What Is the Monetary Policy All About?

What is the price of the money?

Eh, does that even make sense? Yes. It does. This is what a monetary policy does. To regulate the price and supply of the money.

Let’s understand this with an analogy:

Farm and Irrigation: India and RBI

Imagine if India were a farm, and the RBI is the company in charge of irrigation. Its job is to keep water (money) flowing enough to maximise crops (strong employment, economic growth). But not pump in so much water as to cause flooding (inflation).

Monetary Policy operates in the similar way. It is a tool used by central banks (RBI) to regulate growth, inflation, unemployment and currency exchange rates.

Irrigation Agency: MPC

The RBI’s Monetary Policy Committee (MPC) has experience and knowledge about how the controls on its reservoir work and how much to open the valves to get ample amount of water onto the fields. Accordingly, the MPC resorts to expansionary or contractionary policy measures to increase or decrease the money supply in an economy.

Just as a farmer relies on an irrigation system to nurture crops, the Reserve Bank of India (RBI) uses monetary policy to manage the economy's financial resources. The monetary policy committee (MPC) is the body tasked with setting key policy rates, ensuring that inflation is kept in check while fostering economic growth. Comprising six members, including representatives from the RBI and external experts, the MPC meets regularly to assess economic conditions and decide on policy measures. This collaborative approach ensures a balanced and informed decision-making process.

Types of Monetary Policy

Monetary policy serves as a guiding force for economic stability, and it is primarily divided into two types: expansionary and contractionary. Expansionary monetary policy is designed to foster economic growth by enhancing the money supply and reducing interest rates. By making borrowing cheaper and more accessible, this policy encourages consumers and businesses to increase spending and investment. As a result, demand for goods and services rises, stimulating economic activity and potentially reducing unemployment rates. Central banks implement tools such as lowering the repo rate and decreasing reserve requirements for banks to facilitate this approach.

On the other hand, contractionary monetary policy is implemented to temper inflation by reducing the money supply and increasing interest rates. Higher interest rates make borrowing more expensive, discouraging spending and investment. This controlled slowdown in economic activity helps to stabilise prices and prevent the economy from overheating. By increasing the cost of credit, central banks aim to manage inflationary pressures effectively, ensuring long-term economic health. Both expansionary and contractionary monetary policies are essential for maintaining a balanced economy. The central bank's ability to select appropriate measures based on current economic conditions allows for targeted interventions that can address specific challenges, ensuring sustainable growth and stability.

Monetary Policy vs Fiscal Policy

While both monetary and fiscal policies are used to manage a nation's economy, they differ in their approach and implementation. Fiscal policy and monetary policy serve distinct purposes and are executed by different entities. Fiscal policy involves government spending and taxation decisions aimed at influencing economic activity. It is managed by the government and focuses on allocating resources to achieve specific economic objectives.

In contrast, monetary policy and central banking involve controlling the money supply and interest rates to maintain price stability and support economic growth. This is the domain of the central bank, which uses tools like open market operations, reserve requirements, and interest rate adjustments to influence the economy.

Significance of Monetary Policy

The importance of monetary policy cannot be overstated, as it directly impacts inflation rates, employment levels, and economic growth. By carefully adjusting interest rates and money supply, central banks can steer the economy towards desired outcomes. Effective monetary policy fosters a stable environment conducive to investment and consumption, ultimately promoting sustainable growth and improving living standards.

Equipment: Quantitative & Qualitative Measures

RBI uses various quantitative and qualitative instruments like Repo rate, Reverse Repo rate, Statutory Liquidity Ratio, Cash Reserve Ratio, Open Market Operations, Moral Suasion etc. to achieve its purpose. However, on the day of the monetary policy (happens bi-monthly in India), all market participants’ eyes are mainly on the repo and reverse repo rate.

Repo rate is basically the rate at which the RBI lends money to commercial banks against the eligible government securities. When commercial banks run out of funds, they turn to RBI for help. So, when the repo rate is low, banks get funds from the RBI at a cheaper rate. Low rates encourage consumption. On the other hand, when repo rate is hiked, market interest rates will rise too. Thereby resulting in a decrease in consumption and investments, and reduction in the demand. This will eventually lead to a decrease in the rate of inflation.

Meanwhile, the reverse repo rate is the rate at which the RBI absorbs liquidity from banks against the collateral of eligible government securities.

India and the Monetary Policy

Note that repo rate also has an impact on the exchange rate. A hike in repo rate would encourage imports and discourage export; however, achieving all the goals through one policy alone is not possible. In every step, there is a trade-off. So, if inflation reduces, exports suffer and vice versa.

Besides, a combination of or other measures could also be implemented by the MPC to tackle the economic problems.

If we speak of the current Indian scenario, MPC has raised repo rates last three times. Amid heightened risk of recession, the RBI maintained its inflation projection at 6.7% in FY23 and real GDP growth projection at 7.2%. The MPC decided to remain focused on withdrawal of accommodation to ensure inflation remains within the target going forward. The RBI aims to achieve the medium-term target for consumer price index (CPI) inflation of 4% within a band of +/- 2%, while supporting growth.

A look at Repo rate and Inflation rate in India over the years:

Source: Freefincal, RBI’s Database on Indian Economy, Worldbank ,tradingeconomics

Now that you know how monetary policy works, can you tell whether RBI will raise, reduce or maintain the repo rate in the upcoming meet?

References:

CFI, Bank Rate, Forbes, Freefincal

Conclusion

Another aspect within this shifting landscape of monetary policy is the growing attention toward digital currencies. Now, the central banks, including RBI, are actively questioning whether central bank digital currencies could help improve the efficiency of monetary policy. It can bring about a new dawn on central banks' money supply and interest rate management by giving newer arms to fight emerging economic challenges. The future technological evolution in the changing role of monetary policy is likely to throw many surprises and make a remarkable difference.