Sunday, April 29, 2007

Instruments of Monetary Policy in India

I have been trying to understand the Annual Monetary Policy and made my first attempts by asking what factors went into the policy. I asked myself two questions and attempted to put my own answers there. More I try to learn about the policy, the less I seem to understand. But I'm determined.

Actually this monetary policy is nothing but controlling the supply of Money. The big Daddy, I mean the RBI takes a look at the present levels and also takes a call on what should be the desired level to promote growth, bring stability of price(low inflation) and foreign exchange. The factors that decide the desired levels were discussed in my last post.

This brings me to my third question:
What are the instruments of this monetary policy that the RBI has and can use?

We hear of repo rate, reverse repo, CRR in the papers. Are they the only weapons RBI has? No, I found abook on Macro Economics by DN Dwivedi which lists out the following:
A. Quantitative measures:
  1. Open Market operations: Here, the RBI enters into sale and purchase of government securities and treasury bills. So the RBI can pump money into circulation by buying back the securities and vice versa. In absence of an independent security market (all Banks are state owned), this is not really effective in India.
  2. Bank rate policy: Popularly known as repo rate and reverse repo rate, it is the rate at which the RBI and the Banks buy or exchange money. This resuts into the flow of bank credit and thus effects the money supply.
  3. Cash Reserve ratio (CRR): This is the percentage of total deposits that the banks have to keep with RBI. And this instrument can change the money supply overnight.
  4. Statutory Liquidity Requirement (SLR): This is the proportion of deposits which Banks have to keep liquid in addition to CRR. This also has a bearing on money supply.

B. Qualitative measures:

  1. Credit rationing: Imposing limits and charging higher/lower rates of interests in selective sectors is what you see is being done by RBI.
  2. Change in lending margins: Or is the risk weightage assigned for the various lendings.??
  3. Moral suasion: We hear of RBI's directive of priority lending in Agriculture sector. Seems more of a directive rather than persuasion!!
I'm beginning to make sense of the jargons I get to read in the papers. Do you have a question? And if you're still confused about the whole thing and wonder what's the fuss all about, take a break! (I'm taking one, too!!!)

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