Monetary policy and its Transmission

Objectives of RBI:

• to regulate the issue of Bank notes and 
• the keeping of reserves with a view to securing monetary stability in India and
• generally to operate the currency and credit system of the country to its advantage

It is RBI which operates the monetary policy to maintain the stability and growth of financial system. The twin objectives of monetary policy in India are widely

regarded as 

(i) price stability and 

(ii) provision of adequate credit 

to productive sectors of the economy so as to support aggregate demand and ensure high and sustained growth.

Monetary policy

"Monetary policy is essentially a stabilisation policy. It is not intended to influence the long-term growth potential of the economy, but aims at ironing out the fluctuations in the economy."

Monetary policy can be summarised as the central bank’s actions to influence the availability and cost of money and credit in the economy. The primary objective of these actions is to ensure price stability.

How does it work?

As an illustration, consider that an economy is growing too fast. This is also referred to as overheating of the economy: a situation that typically happens in the boom phase when GDP (gross domestic product) growth exceeds the long-term growth potential of the economy. The producers of goods are not able to make enough goods to meet the rising demand. The resultant demand-supply mismatch creates inflationary pressures in the economy. This situation is regarded as unsustainable, as the high growth translates into higher inflation. In this situation, the RBI raises interest rates to depress spending and reduce the pressure on inflation.

And in the opposite?

Conversely, when the economy is growing too slowly, interest rates are reduced to stimulate demand.

Does economic growth demand monetary policy?

Monetary policy is essentially a stabilisation policy. It is not intended to influence the long-term growth potential of the economy, but aims at ironing out the fluctuations in the economy also referred to as business cycles. This is done to minimise fluctuations and ensure a sustainable mix of growth and inflation in the economy.

Instruments of monetary policy

The central bank can influence the cost of funds and availability of credit in the economy by altering the repo/reverse repo rates, changing the reserve requirements, and engaging in open market operations.

Repo and reverse repo....both are as confusing!!

Repo is short for repossess or repurchase. Repo rate is the rate that RBI charges the banks when they borrow from it. Repo operations increase liquidity in the system. Reverse repo rate is the rate that RBI offers the banks for parking their funds with it. Reverse repo operations suck out liquidity from the system.

How do changes in CRR affect?

Usually through the CRR (cash reserve ratio), a commonly used measure to influence credit creation and money supply. CRR is the proportion of deposits that banks are required to keep with the RBI.

What does the RBI do when openly operating in the market?

It sells and buys government securities. These activities are called open market operations (OMO). When inflationary pressures exist, the RBI sells securities to mop up excess cash from the system; and vice-versa in case of tight liquidity/shortage of funds.

What is monetary policy transmission? 

It is the ‘how’ of monetary policy impacting the economy through various channels, directly as well as indirectly  and through these channels the monetary policy of a central bank alters prices or output in the real economy. 

At the cost of simplification, let us take an illustration. Assume that inflation is rising in the economy and the RBI, to tackle it, decides to signal a rate hike by raising the reverse repo rate. This reduces money supply in the economy as banks are induced to park their cash with the RBI. That puts pressure on the longer term interest rates in the economy — for example, the lending rates for housing, consumer loans, etc. These rates tend to go up.

The impact of RBI actions on longer-term commercial rates also depends on the expectations of financial market participants, which are shaped by both actions and statements of the central bank.

flip side to controlling inflation?

Continuing the example, higher interest rates discourage consumption and investment, leading to a reduced aggregate demand (GDP growth) in the system. As a consequence of reduced demand, the pressure on inflation eases. The policy objective of reducing inflation is achieved but at the cost of growth. This is often referred to as the growth-inflation trade-off.

What are the various transmission channels of monetary policy? 

The central bank can achieve its objective through a host of measures. These could include altering the money supply, credit availability, asset prices, influencing exchange rates and finally by managing expectations. The more popular channel of transmission these days is either by changing the bank rate, which is a way of managing expectations. In the last quarter, the central bank used the money supply channel by increasing the cash reserve ratio and thereby reducing the availability of cheap credit. The central bank also influences prices and output by increasing its lending and borrowing rates (repo and reverse repo, respectively). 

A difficulty for the policymakers?

It is necessary to have a better understanding of transmission mechanisms and lags involved with timely availability of data which can help the RBI fine-tune the monetary policy and make it more effective. But because of the lags in monetary policy transmission, the central bank has to be pre-emptive in its approach and diffuse inflationary pressures in the early stages.

How efficient is monetary policy transmission in India? 

The monetary policy transmission is reasonably efficient to the money and bond markets, though, slower to the credit market because of structural rigidities. In recent communications, RBI governor D Subbarao has acknowledged that the transmission of monetary policy is weak on account of which policy rates signals do not get effectively communicated to the market participants. To an extent, the purpose of these signals get diluted. In an attempt to address this, it has asked banks to rework their loan pricing mechanism and adopt what is called the Base Rate system which it feels will help improve monetary policy transmission. 

How does the base rate system work? 

Hitherto, banks were free to decide their prime lending rates which served as the benchmarks for most of bank lending. In future, RBI will have much lesser leeway in determining the benchmark rate. The Base Rate, which will replace the PLR, will be based on a formula linked to the cost of deposits for every bank. From the middle of this fiscal, banks will have to replace PLR with the base rate. RBI believes that the base rate will transmit changes in the monetary policy more effectively as any drop in the cost of borrowing for banks will result in lower lending rates.