The two types of monetary policy in India are Expansionary Monetary Policy and Contractionary Monetary Policy. Expansionary monetary policy focuses on increasing the supply of money in an economy. However, the contractionary monetary policy helps reduce money supply in the economy.
What are The Objectives and Tools of Monetary Policy in India?
Monetary policy is an important factor for economic management in India. The main purpose of it is to regulate the supply of money in India through the Reserve Bank of India (RBI). It helps in controlling the inflation and interest rates in an economy. Monetary policy also helps in maintaining the exchange rate with other nations.
The following article talks about the various objectives of monetary policy and the tools the central bank uses to implement the policy.
Objectives of Monetary Policy in India
There are several objectives that a monetary policy tries to achieve. The primary motive of this policy is to empower an environment that promotes development and maintains reasonable price stability. Following are some of the objectives of monetary policy in India:
- Employment Generation: The monetary policy promotes employment by providing concessional loans to small and medium entrepreneurs and productive sectors. It also provides special loan schemes to unemployed youth to generate more employment.
- Price Stability: One of the prime objectives of India's monetary policy is to maintain price stability in the economy. It controls the inflation rate of the economy. Furthermore, the money supply affects the price level, so monetary policy manages the money supply to maintain price stability.
- Financial Market Stability: Financial market stability is one of the ways to explain the objectives of monetary policy. The major reason for creating a country's central bank is to develop a more secure financial system. One such way is when a central bank promotes stability by preventing financial dreads in case of bank failure. It acts as a lender and provides funds to such banks. In addition, the central bank is eventually the last source of funds in a money market.
- Foreign Exchange Market Stability: Since there has been an increase in international trade in the Indian economy, the rupee value has become a significant factor for the RBI. If there is a rise in the value of the rupee, it makes Indian industries less competitive compared to those abroad. However, if there is a decline, it raises the inflation rate in India.
- Interest Rate Stability: Interest rate stability is vital as fluctuations in it will create a lot of uncertainty in an economy. This will make it more difficult for you to plan for the future. If there is a lot of fluctuation in interest rates, your wish to buy sustainable goods such as a house or a car will get affected. This will directly affect the economy in the long run.
- Economic Growth: One of the major objectives of monetary policy is to ensure that there is a necessary supply of money and credit in an economy for growth. It is important as these things are vital for India's economic growth and with sufficient credit availability. This objective is also related to employment growth because businesses invest more in their capital equipment when unemployment is low to increase productivity, thus contributing to economic growth.
- Control Business Cycle: A business cycle consists of different phases, out of which boom and depression are the most major, and monetary policy keeps a check on them. When a business goes through a boom phase, credit is reduced to minimise money supply and check inflation. However, during a depression phase, credit is increased to raise the money supply, thereby developing total demand in an economy.
- Manage Aggregate Demand: Market aggregate demand is used to discuss the objectives of monetary policy. The central bank tries to stabilise the total demand with an aggregate supply of goods and services in an economy. If there is an increase in the total demand, credit is expanded, and the interest rate gets lowered. Lower interest rates allow you to buy goods and services, increasing aggregate income demand and vice versa.
- Regulate and Expand Banking: Reserve Bank of India regulates the banking system in the Indian economy. It has extended banking to every part of the country. It issues regulations to the banks for setting up rural branches to promote agricultural credit. However, the government has also set up different cooperative and rural banks for the same purpose.
- Ensure More Credit to the Priority Sector: It is one of the major objectives of the monetary policy that provides more funds to the priority sector of an economy. This is done by lowering the interest rates for such sectors. These sectors include small-scale industry, the agricultural sector, and economically weaker sections of society.
- Promote Exports and Substitute Imports: Monetary policy encourages and helps industries to improve the position of balance payments. It provides a reduced interest rate loan amount to the export and import units to help promote these sectors.
Tools of Monetary Policy in India
Now that you have understood the meaning of monetary policy and its objectives, you should know about various tools used by the RBI to implement it in the Indian economy.
- Cash Reserve Ratio (CRR): Under CRR, commercial banks such as public, private, and foreign banks must keep a portion of their deposits with the RBI in the form of reserves. If the RBI plans to lower the lending activity, it would ask these banks to deposit an increased portion of the deposit amount and vice versa.
- Open Market Operations (OMO): In OMOs, the RBI buys and sells government securities from the market to control liquidity in an economy. Its main objective is to regulate the level of reserve balances to alter the short-term interest rates. Furthermore, when the RBI buys securities, the liquidity circumstances are relieved in an economy and vice versa.
- Statutory Liquidity Ratio (SLR): Under this tool, banks must hold a certain part of their net demand and time liabilities (NDTL) in liquid assets at the day's end. These liquid assets include cash, gold and government securities. Furthermore, if the RBI wants to reduce economic activity, it would ask these banks to hold an increased share of deposits in the form of SLR.
- Repo Rates: The repo rate is the rate at which commercial banks borrow money from the RBI to meet their daily regulatory necessity for a shorter period. Commercial banks use treasury bills and notes as collateral against the loan. These banks sell such securities and buy them back later at a promised date. When the RBI plans to revive the Indian economy, it disincentives the banks by providing them with lower repo rates. This helps such banks to lend more money for commercial purposes and earn more returns and vice versa.
- Reverse Repo Rates: These are rates at which the RBI borrows money from commercial banks for a shorter period. The banks with excess funds can lend money to the RBI to earn higher interest amounts. Banks usually lend money to the RBI as it is risk-free when compared to commercial lending. In addition, when the central bank wants to reduce liquidity in an economy, it can hike the reverse repo rate to pull that money from the economy.
- Marginal Standing Facility (MSF): MSF is a window for commercial banks to borrow money from the RBI in an emergency when interbank liquidity dries up. Commercial banks mortgage government securities to borrow funds from the RBI at a rate higher than the repo rates in Liquidity Adjustment Facility (LAF).
Monetary policy helps an economy to stay stable by limiting inflation and unemployment. The objectives of monetary policy are promoting the development of an economy along with sustaining price stability and employment generation in India.
FAQs About the Objectives of Monetary Policy
Contractionary monetary policy helps in controlling inflation in an economy. Its objective is to reduce money supply in an economy by reducing the prices of bonds and raising interest rates. Thereby, consumption falls, leading to a drop in the price, thus slowing down inflation.
Open Market Operations (OMO) is the most frequently used monetary policy. It includes sales and purchases of government securities for immersion and injection of firm liquidity.
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