Table of Content: 

1. INTRODUCTION
2. THE MONETARY POLICY FRAMEWORK
3. The Objectives of Monetary Policy
4. Transmission of Monetary Policy
5. CHANNELS OF MONETARY POLICY TRANSMISSION
6. Operating Procedures and Instruments
7. THE ORGANISATIONAL STRUCTURE FOR MONETARY POLICY DECISIONS

INTRODUCTION

We observe that the Reserve Bank of India is occasionally manipulating policy rates for manoeuvring liquidity conditions with reasons thereof explicitly notified. In fact, we have only a limited understanding of the monetary phenomena which could strengthen or paralyse the domestic economy. The discussion that follows is an attempt to throw light on the well-acknowledged monetary measures undertaken by governments to fight economic instability. 

Reserve Bank of India uses monetary policy to manage economic fluctuations and achieve price stability, which means that inflation is low and stable. Reserve Bank of India conducts monetary policy by adjusting the supply of money, usually through buying or selling securities in the open market. Open market operations affect short-term interest rates, which in turn influence longer-term rates and economic activity. When central banks lower interest rates, monetary policy is easing. When it raises interest rates, monetary policy is tightening.

THE MONETARY POLICY FRAMEWORK

The central bank, in its execution of monetary policy, functions within an articulated monetary policy framework which has three basic components, viz.
(i) the objectives of monetary policy,
(ii) the analytics of monetary policy which focus on the transmission mechanisms, and
(iii) The operating procedure which focuses on the operating targets and instruments.

The Objectives of Monetary Policy

Transmission of Monetary Policy

The transmission of the monetary policy describes how changes made by the Reserve Bank to its monetary policy settings flow through to economic activity and inflation. This process is complex and there is a large degree of uncertainty about the timing and size of the impact on the economy. In simple terms, the transmission can be summarised in two stages.
1. Changes to monetary policy affect interest rates in the economy.
2. Changes to interest rates affect economic activity and inflation.
Although we know that monetary policy does influence output and inflation, we are not certain about how exactly it does so, because the effects of such policy are visible often after a time lag which is not completely predictable. 

CHANNELS OF MONETARY POLICY TRANSMISSION

1. Saving and Investment Channel
2. Cash-flow Channel
3. Asset Prices and Wealth Channel
4. Exchange Rate Channel

Operating Procedures and Instruments

Quantitative tools –

The tools applied by the policy that impact money supply in the entire economy, including sectors such as manufacturing, agriculture, automobile, housing, etc.

Reserve Ratio -

Banks are required to keep aside a set percentage of cash reserves or RBI approved assets. Reserve ratio is of two types:

Cash Reserve Ratio (CRR) –

Banks are required to set aside this portion in cash with the RBI. The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR.

Statutory Liquidity Ratio (SLR) –

Banks are required to set aside this portion in liquid assets such as gold or RBI approved securities such as government securities. Banks are allowed to earn interest on these securities, however it is very low.

Open Market Operations (OMO)

In order to control money supply, the RBI buys and sells government securities in the open market. These operations conducted by the Central Bank in the open market are referred to as Open Market Operations.When the RBI sells government securities, the liquidity is sucked from the market, and the exact opposite happens when RBI buys securities. The latter is done to control inflation. The objective of OMOs are to keep a check on temporary liquidity mismatches in the market, owing to foreign capital flow.

Qualitative tools
Unlike quantitative tools which have a direct effect on the entire economy’s money supply, qualitative tools are selective tools that have an effect in the money supply of a specific sector of the economy.

Margin requirements –

The RBI prescribes a certain margin against collateral, which in turn impacts the borrowing habit of customers. When the margin requirements are raised by the 
RBI, customers will be able to borrow less.

Moral suasion –

By way of persuasion, the RBI convinces banks to keep money in government securities, rather than certain sectors.

Selective credit control –

Controlling credit by not lending to selective industries or speculative businesses.

Market Stabilisation Scheme (MSS) - 
Policy Rates
Bank rate –

The interest rate at which RBI lends long term funds to banks is referred to as the bank rate. However, presently RBI does not entirely control money supply via the bank rate. It uses Liquidity Adjustment Facility (LAF) – repo rate as one of the significant tools to establish control over money supply.Bank rate is used to prescribe penalty to the bank if it does not maintain the prescribed SLR or CRR.

Liquidity Adjustment Facility (LAF) –

RBI uses LAF as an instrument to adjust liquidity and money supply. The following types of LAF are:

Repo rate:

Repo rate is the rate at which banks borrow from RBI on a short-term basis against a repurchase agreement. Under this policy, banks are required to provide government securities as collateral and later buy them back after a pre-defined time.

Reverse Repo rate:

It is the reverse of repo rate, i.e., this is the rate RBI pays to banks in order to keep additional funds in RBI. It is linked to repo rate in the following way:
Reverse Repo Rate = Repo Rate – 1

Marginal Standing Facility (MSF) Rate:

MSF Rate is the penal rate at which the Central Bank lends money to banks, over the rate available under the rep policy. Banks availing MSF Rate can use a maximum of 1% of SLR securities.
MSF Rate = Repo Rate + 1MSF Rate = Repo Rate + 1

THE ORGANISATIONAL STRUCTURE FOR MONETARY POLICY DECISIONS

We have discussed above the instruments of monetary policy. An understanding of the organizational structure for monetary policy decisions is necessary to understand the way monetary policy is conducted in India.

The Reserve Bank of India (RBI) Act, 1934 was amended on June 27, 2016, for giving a statutory backing to the Monetary Policy Framework Agreement (MPFA) and for setting up a Monetary Policy Committee (MPC). The Monetary Policy Framework Agreement is an agreement reached between the Government of India and the Reserve Bank of India (RBI) on the maximum tolerable inflation rate that the RBI should target to achieve price stability. The amended RBI Act (2016) provides for a statutory basis for the implementation of the ‘flexible inflation targeting framework’.

Announcement of an official target range for inflation is known as inflation targeting. The Expert Committee under Urijit Patel to revise the monetary policy framework, in its report in January, 2014 suggested that RBI abandon the ‘multiple indicator’ approach and make inflation targeting the primary objective of its monetary policy. The inflation target is to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly,

• The Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.

• The RBI is mandated to publish a Monetary Policy Report every six months, explaining the sources of inflation and the forecasts of inflation for the coming period of six to eighteen months.

• The following factors are notified by the central government as constituting a failure to achieve the inflation target:

(a) The average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or

(b) The average inflation is less than the lower tolerance level for any three consecutive quarters.

The choice of CPI was made because it closely reflects cost of living and has larger influence on inflation expectations compared to other anchors. With this step, India is following countries such as the New Zealand, the USA, the UK, European Union, and Brazil. In recent times many countries are moving away from this approach and are targeting nominal GDP growth.