What is Monetary Policy? Definition, Objective, Tools and Types

To control inflation RBI will follow dear or contractionary monetary policy to reduce money supply in the economy. It will increase reserve ratios , sell government securities under OMOs or raise various rates such as REPO, MSF, Bank rates etc. In a contrary situation, when central bank wants to take money out of the economy, it will reverse its decisions in all the above cases. So CRR, SLR, repo rate & reverse repo rate will all increase and Central bank will sell Government securities to suck money out of the system. The bank rate is the minimum lending rate of the central bank at which it rediscounts first-class bills of exchange and government securities held by the commercial banks.

example of monetary policy

Once the US Fed begins raising interest rates, its next move will be to reduce its bloated balance sheet, which currently stands at $8.7 trillion, or roughly 37% of GDP. Before the COVID-19 pandemic, its balance sheet represented approximately 20% of GDP. The tapering process began in December 2021, with monthly asset purchases reduced from $120 billion to $105 billion. Surprisingly, within two weeks, the Fed decided to double the pace of tapering in response to rising inflation and a stronger economic recovery. On December 15, Fed ChairmanJeremy Powell announcedthat the Fed would reduce monthly asset purchases by $30 billion. As a result, the Fed’s net new bond purchases will be completely phased out in March 2022, three months ahead of the previous schedule.

Qualitative tools:

Many analysts believe that India’s huge forex reserves would be sufficient to address capital flight and currency depreciation in response to tighter monetary policy by the Fed. That may not be the case if we assess forex reserves in relation to external liabilities. The sudden stops and reversal of capital flows will lead to depreciation pressures on EM currencies.

  • So if central bank decides to increase the interest rate , cost of borrowing funds increases for other banks.
  • Capital tends to move out of a low interest economy to higher interest rate regimes.
  • All of these developments could have a significant adverse effect on the outlook of EMEs.

Let us reconsider the example that we discussed in our previous article. We understood everything about how money flows within the system and its multiplier effect, https://1investing.in/ but we still don’t know how money came into your hand, in the first place. It is the central bank of a country that has all the rights and power to print money.

Bank rate – The interest rate at which RBI lends long term funds to banks is referred to as the bank rate. However, presently RBI does not entirely control money supply via the bank rate. It uses Liquidity Adjustment Facility – repo rate as one of the significant tools to establish control over money supply.

Measures have been undertaken in the hope that banks will be lending loans and investors will make use of this opportunity to access capital at much lower costs. RBI cut repo rate by 125bp last year but banks decreased lending rate only by 60bp. Businesses postpone expansion due to high cost of credit and investment comes down in the economy which drags down growth rates and hurts employment. That’s the reason why corporates and government always clamour for policies which lead to interest rate cuts such as reduction in CRR, SLR. Investment is thus negatively correlated with higher interest rates.

In this way, the government generates a good amount of revenue and that also leads to a reduction in wealth inequalities. Several statements, however, are not very direct about the future policy stance. Also, the statements from the earlier period in the sample are more verbose with detailed discussions of the economic outlook.

Policy Rates:

Suppose large capital outflows from equity markets occur due to the Fed’s tighter monetary policy stance, combined with significant debt repayments and rising international crude oil prices. In that scenario, India’s massive forex reserves may be insufficient to example of monetary policy contain downward pressures on the rupee and protect the domestic economy from large outflows. While the main objective of the monetary policy is economic growth as well as price and exchange rate stability, there are other aspects that it can help with as well.

When foreign investors invest in equities, bonds and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies. If the EM currency depreciates against the US dollar, it decreases the value of their investments in dollar terms and, therefore, they may engage in distress sales of funds. Policy tightening would have direct negative ramifications for EMEs and LICs with open capital accounts, sizeable current account deficits and high levels of external debt. In 2022, these economies will face difficulties managing macroeconomic and financial stability in a highly unsettled global economic environment.

A policy set by the finance ministry that deals with matters related to government expenditure and revenues, is referred to as the fiscal policy. Revenue matter include matters such as raising of loans, tax policies, service charge, non-tax matters such as divestment, etc. While expenditure matters include salaries, pensions, subsidies, funds used for creating capital assets like bridges, roads, etc.

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It is in this context that autonomy of RBI to decide on monetary policy matters becomes so important. Let’s now understand how central banks decide which economic policy, contractionary or expansionary, to pursue. We conduct an event study analysis in a narrow daily window around each RBI announcement.

example of monetary policy

During the COVID-19 crisis, the US Fed offered temporary currency swap lines to only two EM central banks . In 2021, the Fed established a new foreign and international monetary authorities repo facility, which provides dollar liquidity to other foreign central banks in exchange for US Treasury securities as collateral. In an ideal world, swift international policy coordination would manage the spill-over effects of the monetary policy normalisation in the US and other advanced economies. Policy coordination among emerging and advanced economies would also help avoid spillbacks to advanced economies.

When prices start rising and there is a need to control them, the central bank sells securities. The reserves of commercial banks are reduced and they are not in a position to lend more to the business community or general public. Both methods affect the level of aggregate demand through the supply of money, cost of money and availability of credit.

Did anything change with inflation targeting?

Once a recession has already arisen, it intends to end the recession and prevents depression. Expansionary fiscal policy is when the government increases the money supply in the economy using budgetary instruments to either raise spending or cut taxes—both having more money to invest for customers and companies. The Reserve Bank of India had reduced the repo rate and reverse repo rate to 4.40% and 4.00% on 27 March.

The Reserve Bank of India made no changes to the repo rates the seventh straight time and announced that the GDP growth target is to be at 9.5%. RBI also said that India is doing much better economically as compared to how it was doing in June 2021. This is a state when people have excess money to buy goods in the market.

Currently the repo rate stands at 4% and the reverse repo rate stands at 3.35%. Central banks set the minimum amount of reserves that commercial banks must hold with the central bank. A lower interest rate will dissuade consumers from saving and boost spending.

Obviously if RBI raises margin requirement, customers will be able to borrow less. Cash Reserve Ratio – as the name suggests, banks have to keep this proportion as cash with the RBI. Expenditure matters– subsidies, salaries, pensions, money spent on creation of capital assets such as roads, bridges etc. It deals with fiscal matters i.e. matters related to government revenues and expenditure. If someone wants to borrow INR 1,000 for a day and promises to return INR 10,000 the next day, you might not believe him, as magic only happens in Harry Potter movies.

The Reserve Bank’s Monetary Policy Department assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate. Central banks decide how much money the members should keep in reserve. Banks can safely lend most of that amount because everyone doesn’t need all of the money every day. This way, they have ample cash to meet a lot of redemption demands.

Let’s suppose bank lent INR 810 to a farmer, to buy seeds and fertilizers. The company, after receiving payment from the farmer, returns to the bank to deposit the money. Thus money again came back to the bank in the form of deposit, but it was 10% lesser than the deposit amount of INR 900. You deposited INR 1000 with the bank, bank retained INR 100 (10% of 1000) and loaned out the rest to a company seeking a loan of INR 900 to fund its capital requirement. Company utilised this amount to buy tools and machinery, from a capital supplier, for its new plant.

Lack of financial inclusion as borrowers still depend on moneylenders, who are not under RBI’s control. In order to improve monetary transmission, RBI wants banks to change the calculation methodology of base rate to marginal cost of funds from average cost of funds. Unlike quantitative tools which have a direct effect on the entire economy’s money supply, qualitative tools are selective tools that have an effect in the money supply of a specific sector of the economy. The average inflation is greater than the upper tolerance level of the inflation target as predetermined by the Central Government for 3 quarters in a row.

What are the qualitative tools?

Hence banks are left with a smaller pile of cash to lend to retail and institutional investors, cutting down the supply of money in the economy. A contractionary monetary policy is focused on contracting the money supply in an economy. An expansionary monetary policy is focused on expanding the money supply in an economy. There are three basic tools used by all central banks for monetary policy. There are three objectives of monetary policy – Inflation management is the most common objective.

Further investment is discouraged and the rise in prices is checked. Contrariwise, when recessionary forces start in the economy, the central bank buys securities. The reserves of commercial banks are raised so they lend more to the business community and the general public. It further raises Investment, output, employment, income and demand in the economy hence the fall in price is checked. The monetary policy refers to a regulatory policy whereby the central bank maintains its control over the supply of money to achieve the general economic goals.

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