DR.

RAM MANOHAR LOHIYA NATIONAL LAW UNIVERSITY

LUCKNOW

SEMESTER V
(2015-16)

BANKING LAW-I

MONETARY POLICY OF THE RESERVE BANK OF INDIA: AN

ANALYSIS
(FOR THE PARTIAL FULFILLMENT OF THE DEGREE OF B.A. LLB (H ON))

SUBMITTED BY

S UBMITTED TO

GARIMA PARAKH

M S. APARNA SINGH
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ROLL NO. 57
PROFESSOR (LAW)

A SST.
ACKNOWLEDGEMENT

I would like to extend my sincere thanks to

My teacher and my mentor Ms. Aparna Singh for giving me this wonderful opportunity to work on
this project and for her able guidance and advice,
Vice Chancellor, Dr. Gurdeep Singh Sir and Dean (Academics), Professor C.M. Jariwala for their
encouragement and Enthusiasm;
My seniors for sharing their valuable tips;
And my classmates for their constant support.

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TABLE OF CONTENTS

INTRODUCTION................................................................................................................................3
MONETARY POLICY BEFORE THE 90s.........................................................................................4
[2.1] Main Focus of the Policies.......................................................................................................4
[2.3] Instruments of Fiscal Control: Direct or Indirect.....................................................................5
INDUSTRIALISATION AND FOREIGN DIRECT INVESTMENT: THE PERIOD AFTER THE
90s........................................................................................................................................................6
[3.1] Change in the Economic Conditions........................................................................................6
[3.2] Change in the Monetary Policy................................................................................................7
[3.3] New Instruments of Fiscal Control..........................................................................................8
[3.4] Beginning of Foreign Investment: Effect of Foreign Pressure..............................................11
RECENT TRENDS AND SUGGESTIONS OF THE MONETARY POLICY COMMITTEE........11
[4.1] Changing the Focus................................................................................................................11
PROPOSED CHANGE IN THE COMPOSITION OF THE MPC: EFFECT ON MONETARY
POLICY.............................................................................................................................................12
[5.1] Formation of the Monetary Policy Committee......................................................................12
[5.2] Maintenance of Transparency through Current Composition................................................13
[5.3] Alteration of Composition: Effects of Governmental Interference........................................13
CONCLUSION..................................................................................................................................15

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INTRODUCTION
Monetary policy is a regulatory policy by which the central bank or monetary authority of a country
controls the supply of money, availability of bank credit and cost of money, that is, the rate of
interest. Monetary policy/monetary management is regarded as an important tool of economic
management in India. RBI controls the supply of money and bank credit. The central bank has the
duty to see that legitimate credit requirements are met and at the same credit is not used for
unproductive and speculative purposes. RBI rightly calls its credit policy as one of controlled
expansion. For most of the period in the sixties, seventies and eighties, there was an emphasis on
the achievement of price stability. In recent years, starting from the mid- nineties, promoting
economic growth is being given greater emphasis in monetary policy of Reserve Bank of India.
This is evident from the lower cash reserve ratio (CRR) set in order to increase the liquidity and
cash flow in the market. This has led to a conducive borrowing situation with a lower interest rate,
making investments easier. Using indirect fiscal instruments such as ad-hoc treasury bills, enabled
monetization of the budget deficit of the government, which helped even more after measures such
as open market auctions of such treasury bills was initiated. Further, an appropriate devaluation of
the currency has improved foreign investment and has therefore increased the growth rate of our
economy. However, the cap on foreign direct investment was kept at 49%. This helped the economy
bear the blow of the 2008 economic crisis without much damage. In 2002, the suggestion of a
Monetary Policy Committee (MPC) by the advisory group which also had former RBI Deputy
Governor S. S. Tarapore, helped make the laying down of a monetary policy more transparent and
in line with the objectives of the government by involving the Parliament in the discussions. The
main aim at that time was to control the inflationary economy. Today, development is the main
agenda which requires a different set of policy changes and this must be done without being too
drastic.

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MONETARY POLICY BEFORE THE 90s

[2.1] Main Focus of the Policies

In the formative years during 19351950, the focus of monetary policy was to regulate the supply
of and demand for credit in the economy through the Bank Rate, reserve requirements and OMO. 1
During the development phase during 19511970, the need to support plan financing through
accommodation of government deficit financing by the RBI began to significantly influence the
conduct of monetary policy.2 This led to introduction of several quantitative control measures to
contain the consequent inflationary pressures while ensuring credit to preferred sectors. These
measures included selective credit control, credit authorisation scheme (CAS) and social control
measures to enhance the flow of credit to priority sectors. The Bank Rate was raised more
frequently during this period. During 197190, the focus of monetary policy was on credit
planning. However, the dominance of fiscal policy over monetary policy accentuated and continued
through the 1980s.3 In order to raise resources for the government from banks, the statutory
liquidity ratio (SLR) was progressively increased from the statutory minimum of 25 per cent of
banks net demand and time liabilities (NDTL) in 1970 to 38.5 per cent by 1990. 4 And to neutralise
the inflationary impact of deficit financing, the cash reserve ratio (CRR) was gradually raised from
its statutory minimum of 3 per cent to 15 per cent of NDTL during the period. The 1980s saw the
adoption of monetary targeting framework based on the recommendations of Chakravarty
Committee (1985). Under this framework, reserve money was used as operating target and broad
money (M3) as an intermediate target. A number of money market instruments such as inter-bank
participation certificates (IBPCs), certificates of deposit (CDs) and Commercial Paper (CP) were
introduced based on the recommendations of Vaghul Committee (1987).

1 Deepak Mohanty, How does the Reserve bank of India conduct its monetary policy? (IIM Lucknow,
August 12 2011) <http://www.bis.org/review/r110816a.pdf> accessed 25 October 2015.
2 Ibid.
3 Ibid.
4 TR Jain, Mukesh Trehan and Ranju Trehan, Business Environment (F K Publications, 2010).
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[2.3] Instruments of Fiscal Control: Direct or Indirect

Monetary policy was subservient to the fiscal policy. The financial system was characterised by
extensive regulations such as administered interest rates, directed credit programmes, weak banking
structure,
lack of proper accounting and risk management systems and lack of transparency in operations of
major financial market participants (Mohan, 2004b). Moreover, after the nationalisation of banks in
1969 and 1980, 90 per cent of banking assets were in government owned banks and financial
institutions, while entry of foreign banks was restricted. Hence, there was a significant lack of
competition in the financial sector. Such a system hindered efficient allocation of resources.
Financial sector reforms initiated in the early 1990s have attempted to overcome these weaknesses
in order to enhance efficiency of resource allocation in the economy. Simultaneously, the Reserve
Bank took a keen interest in the development of financial markets, especially the money,
government securities and forex markets in view of their critical role in the transmission mechanism
of monetary policy.5 As for other central banks, the money market is the focal point for intervention
by the Reserve Bank to equilibrate short-term liquidity flows on account of its linkages with the
foreign exchange market. Similarly, the Government securities market is important for the entire
debt market as it serves as a benchmark for pricing other debt market instruments, thereby aiding
the monetary transmission process across the yield curve. The Reserve Bank had, in fact, been
making efforts since 1986 to develop institutions and infrastructure for these markets to facilitate
price discovery. These efforts by the Reserve Bank to develop efficient, stable and healthy financial
markets accelerated after 1991. There has been close co-ordination between the Central
Government and the Reserve Bank, as also between different regulators, which helped in orderly
and smooth development of the financial markets in India.

5 Rakesh Mohan, Financial Sector Reforms and Monetary Policy: The Indian Experience (Conference on
Economic Policy in Asia, Stanford,June 2006) https://siepr.stanford.edu/?
q=system/files/shared/pubs/320_rakesh-rev.pdf accessed 27 October 2015.
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INDUSTRIALISATION AND FOREIGN DIRECT INVESTMENT: THE PERIOD AFTER

THE 90s
[3.1] Change in the Economic Conditions
Structural reforms and financial liberalisation in the 1990s led to a shift in the financing paradigm
for the government and commercial sectors with increasingly market-determined interest rates and
exchange rate. The main objective of the financial sector reforms in India initiated in the early
1990s was to create an efficient, competitive and stable financial sector that could then contribute in
greater measure to stimulate growth. 6 Concomitantly, the monetary policy framework made a
phased shift from direct instruments of monetary management to an increasing reliance on indirect
instruments. However, as appropriate monetary transmission cannot take place without efficient
price discovery of interest rates and exchange rates in the overall functioning of financial markets,
the corresponding development of the money market, the Government securities market and the
foreign exchange market became necessary. Reforms in the various segments were therefore
coordinated. In this process, growing integration of the Indian economy with the rest of the world
also had to be recognised and provided for. By the second half of the 1990s, in its liquidity
management operations, the RBI was able to move away from direct instruments to indirect marketbased instruments. The CRR and SLR were brought down to 9.5 per cent and 25 per cent of NDTL
of banks by 1997.7 After the economy was liberalized, the standard of living of people began to rise
an inflationary economy could be observed. Inflation raises the cost of living of the people and
hurts the poor most and sends many people below the poverty line. Further, inflation makes exports
costlier and, therefore, discourages them. On the other hand, due to higher prices at home people
are induced to import goods to a large extent. Thus, inflation has an adverse effect on the balance of
payments. Thirdly, when due to a higher rate of inflation value of money is rapidly falling, people
do not have much incentive to save. This lowers the rate of saving on which investment and
economic growth depend. Fourthly, a high rate of inflation encourages businessmen to invest in the
productive assets such as gold, jewellery, real estate etc. 8 An expert committee on monetary reforms
headed by Late Prof. S. Chakravarty suggested 4 per cent rate of inflation as a reasonable rate of
6 Ibid.
7 Deepak Mohanty, How does the Reserve bank of India conduct its monetary policy? (IIM Lucknow,
August 12 2011) <http://www.bis.org/review/r110816a.pdf> accessed 25 October 2015.
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inflation and recommended that monetary policy by RBI should be so formulated that ensures that
rate of inflation does not exceed 4 per cent per annum. Emphasising the importance of price
stability from the viewpoint of Indias balance of payments, Prof. Rangarajan said9
The increasing openness of the economy, the need to service external debt and the necessity to
improve the share of our exports in a highly competitive external environment require that the
domestic price level not be allowed to rise unduly, particularly since our major trading partners
have had notable success in recent years in achieving price stability.
[3.2] Change in the Monetary Policy
1.

Reduced Reserve Requirements : During 1990s both the Cash Reserve Ratio (CRR) and
the Statutory Liquidity Ratio (SLR) were reduced to considerable extent. The CRR was at its
highest 15% plus and additional CRR of 10% was levied, however it is now reduced by 4%. The
SLR is reduced form 38.5% to a minimum of 25%.10

2.

Increased Micro Finance : In order to strengthen the rural finance the RBI has focused
more on the Self Help Group (SHG). It comprises small and marginal farmers, agriculture and
non-agriculture labour, artisans and rural sections of the society. However still only 30% of the
target population has been benefited.11

3.

Fiscal Monetary Separation : In 1994, the Government and the RBI signed an agreement
through which the RBI has stopped financing the deficit in the government budget. Thus it has
seperated the Monetary policy from the fiscal policy.

8 Rakesh Mohan, Financial Sector Reforms and Monetary Policy: The Indian Experience (Conference on
Economic Policy in Asia, Stanford,June 2006) https://siepr.stanford.edu/?
q=system/files/shared/pubs/320_rakesh-rev.pdf accessed 27 October 2015.
9 Supriya Guru, The Meaning and Objective of Monetary Policy (Ypur Article Library, 20 April 2014)
<http://www.yourarticlelibrary.com/economics/the-meaning-and-objectives-of-monetary-policy/37889/>
accessed 25 October 2015.
10 Gaurav Akrani, Monetary Policy in India: 1990 reforms and its evaluation (Kalyan City Life, 13
September 2010) <http://kalyan-city.blogspot.in/2010/09/monetary-policy-in-india-1900-reforms.html>
accessed 26 October 2015.
11 Ibid.
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4.

Changed Interest Rate Structure : During the 1990s, the interest rate structure was
changed from its earlier administrated rates to the market oriented or liberal rate of interest.
Interest rate slabs are now reduced up to two and minimum lending rates are abolished. Similarly,
lending rates above Rs. 2 lakh are freed.12

5.

Changes in Accordance to the External Reforms : During the 1990, the external sector
has undergone major changes. It comprises lifting various controls on imports, reduced tariffs,
etc. The Monetary policy has shown the impact of liberal inflow of the foreign capital and its
implication on domestic money supply.13

6.

Higher Market Orientation for Banking : The banking sector got more autonomy and
operational flexibility. More freedom to banks for methods of assessing working funds and other
functioning has empowered and assured market orientation.14

[3.3] New Instruments of Fiscal Control

Since 1991 RBIs monetary management has undergone some major changes. Upto late 1990s, RBI
used the Monetary targeting approach to its monetary policy. Monetary targeting refers to a
monetary policy strategy aimed at maintaining price stability by focusing on changes in growth of
money supply. After 1991 reforms this approach became difficult to follow. So RBI adopted
Multiple Indicator Approach in which it looks at a variety of economic indicators and monitor their
impact on inflation and economic growth. With rapid progress in financial markets, the selective
methods of credit control such as, ceiling on credit, discriminatory interest rates, margin
requirements, directives, direct action and moral suasion, were slowly phased out and quantitative
methods became more important by virtue of being in tune with the rapidly changing economy.
Further, in post-reform period, the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
were progressively lowered, as a part of financial sector reforms. As a result, more bank funds were
available for loan purposes which led to growth in the economy. Liquidity Adjustment Facility
(LAF) which allows banks to borrow money through repurchase agreement was introduced by the
12 Ibid.
13 TH Smitha, Impact of Monetary Policy on Indian Economy in the Post-Reform Period (DPhil thesis,
Cochin University of Science and Technology 2010).
14 Ibid.
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RBI in June 2000, in phases. The funds under LAF are used by banks to meet day-to-day
mismatches in liquidity. With globalisation there was large influx of foreign capital in the country.
Therefore to provide stability in financial markets, RBI uses sterilization and LAF to absorb the
excess liquidity that comes in with huge inflow of foreign capital. Other reforms included
deregulation of administered interest rate system by allowing commercial banks to determine
lending rates based on market forces and delinking of monetary policy from budget deficit by
phasing out the use of ad hoc Treasury Bills which were used by government to borrow from RBI to
finance fiscal deficit. This meant that RBI would no longer finance the governments fiscal deficit.
Another important change that occurred was linking of the banking system with Self Help Groups
(SHGs). RBI introduced the scheme of micro finance for rural poor along with NABARD, and is
now promoting various other microfinance institutions.
1. Open Market Operations
An open market operation is an instrument of monetary policy which involves buying or
selling of government securities from or to the public and banks. This mechanism influences
the reserve position of the banks, yield on government securities and cost of bank credit.
The RBI sells government securities to control the flow of credit and buys government
securities to increase credit flow. Open market operation makes bank rate policy effective
and maintains stability in government securities market.
2. Cash Reserve Ratio
Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to
keep with RBI in the form of reserves or balances. Higher the CRR with the RBI lower will
be the liquidity in the system and vice versa. RBI is empowered to vary CRR between 15
percent and 3 percent. But as per the suggestion by the Narsimham committee Report the
CRR was reduced from 15% in the 1990 to 5 percent in 2002. As of September 2015, the
CRR is 4.00 percent.
3. Statutory Liquidity Ratio
Every financial institution has to maintain a certain quantity of liquid assets with themselves
at any point of time of their total time and demand liabilities. These assets have to be kept in
non-cash form such as precious metals, approved securities like bonds etc. The ratio of the
liquid assets to time and demand liabilities is termed as the Statutory liquidity ratio. There

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was a reduction of SLR from 38.5% to 25% because of the suggestion by Narshiman
Committee. The current SLR is 21.5%.
4. Bank Rate Policy
The bank rate, also known as the discount rate, is the rate of interest charged by the RBI for
providing funds or loans to the banking system. This banking system involves commercial
and co-operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other
approved financial institutes. Funds are provided either through lending directly or
rediscounting or buying money market instruments like commercial bills and treasury bills.
Increase in Bank Rate increases the cost of borrowing by commercial banks which results
into the reduction in credit volume to the banks and hence declines the supply of money.
Increase in the bank rate is the symbol of tightening of RBI monetary policy. As of 3
February 2015, the bank rate is 8.75%.8.50% in 4 March 2015.8.25% in 2 June 2015
5. Change in Margin Requirements on Loans
Margin is the difference between loan value and market value of security and is fixed by
RBI. For different types of loans the margin requirement differs. If the margin percentage is
high then less loan will be given for a certain value of security and vice versa. For example,
if the margin requirement is 0% then bank will give at max 80% of market value of security
as loan. For priority sector (where more loans are preferred), where credit is to be expanded,
the margin requirement is reduced.
6. Moral Suasion
Moral Suasion is just as a request by the RBI to the commercial banks to take so and so
action and measures in so and so trend of the economy. RBI may request commercial banks
not to give loans for unproductive purpose which does not add to economic growth but
increases inflation. From time to time the RBI holds meetings wih the member banks
seeking their cooperation in effectively controlling the monetary policy of the country. It
advices them to extend more credit to priority sectors i.e. agriculture and small industries
and invest more in government securities.
7. Repo Rate and Reverse Repo Rate
Repo rate is the rate at which RBI lends to commercial banks generally against government
securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper
rate and increase in Repo rate discourages the commercial banks to get money as the rate
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increases and becomes expensive. Reverse Repo rate is the rate at which RBI borrows
money from the commercial banks. The increase in the Repo rate will increase the cost of
borrowing and lending of the banks which will discourage the public to borrow money and
will encourage them to deposit. As the rates are high the availability of credit and demand
decreases resulting to decrease in inflation. This increase in Repo Rate and Reverse Repo
Rate is a symbol of tightening of the policy.
[3.4] Beginning of Foreign Investment: Effect of Foreign Pressure
Until 1991, India followed fixed exchange rate system and only occasionally devalued the rupee
with the permission of IMF. The policies of floating exchange rate and increasing openness and
globalisation of the Indian economy, adopted since 1991 have made the exchange rate of rupee
quite volatile. The changes in capital inflows and capital outflows and changes in demand for and
supply of foreign exchange, particularly US dollar, arising from the imports and exports cause great
fluctuations in the foreign exchange rate of rupee.

RECENT TRENDS AND SUGGESTIONS OF THE MONETARY POLICY COMMITTEE

[4.1] Changing the Focus

With the initiation of financial sector reforms, monetary management in India has been increasingly
relying on the use of indirect instruments like open market operations and fine-tuning of liquidity
conditions through the Liquidity Adjustment Facility. The modulations in policy interest rates have
emerged as a principal instrument of signaling monetary policy stance. With the changing
framework of monetary policy in Indian from monetary targeting to an augmented multiple
indictors approach, the operating targets and processes have also undergone a change. There has
been a shift from quantitative intermediate targets to interest rates, as the development of financial
markets enabled transmission of policy signals through the interest rate channel. At the same time,
availability of multiple instruments such as CRR, OMO including LAF and MSS has provided
necessary flexibility to monetary operations.15 While monetary policy formulation is a technical
process, it has become more consultative and participative with the involvement of market
participant, academics and experts. The internal process has also been re-engineered with more
15 TH Smitha, Impact of Monetary Policy on Indian Economy in the Post-Reform Period (DPhil thesis,
Cochin University of Science and Technology 2010).
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technical analysis and market orientation. In order to enhance transparency in communication the
focus has been on dissemination of information and analysis to the public through the Governors
monetary policy statements and also through regular sharing of policy research and macroeconomic
and financial information. Through rise in the cost of credit and reduction in the availability of
credit, borrowing from the banks were discouraged which was expected to reduce the demand for
dollars. The higher interest rates in India would also discourage foreign institutional investors and
Indian corporate to invest abroad. This will also work to reduce the demand for dollars which will
prevent the fall in the value of the rupee. Alternatively, to prevent the depreciation of the rupee, RBI
can release more dollars from its foreign exchange reserves. The release of more dollars by RBI
will increase the supply of US dollars in the foreign exchange market and will therefore tend to
correct the mismatch between demand for and supply of the US dollar.16 This will help in stabilising
the exchange rate of the rupee. It is clear from above that in the context of flexible exchange rate
system, the RBI has to intervene frequently to achieve stability of exchange rate at a reasonable
level.

PROPOSED CHANGE IN THE COMPOSITION OF THE MPC: EFFECT ON

MONETARY POLICY
[5.1] Formation of the Monetary Policy Committee
Several committees have recommended formation of a full-fledged monetary policy committee
(MPC). The Standing Committee on International Standards and Codes, 2002 (Chairman: Dr. Y.V.
Reddy) recommended legislative changes in the RBI Act so as to facilitate a mechanism for
effective monetary policy. It recommended setting up of a Monetary Policy Committee on the lines
of the Board of Financial Supervision. The Committee on Fuller Capital Account Convertibility,
2006 (Chairman: Shri S.S. Tarapore) recommended that there should be a formal Monetary Policy
Committee. It also recommended that at some appropriate stage, a summary of the minutes of the
Monetary Policy Committee should be put in the public domain with a suitable lag. The Committee
on Financial Sector Reforms, 2009 (Chairman: Dr. Raghuram G. Rajan) recommended that a
Monetary Policy Committee should take a more active role in guiding monetary policy actions. It
16 Supriya Guru, The Meaning and Objective of Monetary Policy (Ypur Article Library, 20 April 2014)
<http://www.yourarticlelibrary.com/economics/the-meaning-and-objectives-of-monetary-policy/37889/>
accessed 25 October 2015.
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should meet more regularly; its recommendations and policy judgments should be made public with
minimal delays. The Committee on Financial Sector Assessment, 2009 (Chairman: Dr. Rakesh
Mohan) counseled on the need for strengthening the role of the TACMP and recommended that
practices/ procedures towards this goal be considered as it gains more experience. 17 Globally,
central banks follow different models. While some have government-appointed members on these
committees, the appointments are done in a manner to avoid any political interference. The Bank of
Englands monetary policy committee is made up of nine members. This includes the governor,
three deputy governors and the chief economist of the central bank. The remaining four members
are appointed by UKs Chancellor. The four members are independent and do not represent any
interest group. They are appointed for fixed terms. Each member of the committee has one vote.
While a member of the treasury is allowed to sit in on the meetings and debate along with the
monetary policy committee, this person doesnt get a vote.18
[5.2] Maintenance of Transparency through Current Composition
In India, although guided by internal inputs and of those received by the Committee of the Central
Board of Directors of the RBI, monetary policy decisions are made by the Governor alone, and the
quarterly (and now bi-monthly) policy statements are issued in his name. However, over time, the
process of monetary policy decision making has become more consultative and participative, and
relies even more on external inputs. A Technical Advisory Committee (TAC) on Monetary Policy
was established in 2005, but its role is purely advisory in nature. 19 Communicating the rationale of
monetary policy actions is central to both the credibility of the central bank and to enable the
incidence targets of the policy to adjusting behaviour appropriately. Heightened public interest and
scrutiny of MP decisions and outcomes has propelled a worldwide movement towards a committee
17 URP Committee Report (21 January 2014) https://rbi.org.in/scripts/PublicationReportDetails.aspx?
UrlPage=&ID=747 accessed 26 October 2015.
18 Ira Dugal, How different will the proposed monetary policy be (Live Mint, 24 July 2015)
<http://www.livemint.com/Politics/hv0Q0axSRddH2Xfq9azT3O/How-different-will-be-the-proposedmonetary-policy-committee.html> accessed 27 October 2015.
19 Saugata Bhattacharya, Why a Monetary Policy Committee is the best decision making structure
(Huffington Post, 12 August 2015) <http://www.huffingtonpost.in/saugata-bhattacharya/a-monetary-policycommitt_b_7963844.html> accessed 26 October 2015.
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based approach to decision making with a view to bringing in greater transparency and
accountability in India.20 However, the function of the present committee is merely consultative and
suggestive. The final decision maker is the Governor and deciding the monetary policy of the
country is an enormous power to be vested in a single individual.
[5.3] Alteration of Composition: Effects of Governmental Interference
The RBIs internal panel, the Urjit Patel committee 21, had recommended a five-member committee
where three members would be from the RBI and two external members (all members having 3 yesr
terms) would be appointed by the RBI governor and the deputy governor in-charge. It was also
suggested that the governor would have a casting vote in case of a tie. In contrast, the latest draft of
the code22 envisages a wider monetary policy committee with seven members. Three members
would be from the RBI, including the governor, an executive board member and an RBI employee.
The remaining four members would be appointed by the government for a four-year term. The
government will have the right to remove these members mid-term under certain conditions. Each
of these members would have voting rights. A government nominee would also sit in on the
meetings, but would not have voting powers. Decisions will be taken by a majority vote, says the
code. In the event of a tie, the RBI governor would have a second and casting vote, it adds, while
removing the provision giving the RBI governor veto power of the committee's decisions.
Under the present system, the Governor is appointed by the government, but controls monetary
policy and has veto power over the existing advisory committee of RBI members and outside
appointees that sets rates. The revised draft of the Indian Financial Code (IFC) as released by the
Finance Ministry last month had suggested doing away with this veto power adding that the sevenmember MPC to take decisions by a majority vote. 23 Of the seven members, four would be
government nominees and the rest from RBI. The government and RBI are finalising the structure
of the Monetary Policy Committee (MPC) and Governor Rangarajans comment that the
20 URP Committee Report (RBI, 21 January 2014) https://rbi.org.in/scripts/PublicationReportDetails.aspx?
UrlPage=&ID=747 accessed 26 October 2015.
21 Ibid.
22
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government can do away with the veto power of Governor but the majority of members in the
Monetary Policy Committee should be from the apex bank,24 conveys only half the problem the
economy would have to face in case governmental majority is retained in the MPC. Setting of the
monetary policy has traditionally been the domain of the central bank and must remain so in order
to preserve transparency and ensure accountability, as has been done so for the past so many years
with the help of the reforms that have been introduced in the functioning of the MPC. An alteration
in the present composition may result in unwarranted governmental interference, especially in the
light of the corruption scandals that tainted the previous government. Monetary policy is a sensitive
area and a crucial cog in the wheel of fiscal policy, affecting the economy, and politicizing of the
control exercised over the monetary policy will only cause economic anarchy in the country. In
other words, we cannot always trust the government to act in the best interests of the country.
Therefore, the present composition of the committee should be retained or atleast, a majority of the
RBI should be retained. Further, the committee should be the decision making body of the RBI and
the Governors power should be reduced to ensure that the pressure on a single individual is
reduced while at the same time also ensuring continuity in policy when any single member of the
committee changes.
CONCLUSION
The RBI is now more able and more responsible for controlling the overall growth of money and
credit in a manner best suited for moderating inflation, while meeting the genuine credit needs of
the economy. Price stability remains the key objective of monetary policy and there is virtually a
national consensus that high inflation is not good. Inflation expectations and inflation tolerance
have come down. It even affects the spending decisions and saving pattern of the people. Even in an
environment of price stability, the 1990s witnessed episodes of financial instability. The
presumption that price stability ensures financial stability is thus not true, at least in the short-run.

23 Rangarajan favours RBI majority in Monetary Policy Committee (Time of India, 9 August 2015)
<http://timesofindia.indiatimes.com/business/india-business/Rangarajan-favours-RBI-majority-in-MonetaryPolicy-Committee/articleshow/48410456.cms> accessed 27 October 2015.
24 Ibid.
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While the basic objectives of monetary policy, namely price stability and ensuring credit flow to
support growth, have remained unchanged, the underlying operating environment for monetary
policy has undergone a significant transformation. The key development that has enabled a more
independent monetary policy environment was the discontinuation of automatic monetization of the
Government's fiscal deficit through an agreement between the Government and the Reserve Bank in
1997. In order to meet challenges thrown by financial liberalization and the growing complexities
of monetary management, the Reserve Bank switched from a monetary targeting framework to a
multiple indicator approach.

With the growing globalization and integration of economies,

monetary authorities are now required to pay greater attention to external developments. Swings in
trade flows and especially capital flows are quite common and these impart a high degree of
volatility to exchange rates.
Moreover, the existing composition of the MPC should be altered with caution and a larger role
must be retained with the RBI.

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