How is the monetary policy in India decided?

Monetary policies of an economy mould its credit and financial stability with an aim to regulate inflation and cash flows

Publish Date: February 26, 2019

By: Sandhya Kannan, Head – Content

Monetary policies are made to regulate the volume of credit created by banks and how it is supplied further with an aim to bring stability in terms of price and finances and generate adequate credit for the growth of the countries goals. It lays focus on the macroeconomic factors of an economy.

What is a monetary policy?

Monetary policy is the policy pursued by the central bank of a country for administering and controlling the country’s money supply, including currency and demand deposits, and managing the foreign exchange rates. The Reserve Bank of India is the supreme monetary authority of India and the RBI enjoys absolute power to control currency and credit in the country. On 1st April 1935, the Reserve Bank of India was established according to the RBI Act, 1934. At first, this bank was established as a joint stock bank with a share capital of Rs. 5 crores. On 1st January 1949, the RBI was nationalized by the Government of India. Since then, the RBI has been functioning as the central bank of India.

Learn about the RBI credit policy stance here

What is the difference between monetary and fiscal policy?

We have first to understand the meaning of fiscal policy.

Fiscal policy is a policy using which the government uses its expenditure and revenue programs to produce desirable effects. In other words, fiscal policy refers to government spending, borrowing, taxation, and debt management to attain and maintain full employment.

What are the objectives of fiscal policy?

The purpose of a robust fiscal policy in a developing economy such as India is as important as the monetary policy.

Mobilization of resources is the chief aim of fiscal policy. Most developing countries are caught in a vicious cycle of poverty. The most important objectives of the fiscal policy are to break this cycle of poverty by increasing the increase in the rate of capital formation. This is done by maximizing taxes when possible, imposing new taxes, imposing tariffs if needed on imports and exports, and public borrowing and deficit financing.

The aim of the fiscal policy in a developing economy is also to accelerate the rate of economic growth so that the real net income of the country can increase in the long run. The government through its taxation policy and public borrowing, deficit financing, subsidies, tax relief, can provide a sufficient impetus for growth and raising the level of economic activities.

Monetary policy is primarily concerned with the interest rates. The interest rates can be lowered to increase economic activities, or they can be raised, which leads to a decrease in economic activities. The reason for this is businesses constantly need loans to function. A lower interest rate regime encourages new loans as working capital or for developing capital assets. However, this can lead to economic activity getting out of hand, which results in inflation. Inflation happens because by lowering interest rates, too much money circulates inside the financial system. In this situation, the central banks raise the interest rates usually at a rate of 0.25% every few weeks to slow the economy down. Increased interest rates encourage saving and suck money out of the economic system and bring inflation under control.

While fiscal policy impacts the economy through taxation, deficit financing, and subsidies, monetary policy affects it through the supply of money circulating in the system. The finance department of the government (also known as the treasury department in some countries) handles the fiscal policy whereas the central bank is in charge of the monetary policy. It is of utmost importance that the two functions independently of each other to make economic growth possible at reasonably low rates of inflation.

Know about a dovish monetary policy here

Who decides the monetary policy?

As has been noted before, the monetary policy of India is determined by the RBI. The RBI makes use of many different types of measures to control the amount of money in the system.

Most effective forms of monetary control include policies such as bank rate and open market operations.

Bank rate - The bank rate is the standard rate at which the Reserve Bank discounts or buys bills or securities from commercial banks. A change in the bank rate influences the cost and quantum of credit available for lending. The RBI has used bank rate mainly as a tool for controlling inflation.

Open market operations – It refers broadly to the actions by the Reserve Bank to buy and sell government bonds. Open market operations principally are used to raise funds and provide liquidity to the government. Commercial banks invest their surplus in buying the government bonds and in this way the Reserve Bank can act as an avenue for public deposits to find its way into government coffers.

Who decides the monetary policy?

There are principally two factors that determine the monetary policy.

Expansion in the supply of money – In a developing economy like India, money supply has to be expanded sufficiently to match the growth of GDP. Although it is difficult to say what relation must ideally exist between the increase in money supply and growth of national income, there is exists a close link between the two. Therefore, a sudden spurt in GDP leads to an inflationary period and vice versa. The purpose of the monetary policy is to keep a close watch on the relationship between the rise and fall of GDP vis-a-vis the expansion and contraction of monetary supply.

Restraint upon secondary expansion of credit – The deficit budget is an indispensable source of funds for the government. When the government spends through deficit financing, there is a domino effect. The money finds its way into the hands of businesses, which deposit it in a bank which in turn lends it out, and the process creates secondary credit. It is very essential to control the growth of this credit, since too much can lead to inflation.

To conclude, it can be seen that the RBI is the watchdog of the monetary system and solely in charge of the monetary policy of India. It is also the banker to commercial banks and determines the prevalent lending rate by these banks. Smooth and independent functioning of the central bank is pivotal to the development of an economy. The monetary system of India is centered around the Reserve Bank, which keeps a close eye on the day to day economic developments.

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