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Guest Blog: Should the RBI have an 'easy' or 'tight' Monetary Policy?


DR. PM MATHEW | New Delhi, April 14, 2012 20:31
Tags : rbi | monetary policy | subbarao | business | fiscal policy | macroeconomic policy |

Reserve Bank of India (RBI) Governor Subbarao will communicate to the nation the first Monetary Policy of fiscal 2013 on 17 April. Industry and business are extremely concerned over the nature of the forthcoming policy announcement since it has the potential to affect income, employment, price level and output of the economy. In India, the major goal of monetary policy is to accomplish growth without inflation.

However, one must understand that a blend of monetary and fiscal policy comprise macroeconomic policy. Gone are the days when even veteran German economist like Rudiger Dornbusch held the view that fiscal policy matters only in those areas where Monetary Policy is ‘impotent’. It is also widely acknowledged that fiscal consolidation is a must for the success of monetary policy. However, given the macroeconomic environment in the economy, monetary policy should be considered a potent instrument to tackle inflation and boost economic growth.

The Reserve Bank of India Act, 1934 sets out the Central Bank’s objectives :" 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." Monetary Policy in India aims to maintain price stability, ensuring adequate flow of credit to sustain the growth momentum and secure financial stability. In order to ensure financial stability the RBI has to regulate/supervise the financial system and its constituents namely: money, debt and foreign exchange segments of the financial markets in India; besides the payment and settlement system. Its other objectives are to control inflation and provide sufficient credit to productive sectors of the economy which would foster growth.

The RBI uses three principal tools to control the size of the money supply and thereby inflation. The Central Bank can buy government securities or bonds in exchange for money thereby increasing the stock of money. It can also sell bonds in exchange for money paid by the purchasers of the bonds to reduce money stock.

In addition, to the above open market operations, the RBI can raise or lower the cash reserve ratio (CRR) -- which is the portion of deposits that banks are required to keep with the Central Bank. Raising the CRR decreases the excess reserves of banks and the size of the demand deposits. Lowering the CRR increases the excess reserves of banks and size of demand deposits. The RBI can also lower the ‘Bank Rate’ to encourage banks to borrow reserves from it and raise it to discourage them from borrowing reserves. The ‘bank rate’ is also known as the discount rate, which is the interest rate that the Central Bank charges banks to borrow short-term funds directly from it.

Monetary policy can be ‘easy’ or ‘tight’. An ‘easy’ monetary policy can be implemented by the RBI’s actions to buy government bonds in the open market, decrease the discount rate or decrease the CRR. This is done to increase the money supply to curb deflation. On the other hand, a ‘tight’ monetary policy can be implemented by RBI’s actions to sell government bonds in the open market, increase the discount rate or increase the CRR. This is done to decrease the money supply to curb inflation. A fall in money supply can cause the interest rate to rise and investment spending to decrease – thereby reducing aggregate demand and inflation.

Though mild inflation is an engine of growth, high inflation is a growth depressing factor .This is mainly due to the negative impact of high inflation on investments. In India, inflation has never been mild. Given the budget proposals on freight rates, excise duties and power tariffs, inflation in the country will increase or stagnate at the present level. For instance, ‘elevated’ Consumer Price Index in February is a clear indication of an impending wage price spiral. Depreciation in rupee value may import inflation. Despite the fact that core inflation has lately declined marginally – the RBI has no control over food inflation. The first monetary policy of fiscal 2012 demonstrated the RBI’s efforts to combat inflation even if it meant the need to sacrifice short-term growth.

The RBI now needs to act via a mix of policy instruments. It has to effect changes in CRR and resort to open-market operations. These changes must affect the quantum of liquidity, and policy rates such as the bank rate and repo rate to influence the price of liquidity. Also the RBI should manage its liquidity adjustment facility on a daily basis to transmit interest rate signals to the market.

Given the macroeconomic environment of rising fiscal deficits, slow growth and price instability, the RBI must opt for an aggressive monetary policy to increase liquidity and reduce interest rates. A reduction in the cash reserve ratio (CRR) will be more effective than a repo rate cut to lower borrowing costs. The repo rate is the overnight lending rate at which banks borrow money from the RBI. Also as some heads of State-run banks recently exhorted, a 75 basis points (bps) cut in the CRR and a 25 bps reduction in the repo rate is necessary. One basis point is one hundredth of a percentage point. Importantly the RBI should also continue buying bonds through its open market operations. All these moves if adopted are expected to generate growth without much inflation.


The writer is Senior Professor of Economics, Christ University, Bangalore.

(Disclaimer: The views expressed in the blog are that of the author and does not necessarily reflect the editorial policy of The Sunday Indian)
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Posted By: Ancy | Cochin | April 15th 2012 | 07:04
Why there is no conclusion on what policy should India have-tight or easy?

Issue Dated: Feb 5, 2017