RBI FLAGS INFLATION RISK TO STABILITY

  • October 7, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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RBI FLAGS INFLATION RISK TO STABILITY

Subject :Economy

Section :Monetary Policy

Context:

MPC leaves benchmark interest rates unchanged for a fourth straight meeting, reiterates its real GDP growth and retail inflation projections for the fiscal year  at 6.5%  and 5.4%, respectively.

What is Monetary policy?

  • 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.
  • The primary objective of the RBI’s monetary policy is to maintain price stability while keeping in mind the objective of growth.
  • The amended RBI Act, 1934 also provides for the inflation target (4% +-2%) to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.

What is the Monetary Policy Committee?

  • It is a statutory and institutionalized framework under the Reserve Bank of India Act, 1934, for maintaining price stability, while keeping in mind the objective of growth.
  • The Governor of RBI is ex-officio Chairman of the committee.
  • The MPC determines the policy interest rate (repo rate) required to achieve the inflation target.

What is the repo rate?

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).

Types of Monetary Policy

  1. Expansionary Monetary Policy
  • This is a monetary policy that aims to increase the money supply in the economy by decreasing interest rates, purchasing government securities by central banks, and lowering the reserve requirements for banks.
  • An expansionary policy lowers unemployment and stimulates business activities and consumer spending.
  • The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also possibly lead to higher inflation.
  1. Contractionary Monetary Policy
  • The goal of a contractionary monetary policy is to decrease the money supply in the economy.
  • It can be achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for banks.
  • The contractionary policy is utilized when the government wants to control inflation levels.

Monetary Policy Tools

  • To control inflation, the Reserve Bank of India needs to decrease the supply of money or increase cost of fund in order to keep the demand of goods and services in control.
  • RBI Monetary Policy instruments are divided into two category qualitative instruments and quantitative instruments.
  1. 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.

  1. 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.
  1. 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 is to keep a check on temporary liquidity mismatches in the market, owing to foreign capital flow.
  1. Market Stabilization Scheme (MSS)
  2. 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.
economy RBI FLAGS INFLATION RISK TO STABILITY