HPAS/Allied Mains 2022 Answer Writing Challenge Day 194: Model Answer

Question: Explain the various Instruments of Monetary Policy. (8 marks/ 120 words)

Answer:

Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income.

The instruments of monetary policy are of two types:

Quantitative Methods

The quantitative instruments are also known as general tools used by the RBI (Reserve Bank of India). As the name suggests, these instruments are related to the quantity and volume of the money. These instruments are designed to control the total volume/money of the bank credit in the economy. These instruments are indirect in their nature and are used to influence the quantity of credit in the economy.

• Bank Rate Policy

The bank rate is the minimum rate at which the central bank lends money and rediscounts first-class bills of exchange and securities held by commercial banks. When RBI gets a hint that inflation is rising, it increases the bank interest rates so that commercial banks borrow less money and the inflation stays under control.

Commercial banks also increase their lending rate to the public and business enterprises so that people borrow less money, which will eventually help to control inflation.

On the other hand, when RBI reduces bank rates, that means borrowing for commercial banks will become cheap and easier. This allows the commercial banks to lend money to borrowers on a lower lending rate, which will further encourage borrowers and businessmen.

• Legal Reserve Ratios 

The commercial banks have to keep a certain amount of reserve assets in the form of reserve cash. Some portion of these cash reserves is their total assets in the form of cash.

To maintain liquidity and to control credit in the economy, the RBI also keeps a certain amount of cash reserves. These reserve ratios are known as SLR (Statutory Liquidity Ratio) and CRR (Cash Reserve Ratio).

• CRR refers to a certain percentage of commercial bank’s net demand and time liability that commercial banks have to maintain with the RBI at all times. In India, the CRR remains between 3-15 per cent by the law.
• SLR refers to a certain percentage of reserves to be maintained in the form of gold and foreign securities. In India, SLR remains 25-40% by the law.

Any changes in SLR and CRR bring out the change in the position of commercial banks.

• Open Market Operations (OMO)

The sale and purchase of security in the long run/short run by the RBI in the money market is known as open market operations. This is a popular instrument of the RBI’s monetary policy.

To influence the term and structure of the interest rate and to stabilize the market for government securities, etc., the RBI uses OMO, and this operation is also used to wipe out the shortage of money in the money market.

If RBI sells securities in the money market, private and commercial banks and even individuals buy it. This leads to a reduction in the existing money supply as money gets transferred from commercial banks to the RBI. On the other hand, when RBI buys securities from the commercial banks, the commercial banks that sell receive the amount they had invested in RBI before.

There are certain factors that affect OMO which include underdeveloped securities market, excess reserves with the commercial banks, indebtedness of the commercial banks, etc.

• Repo Rate

A Repo rate is a rate at which commercial banks borrow money by selling their securities to the RBI to maintain liquidity. Commercial banks sell their securities in case of a shortage of funds or due to some statutory measures. It is one of the main instruments of the RBI to keep inflation under control.

• Reverse Repo Rate

Sometimes, the RBI borrows money from commercial banks when there is excess liquidity in the market. In that case, commercial banks get benefits by receiving the interest on their holdings with the RBI.

At the time of higher inflation in the country, RBI increases the reverse repo rate that encourages banks to park more funds with the RBI, which will help it earn higher returns on excess funds.

Qualitative Methods

Qualitative instruments are also known as selective instruments of the RBI’s monetary policy. These instruments are used for discriminating between various uses of credit; for example, they can be used for favouring export over import or essential over non-essential credit supply. This method has an influence on both borrowers and lenders.

Following are some selective tools of credit control used by the RBI:

Rationing of Credit

RBI fixes a credit amount to be granted for commercial banks. Credit is given by limiting the amount available for each commercial bank. For certain purposes, the upper credit limit can be fixed, and banks have to stick to that limit. This helps in lowering the bank’s credit exposure to unwanted sectors.

Regulation of Consumer Credit

In this instrument, consumers’ credit supply is regulated through the instalment of sale and hire purchase of consumer goods. Here, features like instalment amount, down payment, loan duration, etc., are all fixed in advance, which helps to check the credit and inflation in the country.

Change in Marginal Requirement

Margin is referred to the certain proportion of the loan amount that is not offered or financed by the bank. Change in marginal can lead to change in the loan size. This instrument is used to encourage the credit supply for the necessary sectors and avoid it for the unnecessary sectors. That can be done by increasing the marginal of unnecessary sectors and reducing the marginal of other needy sectors.

Suppose, RBI feels that more credit supply should be allotted to the agricultural sector, then RBI will reduce the margin, and even 80-90% of the loan can be allotted.

Moral Suasion

Moral suasion refers to the suggestions to commercial banks from the RBI that helps in restraining credits in the inflationary period. RBI implies pressure on the Indian banking system without taking any strict action for compliance with rules.

Through monetary policy, commercial banks get informed of the expectations of RBI. The RBI can issue directives, guidelines, suggestions for commercial banks regarding reducing credit supply for speculative purposes under the moral suasion.