MONETARY POLICY

INTRODUCTION :- Monetary policy refers to the credit control measures adopted by the
central bank of a country.
Monetary policy consists of the process of drafting, announcing, and implementing the plan
of actions taken by the central bank, currency board, or other competent monetary authority
of a country that controls the quantity of money in an economy and the channels by which
new money is supplied.

Monetary policy is how a central bank or other agency governs the supply of money and
interest rates in an economy in order to influence output, employment, and prices.

Understanding Monetary Policy :-

Economists, analysts, investors, and financial experts across the globe eagerly await the
monetary policy reports and outcome of the meetings involving monetary policy decision-
making. Such developments have a long lasting impact on the overall economy, as well as on
specific industry sector or market.

Monetary policy is formulated based on inputs gathered from a variety of sources. For
instance, the monetary authority may look at macroeconomic numbers like GDP and
inflation, industry/sector-specific growth rates and associated figures, geopolitical
developments in the international markets (like oil embargo or trade tariffs), concerns raised
by groups representing industries and businesses, survey results from organizations of repute,
and inputs from the government and other credible sources.

Monetary authorities are typically given policy mandates, to achieve stable rise in gross
domestic product (GDP), maintain low rates of unemployment, and maintain foreign
exchange and inflation rates in a predictable range. Monetary policy can be used in
combination with or as an alternative to fiscal policy, which uses to taxes, government
borrowing, and spending to manage the economy.

The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal
Reserve has what is commonly referred to as a "dual mandate": to achieve maximum
employment (with around 5 percent unemployment) and stable prices (with 2 to 3 percent
inflation). It is the Fed's responsibility to balance economic growth and inflation. In addition,
it aims to keep long-term interest rates relatively low. Its core role is to be the lender of last
resort, providing banks with liquidity and serve as a bank regulator, in order to prevent the
bank failures and panics in the financial services sector.

Types of Monetary Policy:-

Central banks use contractionary monetary policy to reduce inflation. They reduce the money
supply by restricting the amount of money banks can lend. The banks charge a higher interest
rate, making loans more expensive. Fewer businesses and individuals borrow, slowing
growth.

Central banks use expansionary monetary policy to lower unemployment and

avoid recession. They increase liquidity by giving banks more money to lend. Banks lower
 interest rates, making loans cheaper. Businesses borrow more to buy equipment, hire
employees, and expand their operations. Individuals borrow more to buy more homes, cars,
and appliances. That increases demand and spurs economic growth.

Objectives or Goals of Monetary Policy:

1. Full Employment:-Full employment has been ranked among the foremost objectives
of monetary policy. It is an important goal not only because unemployment leads to
wastage of potential output, but also because of the loss of social standing and self-
respect.
2. Price Stability: One of the policy objectives of monetary policy is to stabilise the price
level. Both economists and laymen favour this policy because fluctuations in prices bring
uncertainty and instability to the economy.

3. Economic Growth: One of the most important objectives of monetary policy in recent
years has been the rapid economic growth of an economy. Economic growth is defined
as “the process whereby the real per capita income of a country increases over a long
period of time.”

4. Balance of Payments: Another objective of monetary policy since the 1950s has been
to maintain equilibrium in the balance of payments.

Instruments of Monetary Policy:-

There are several direct and indirect instruments that are used for implementing monetary
policy.

 Repo Rate: The (fixed) 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).

 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.

 Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo
auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected
under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to
help develop the inter-bank term money market, which in turn can set market based
benchmarks for pricing of loans and deposits, and hence improve transmission of monetary
policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as
necessitated under the market conditions.
 Marginal Standing Facility (MSF): A facility under which 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.

 Corridor: The MSF rate and reverse repo rate determine the corridor for the daily
movement in the weighted average call money rate.

 Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of
exchange or other commercial papers. The Bank Rate is published under Section 49 of the
Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore,
changes automatically as and when the MSF rate changes alongside policy repo rate
changes.

 Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain
with the Reserve Bank as a share of such per cent of its Net demand and time liabilities
(NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.

 Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in
safe and liquid assets, such as, unencumbered government securities, cash and gold.
Changes in SLR often influence the availability of resources in the banking system for
lending to the private sector.

 Open Market Operations (OMOs): These include both, outright purchase and sale of
government securities, for injection and absorption of durable liquidity, respectively.

 Market Stabilisation Scheme (MSS): This instrument for monetary management was
introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government securities and treasury bills.
The cash so mobilised is held in a separate government account with the Reserve Bank.

CURRENT RATES :-

REPO RATE :- 5.40%

MSF :- 5.65%
REVERSE REPO RATE :- 5.15%
BANK RATE:- 5.65%
CRR :- 4%
SLR :- 18.75%

Monetary Policy Versus Fiscal Policy

Ideally, monetary policy should work hand-in-glove with the national government's fiscal
policy. It rarely works this way. Government leaders get re-elected for reducing taxes or
increasing spending. As a result, they adopt expansionary fiscal policy. To avoid inflation in
this situation, the Fed is forced to use restrictive monetary policy.
For example, during the Great Recession, Republicans in Congress became concerned about
the U.S. debt. It exceeded the benchmark debt-to-GDP ratio of 100%. As a result, fiscal
policy became contractionary just when it needed to be expansionary. To compensate, the
Fed injected massive amounts of money into the economy with quantitative easing.

ADVANTAGES OF MONETARY POLICY :-

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.
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.

DISADVANTAGES OF MONETARY POLICY :-

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 gains.
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 barriers to access for the average person.
Venezuela experienced devastating hyperinflation in 2018 to the tune of 1.29 million percent.
The new sovereign bolivar recently traded at 500 for a single U.S. Dollar, with the value
lowering for it each day. That means workers cannot essential basic items. The cost of a
banana in Venezuela today is what a house cost just a decade ago.

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 behaviors, consumer fear, and a lack of overall economic
activity.
6. They can hurt 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 fueled 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 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.

SUGGESTIONS FOR EFFECTIVE MONETARY POLICY:-

Forget the common man, even market economists and investors suffered uncertainty about
the immediate interpretation of the key message of the recent quarterly policy announcement
by Reserve Bank of India.

Indeed, it took the usual post-policy media comments and interviews by the governor and the
deputy governor to better explain the RBI's intention.

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:

Standalone, shorter monetary policy statement: The current statements are way too long
(the latest one was 71 pages), possibly because they attempt to cover too many things, from
monetary policy measures to financial development initiatives.
There is a pressing need for a standalone monetary policy statement; non-monetary policy
measures can be issued as a separate statement.

Single policy interest rate: 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.

The bank rate is practically dead, while the repo rate is not the operational monetary policy
rate. The cash reserve ratio's usage is so infrequent now that it does not warrant a mention in
every quarterly statement. All other central banks are able to use a single interest rate for
communicating with markets.

Continuity in policy statements: 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.

The bottom line is that monetary policy statements should be viewed as a tapestry of
economic assessments and the evolving risks to the outlook for growth and inflation,
especially when compared to the prior statements. The bureaucratic need for long, unwieldy,
and all-in-one policy statements appears to have outlived its usefulness.

As financial markets play a more important role in economic and monetary management, the
RBI's monetary communication needs to be better targeted at financial markets and
individuals.