that policymakers need to allocate the money in different sectors of the society and move the flow of money from most important sectors to least important sectors of the economy. In addition, the policymaker’s nave to reduce the risk factors associated with the availability of bank credit. All these objectives of monetary control can be achieved by implementing quantitative measures. Therefore, several selective credit controls are introduced by monetary authorities.

Limitations of Monetary Policy: As discussed above, the monetary policy of a government plays a major role in maintaining the supply of money in an economy. However, monetary policy is not free from limitations.

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CHAPTER 3 REVIEW OF LITERATURE

A large body of literature on the monetary transmission mechanism has debated on the working of the traditional “monetary” or “interstate” channel and “credit channel” of transmission. The traditional channels of monetary policy transmission are based on models of investment, consumption and international trade. cycle theory of consumption emphasized the role of asset based wealth as well as income in determining consumption behavior. Identifying a channel of monetary transmission, life-cycle theory highlighted that if stock prices fall after a tightening of monetary policy, household would find the value of their assets(wealth) falling, leading to a fall in consumption and output..

Examining the impact of monetary policy on bank loans in the context of the US, Bernanke and Blinder suggested that open market sales by the Federal Reserve, draining reserves and hence deposits from the banking system, would limit the supply of bank loans by reducing banks' access to loan able funds.

However, Roomer and Roomer concluded that credit channel was ineffective. The debate on monetary policy transmission was extended further in a Symposium on ‘The Monetary Policy Transmission’ in the Journal of Economic Perspectives.

where alternative views on channels of monetary policy transmission were provided By framework highlighted the role of monetary policy in determining prices and rates of return on financial assets, interest rates, and exchange rates which intern influence the spending decisions of firms and households.

Under the financial market view, Taylor found the traditional interest rate channel to be important for monetary policy transmission to the real economy. Roof and Obstfeld emphasized the importance of exchange rate channel of monetary policy transmission. Meltzer .

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CHAPTER 4 DATA ANALYSIS AND INTERPRETATION

4.1 Monetary policy of the country: (a) Time Gap: Refers to one of the major limitations of the monetary policy. It involves time taken in formulating and implementing monetary policy in an economy. Time gap can be classified into two categories, namely, inside time lag and outside time lag. Inside time lag denotes to the time gap in analyzing the type, selection, and implementation of monetary policy as well as its results. On the other hand, outside time lag is the time taken to receive feedback from individuals and organizations on monetary measures that are implemented in the economy. In case, both the time lag increase, result in new types of economic problems, but make the whole monetary policy ineffective. Fiscal policy has a shorter time lag as compared to monetary policy. The time lag in monetary policy can be 12 to 16 months. (b) Difficulty in Forecasting: Implies that monetary policy can be effective if there is a proper analysis of economic problems for which the policy is being used. Moreover, the consequences of monetary policy to be implemented should be assessed properly. However, forecasting economic conditions has always been a controversial issue. This is because different economists have different viewpoints and they analyze the situation differently. Forecasting based on guesses is unfruitful. Therefore, monetary policy can be effective if it is based on evidences. (c) Non-banking Financial Intermediaries: Refers to the fact that the growth of financial market has decreased the scope of monetary policy. With the emergence of non-banking financial intermediaries, such as industrial development banks, insurance companies, and mutual funds, there is only a small room for bank credit. 31

This new segment of the economy is responsible in grabbing the share of commercial banks. The non-financial intermediaries do not make credit with the help of credit multiplier, but their share in money supply makes the monetary policy ineffective. (d) Less Development of Money and Credit Market: Acts as one of the important factors for ineffectiveness of policy. The effectiveness of monetary policy. The effectiveness of monetary policy depends upon the efficiency of money and credit market. Usually, in underdeveloped countries, the structure of money and credit market is not so strong. Therefore, monetary policy in these countries has proved ineffective. 4.2 Major Limitations of Monetary Policy in less Developed Countries 1. Large Non-monetized Sector: There is a large non-monetized sector which hinders the success of monetary policy in such countries. People mostly live in rural areas where barter is practised. Consequently, monetary policy fails to influence this large segment of the economic. 2. Undeveloped Money and Capital Markets: The money and capital markets are undeveloped. These markets lack in bills, stocks and shares which limit the success of monetary policy. 3. Large Number of NBFLs: Non-bank financial intermediaries like the indigenous bankers operate on a large scale in such countries but they are not under the control of the monetary authority. The factor limits the effectiveness of monetary policy in such countries. 4. High Liquidity: The majority of commercial banks possess high liquidity so that they are not influenced by the credit policy of the central bank. This also makes monetary policy less effective. 5. Foreign Banks: In almost every underdeveloped country foreign owned commercial banks exist. They also render monetary policy less effective by selling foreign assets and drawing

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money from their head officers when the central bank of the country is following a tight monetary policy. 6. Small Bank Money: Monetary policy is also not successful in such countries because bank money comprises a small proportion of the total money supply in the country. As a result, the central bank is not in a position to control credit effectively. 7. Money not deposited with Banks: The well-to-do people do not deposit money with banks but use it in buying jewellery, gold, real estate, in speculation, in conspicuous consumption, etc. Such activities encourage inflationary pressures because they lie outside the control of the monetary authority. On account of these limitations of monetary policy in an under-developed country, economists advocate the use of fiscal policy along-with it.

4.3 Role of monetary policy in a development economy: Monetary policy in an underdeveloped country plays an important role in increasing the growth rate of the economy by influencing the cost and availability of credit, by controlling inflation and maintaining equilibrium the balance of payments. So the principal objectives of monetary policy in such a country are to control credit for controlling inflation and to stabilise the price level, to stabilise the exchange rate, to achieve equilibrium in the balance of payments and to promote economic development. To Control Inflationary Pressures: To control inflationary pressures arising in the process of development, monetary policy requires the use of both quantitative and qualitative methods of credit control. Of the instruments of monetary policy, the open market operations are not successful in controlling inflation in underdevelopment countries because the bill market is small and undeveloped. Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete. They are also reluctant to invest in government 33

securities due to their relatively low interest rates. Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of redics counting or borrowing from the central bank. The bank rate policy is also not so effective in such countries due to: (i) the lack of bills of discount; (ii) the narrow size of the bill market; (iii) a large non-monetised sector where barter transactions take place; (iv) the existence of indigenous banks which do not discount bills with the central bank; (v) the habit of the commercial banks to keep large cash reserves; and (vi) the existence of a large unorganised money market. The use of variable reserve ratio as an instrument of monetary policy is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open market operations are not successful. But a rise or fall in the variable reserve ratio by the central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities. Again, the commercial banks keep large cash reserves which cannot be reduced by an increase in bank rate or sale of securities by the central bank. But raising the cash reserve ratio reduces liquidity with the banks. The use of variable reserve ratio has certain limitations in LDCs. The non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are more affected than those who maintain it. The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In LDCs, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive changes available in agriculture, mining, plantations and industry. The selective credit controls are more appropriate for controlling and limiting credit facilities for such unproductive purposes. They are beneficial in controlling speculative activities in food-grains and

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raw materials. They prove more useful in controlling ‘sectional inflations’ in the economy. They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency. This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the central bank in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral the regulation of consumer credit and the rationing of credit. To Achieve Price Stability:

Monetary policy is an important instrument for achieving price stability k brings a proper adjustment between the demand for and supply of money. An imbalance between the two will be reflected in the price level. A shortage of money supply will retard growth while an excess of it will lead to inflation. As the economy develops, the demand for money increases due to the gradual monetization of the nonmonetized sector, and the increase in agricultural and industrial production. These will lead to increase in the demand for transactions and speculative motives. So the monetary authority will have to raise the money supply more than proportionate to the demand for money in order to avoid inflation.

To Bridge BOP Deficit:

Monetary policy in the form of interest rate policy plays an important role in bridging the balance of payments deficit. Underdeveloped countries develop serious balance of payments difficulties to fulfil the planned targets of development. To establish infrastructure like power, irrigation, transport, etc. and directly productive activities like iron and steel, chemicals, electrical, fertilisers, etc., underdeveloped countries have to import capital equipment, machinery, raw materials, spares and components thereby raising their imports. But exports are almost stagnant. They are high-price due to inflation. As a result, an imbalance is created between imports and exports which lead to disequilibrium in the balance in payments. Monetary policy can help in narrowing the balance of payments deficit through high rate of interest. A high 35

interest rate attracts the inflow of foreign investments and helps in bridging the balance of payments gap. Interest Rate Policy:

A policy to high interest rate in an underdeveloped country also acts as an incentive to higher savings, develops banking habits and speeds up the monetization of the economy which are essential for capital formation and economic growth. A high interest rate policy is also anti-inflationary in nature, for it discourages borrowing and investment for speculative purposes, and in foreign currencies. Further, it promotes the allocation of scarce capital resources in more productive channels. Certain economists favour a low interest rate policy in such countries because high interest rates discourage investment. But empirical evidence suggests that investment in business and industry is interest-inelastic in underdeveloped countries because interest forms a very low proportion of the total cost of investment. Despite these opposite views, it is advisable for the monetary authority to follow a policy of discriminatory interest rate-charging high interest rates for nonessential and unproductive uses and low interest rates for productive uses. To Create Banking and Financial Institutions: One of the objectives of monetary policy in an underdeveloped country is to create and develop banking and financial institutions in order to encourage, mobilise and channelize savings for capital formation. The monetary authority should encourage the establishment of branch banking in rural and urban areas. Such a policy will help in monetizing the non-monetized sector and encourage saving and investment for capital formation. It should also organise and develop money an capital market. These are essential for the success of a development oriented monetary policy which also includes debt management.

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Debt Management: Debt management is one of the important functions of monetary policy in an underdeveloped country. It aims at proper timing and issuing of government bonds, stabilising their prices and minimising the cost of servicing the public debt. The primary aim of debt management is to create conditions in which public borrowing can increase from year to year. Public borrowing is essential in such countries in order to finance development programmes and to control the money supply. But public borrowing must be at cheap rates. Low interest rates raise the price of government bonds and make them more attractive to the public. They also keep the burden of the debt low. Thus an appropriate monetary policy, as outlined above, helps in controlling inflation, bridging balance of payments gap, encouraging capital formation and promoting economic growth.

4.1 The Role Of Monetary Policy In Promoting Faster Economic Growth: Economic growth refers to a sustainable or a continuous increase in national and per capita incomes. This occurs when there is an increase in an economy’s capital stock through an increased investment. As a result there is expansion of the economy’s 37

production capacity. This enables the economy to produce more goods and services every year. In truth, faster economic growth can be attained by an economy largely if not entirely, by increasing the rate of saving and investment How this can be achieved by using monetary policy may now be discussed: 1. Increasing the Rate of Saving: If monetary policy is to promote economic growth, it has to raise the rate of saving. In a developing country like India, the central bank should raise the rate of interest to a reasonable level to induce people to save more. So larger and larger volume of resources will be available for investment (particularly in fixed assets). In times of inflation the nominal rate of interest has to be raised so that the real rate of interest remains constant. In fact in order to mobilise more and more saving through the banking system for investment purposes, it is absolutely essential to maintain reasonable price stability so that people have less incentive to buy gold, real estate or goods for hoarding and speculation. If due to excessive rise in price the real rate of interest becomes negative, people will have less incentive to save. However, the rate of interest affects only people’s desire to save. But their capacity to save depends, apart from income, on the existence of banks and other financial institutions. So the governments of developing countries should build a strong financial infrastructure by setting up banks, post offices, insurance companies, stock exchanges, mutual funds, and pension funds mainly in rural areas where the majority of the people live. 2. Monetary Policy and Investment: Even if the rate of interest is very low, private enterprises may not be willing to make new investment in time of depression due to lack of profitable business opportunities. This, of course, is Keynes’s view. But in normal times an increase in the supply of money due to an increase in bank credit leads to an increased investment. In addition

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in a developing country public (government) investment plays an important role in economic development. So monetary policy should also make adequate funds available for public investment. (a) Monetary Policy and Public Investment: The monetary policy of a developing country like India has to be such as to ensure that a large portion of deposits mobilised by banks is invested in government and other approved securities so as to enable the government to finance its planned investment. Infrastructure building is so important for economic development. So public investment has to be made to set up power plants, build roads, highways and ports. Such investment promotes industrial development directly and indirectly (by establishing backward and forward linkages). As a result there is a tremendous increase in demand for industrial products. Each industry purchases inputs from other industries and sells its products to both households and other businesses. The operation of multiplier stimulates private investment further. Thus public investment on social overhead capital will crowd in, rather than crowd out, private investment. Moreover, construction of irrigation dams promotes agricultural growth by raising both production and productivity. In India, a new tool of monetary control has been introduced for taking out large resources from the banking sector for financing public investment, viz., statutory liquidity ratio (SLR). Now in addition to keeping cash reserves commercial banks are to keep a minimum portion of their total demand and time deposits in some specified liquid assets, mainly in government and other approved securities’. (b) Monetary Policy and Private Investment: Since both large-scale and medium-size industries require funds for investment in fixed capital, working capital as also for holding inventories (of both finished goods and raw materials) monetary policy has also to ensure that the need for bank credit for investment and production in the private sector is fully satisfied.

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Adequate bank credit is necessary for two purposes: (i) To utilise the existing production capacities in the private sector and (ii) To create additional capacity. Banks must also provide adequate credit to meet the minimum working capital needs of agriculture and industry. (c) Allocation of Investment Funds: The mobilisation of savings is not enough. Savings are to be utilised for productive investment. So monetary policy should be discriminatory in nature. It should restrict the flow of credit in unproductive sectors and wasteful activities which are inimical to economic growth. At the same time it should direct the flow of credit in productive channels. So there is need for much stricter application of selecting credit control (SCC) mainly with a view to influencing the pattern of investment. SCC also helps the process of development indirectly by checking price rise and thus avoiding the distortion created by double digit inflation. However, it has to be supported by proper credit rationing. In addition, measures such as lengthening the periods of repayment of loans, lowering of margin requirements, provision of rediscounting facilities at rates below the market rates, interest and provision of special loans to entrepreneurs setting up labourintensive industries in backward areas are to be adopted for promoting faster industrial growth.

4.2 Conditions of a Good Target: In order to become a good target for monetary policy a variable should satisfy the following conditions:

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1. Measurability: The target variable should be easily measurable with little or no time lag. To meet this condition, accurate and reliable data must be available. The data should also conform to the theoretical definitions of the target variables. 2. Attainability: The monetary authority should be able to attain its targeted goals, otherwise, setting the targets will be an exercise in futility. The targets which are unattainable are not practical. A target will be attainable when- (a) it is rapidly affected by policy instruments; and (b) there are no or very little non-policy influences on it. 3. Relatedness to Goal Variables: The target variable should be closely related to the higher level goal variables and this relation should be well understood and reliably estimable. For example, even if the monetary authority is able to attain the interest rates target, all is in vain if the interest rates do not affect the ultimate goals of employment. The price level, the rate of economic growth, and the balance of payments.

Superiority of Target Variables: There are three main variables used as monetary targets. They are- money supply, bank credit and interest rates. Which of these variables is superior and chosen as target variable depends upon how far it satisfies the three criteria of measurability, attainability and relatedness to ultimate goals. In spite of certain conceptual and practical difficulties in the measurement of target variables, all the three variables satisfy equally well the criterion of measurability and can be estimated with reasonable accuracy. As regard the condition of attainability, both money supply and bank credit meet equally well this condition, whereas interest rates do not fulfil it satisfactorily. All the interest rates in the market do not change together and equi-proportionately. Interest rates are also not affected by the policy instruments as rapidly as other target variables are. Moreover, non-policy factors greatly influence the interest rates.

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As regards the fulfilment of the criterion of relatedness to goal variables, the economists differ sharply. The Keynesians recommend interest rate as appropriate target variable, while the monetarists prescribe money supply. Practical central bankers, on the other side, consider bank credit as a better target variable.

Economists are not in agreement as to which one is the best target variable: (i) On the basis of the criteria of measurability and attainability, both money supply and bank credit are better target variables than interest rates. (ii) As between money supply and bank credit, money supply is definitely superior because there exists weak theoretical and empirical evidence in support of close causal link between credit and higher goals variables. (iii) Money supply is much more easily influenced by policy instruments than interest rates and the weight of policy factors is heavier than non- policy factors on money supply variable. (iv) Empirically also, the relation between money supply and the level of economic activity (and thus other goal variables) is stable and calculable. The same cannot be said about interest rates. Recently, Benjamin Friedman, a Harvard economist, has suggested that the best intermediate target would be a combination of a credit variable target and a monetary growth target. Such a system, according to him, would draw on a more diverse and hence more reliable information base for the signals that govern the systematic response of monetary policy to emerging developments. Under such a system, the central bank would select one monetary aggregate and total net credit, specify growth rate together for both and carry out open market operations aimed at achieving both targets. A deviation in either target from its respective target range would require a change in open market operations. Impossibility of Simultaneous Targeting of Money Supply and Interest Rate:

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It is to be carefully noted that the targets of money supply and interest rate pose a problem of mutually exclusivity. The monetary authority can select an interest rate or a money supply target, but not both. In Figure-5, for example, the monetary authority cannot choose both Oi interest rate, and OM1 money supply. If it chooses Oi interest rate, it must accept OM money supply and if it chooses OM1 money supply, it must allow the interest rate to fall to Oi1..

Choosing an Appropriate Target: Actual practice, whether the monetary authority should choose interest rate target or money supply target depends upon the source of instability in the economy. If the source of instability is in the commodity market, i.e., variations in private and public spending or variations in the is curve, then money supply target should be set and pursued. On the contrary, if the source of instability in the economy is in the money market, i.e., unstable demand or supply of money, or variations in the LM curve, then the interest rate target will be selected. These two cases are discussed below in detail: 1. Instability of IS Curve: 43

Instability in the IS curve can arise- (a) because of destabilising fiscal policy adopted by the government (i.e., changes in public spending), or (b) because of variations in consumption function or investment function (i.e., changes in the private spending). Given the money market conditions (i.e., given the LM0 curve in Figure-6), a fall in spending will cause the IS curve to shift to the left from IS0 to IS1. This will reduce the rate of interest from Oi0 to Oi1 and the income level from OY0 to OY1. Using the strategy of stabilizing the money supply, the monetary authority is induced to increase the money supply, thus shifting the LM curve to the right. This will cause income to rise above OY1 back towards the target level OY0, although the interest rate is further reduced. Thus, if the LM curve is stable, then an unstable IS curve causes the level of income to fluctuate between OY1 and OY0, when a money supply target is followed. This implies that money supply targeting will be stabilising or counter-cyclical; that is, increasing money supply during recession will increase income and reduce rate of interest, and reducing money supply during inflation will reduce income and raise rate of interest. On the other hand, using the strategy of setting the interest- rate target means keeping the desired rate of interest at a particular level, say Oi0. In this case, the LM curve becomes horizontal at i0 (i.e., LM1 curve in Figure-6). The money supply must be adjusted to maintain Oi0 level of interest rate. In this process, the national income will fluctuate between Y2 and Y0. Since Y2 Y0 > Y1 Y0, a money stock

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implies that changes in the money supply to maintain a constant interest rate will be pro-cyclical when the IS curve is unstable. During recession, when IS curve shifts from IS0 to IS1, the interest rate falls from i0 to i1 and income level falls from Y0 to Y1. The monetary authority would be prompted to decrease money supply to achieve the equilibrium level where LM curve intersects IS curve and the interest rate is raised to the desired Oi0 level. This will, however, further reduce the income level from OY1- to OY2. Thus, when IS curve is unstable, setting the interest rate target by changing money supply will be destabilising and inappropriate. The monetary authority would be prompted to decrease money supply during recession to restrict interest rate from falling and to increase money supply during inflation to keep interest rate down. 2. Instability of LM Curve: Instability in the LM curve arises mainly due to unstable demand for money in the money market which causes shifts in the LM curve. In a situation of stable IS curve and unstable LM curve, the strategy of constant money supply will cause the With the increase in demand for money, the LM curve will shift from LM0 to LM1.The effect of this shift is to reduce income from OY0 to OY1 and raise the rate of interest from Oi0 to Oi1. Moreover, pursuing constant money supply target will be pro-cyclical. Increase in the rate of interest induces an increase in money supply. In such condition, constant money stock-policy will require that the monetary authority should reduce money supply.

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This will cause the lm carve to shift further from lm1 to the left, rate of interest to rise further above oi1, and the income level to fall further below oy1. Thus, in a situation of unstable lm curve and stable is curve, setting a constant money supply target will be destabilizing and inappropriate. It will require decrease in money supply, causing interest rate to rise and income level to fall, every time the demand for money rises during recession, and increase in money supply, causing interest rate to fall and income level to rise, every time the demand for money falls during inflation. In contrast, the policy of targeting interest rate at Oi0 means that the LM curve becomes horizontal at i0 (i. e., LM2 curve in Figure-7). This will leave the level of income unaltered at OY0 which corresponds to the point of intersection of IS0 and LM2. The interest rate target will be stabilizing and counter- cyclical. It will induce the monetary authority to increase the money supply when the demand for money increases during recession, and to decrease the money supply when the demand for money falls during inflation. Thus, the general conclusion is that the question as to which target is better is an empirical question. If is more stable than LM, setting an interest rate target is appropriate. If, on the other hand, LM is more stable than IS, setting a monetary aggregate target is appropriate. 4.3 Monetary Targeting in India: Recently, the need for pursuing monetary target has been widely recognised and seriously discussed in India. In 1982, the Reserve Bank of India appointed a committee, with Prof. Sukhumi Chakra arty as its chairman, with the objective of reviewing the working of monetary system in the country. In its report, submitted in 1985, the Committee, among other things, laid stress on the desirability of developing monetary targets at the aggregate level for securing an acceptable and orderly pattern of monetary growth. The Committee has emphasised the need to pursue price stability as the broad objective of the monetary policy consistent with the other socio-economic goals 46

embodied in the Five Year Plans. For achieving this objective, money supply (M3) should be regulated in the framework of monetary targeting in terms of a range, with feedback and necessary support from an appropriate interest rate policy. Instruments of Monetary Policy and the Reserve Bank of India Monetary policy is a way for the RBI to control the supply of money in the economy. So these credit policies help control the inflation and in turn help with the economic growth and development of the country. So now let us take a look at the various instruments of monetary policy that the RBI has at its disposal. 1] Open Market Operations: Open Market Operations is when the RBI involves itself directly and buys or sells short-term securities in the open market. This is a direct and effective way to increase or decrease the supply of money in the market. It also has a direct effect on the ongoing rate of interest in the market. Let us say the market is in equilibrium. Then the RBI decides to sell short-term securities in the market. The supply of money in the market will reduce. And subsequently, the demand for credit facilities would increase. And so correspondingly the rate of interest would also see a boost. On the other hand, if RBI was purchasing securities from the open market it would have the opposite effect. The supply of money to the market would increase. And so, in turn, the rate of interest would go down since the demand for credit would fall. 2] Bank Rate: One of the most effective instruments of monetary policy is the bank rate. A bank rate is essentially the rate at which the RBI lends money to commercial banks without any security or collateral. It is also the standard rate at which the RBI will buy or discount bills of exchange and other such commercial instruments. So now if the RBI were to increase the bank rate, the commercial banks would also have to increase their lending rates. And this will help control the supply of money in the market. And the reverse will obviously increase the supply of money in the market. 47

3] Variable Reserve Requirement: There are two components to this instrument of monetary policy, namely – The Cash Reserve Ratio (CLR) and the Statutory Liquidity Ratio (SLR). Let us understand them both. Cash Reserve Ratio (CRR) is the portion of deposits with the commercial banks that it has to deposit to the RBI. So CRR is the percent of deposits the commercial banks have to keep with the RBI. The RBI will adjust the said percentage to control the supply of money available with the bank. And accordingly, the loans given by the bank will either become cheaper or more expensive. The CRR is a great tool to control inflation. The Statutory Liquidity Ratio (SLR) is the percent of total deposits that the commercial banks have to keep with themselves in form of cash reserves or gold. So increasing the SLR will mean the banks have fewer funds to give as loans thus controlling the supply of money in the economy. And the opposite is true as well. 4] Liquidity Adjustment Facility: The Liquidity Adjustment Facility (LAF) is an indirect instrument for monetary control. It controls the flow of money through repo rates and reverse repo rates. The repo rate is actually the rate at which commercial banks and other institutes obtain short-term loans from the Central Bank. And the reverse repo rate is the rate at which the RBI parks its funds with the commercial banks for short time periods. So the RBI constantly changes these rates to control the flow of money in the market according to the economic situations 5] Moral Suasion: This is an informal method of monetary control. The RBI is the Central Bank of the country and thus enjoys a supervisory position in the banking system. If there is a need it can urge the banks to exercise credit control at times to maintain the balance of funds in the market. This method is actually quite effective since banks tend to follow the policies set by the RBI. 48

CHAPTER 5 CONCLUSION While monetary policy has been primarily acting through availability of credit, the cost of

credit has also been adjusted upward, sometimes very sharply to meet

effectively the inflationary situations. The areas of operation of monetary policy did not remain confined to those related to the regulation of monetary supply and keeping prices in check. Role of RBI as a Regulator and Supervisor of the financial system which have gone under various strategic shifts and RBI has made significant improvements in the quality of performance of its regulatory and supervisory function, and as a result our standards are comparable to the worlds. From the data collected and analyzed the impact of credit policy on nationalised bank .

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5.1 SUGGESTION The monetary policy statement should focus on a single policy interest rate (in India's case, the reverse repo rate). By giving importance of a potential monetary signal in the repo rate and the bank rate, the RBI only causes confusion's The RBI deserves credit for more frequent communication with financial markets. The move toward quarterly economic assessments and policy announcements are steps toward the right direction. However, the art of written central bank communication is a new experience for the RBI, so it is understandable if there is a bit of learning by doing. A few suggestions to improve the communication: The clarity in communication that came across in the media comments by the governor and deputy governor was conspicuous by its absence in the policy statement. Separately, there appears to be a mismatch between the concern about the inflation outlook expressed in recent statements, the guidance offered, and the actual monetary action.

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5.2 REFERENCE https://www.google.com/amp/s/m.economictimes.com/definition/monetarypolicy/amp?espv=1 https://www.investopedia.com/terms/r/rbi.asp http://www.economicsdiscussion.net/trade-cycle/control-trade-cycle/monetary-policyconcept-instruments-and-objectives-trade-cycle-control/14665 https://businessjargons.com/types-of-monetary-policy.html https://vittana.org/15-advantages-and-disadvantages-of-monetary-policy-tools http://www.economicsdiscussion.net/monetary-policy/objectives-of-monetary-policy6-objectives-india/26107 http://www.economicsdiscussion.net/monetary-policy/monetary-policy-meaningobjectives-scope-role-and-targets-economics/31314

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