The keynote of monetary policy can be said to be controlled expansion of bank credit and money supply, with special attention to seasonal requirement for credit. The RBI regards money supply and the volume of bank credits as the two major intermediate variables, but it seeks to control the former through the latter. It is said that money supply doesn’t change on its own; it changes because of certain underlying development with regard to bank credit.
Instruments of Monetary Policy
The instrument of monetary policy (methods of credit control) may be broadly divided into the following parts:
Open Market Operations: Open market operations involve the sale and purchase of government securities by the RBI to influence the volume of cash reserve with commercial banks and thus influence the volume of loans and advances they can make to the industrial and commercial sectors. The environment for open market operations is quite favourable because the government securities market is fairly developed in the country. At present, the RBI is authorised to conduct purchase and sale operations in government securities, treasury bills and other approved securities.
Open Market Operations have both monetary policy and fiscal policy goals. Their multiple objectives include: (a) To control the amount of and changes in bank credit and monetary supply through controlling the reserve base of banks,
(b) To make bank rate policy more effective, (c) To maintain stability in government securities market, (d) To support government borrowing programme, (e) To smoothen the seasonal flow of funds in the bank credit market.
The Bank Rate: The bank rate is also known as discount rate. It is the rate at which the central bank discounts, or more accurately rediscounts, eligible bills. In a broader sense it refers to the minimum rate at which the central bank provides financial accommodation to commercial banks in the discharge of its function as the lender of the last resort. The bank rate is the basic cost of refinance and rediscounting facilities.
Direct Regulation of Interest Rates: It is expected that change in bank rate will bring a change in all market rates of interest in the same direction. But when the bank rate loses its significance in regulating market rates, the RBI is compelled to directly regulate interest rates on bank deposits and credit.
Cash Reserve Ratio: The CRR refers to the cash which banks have to maintain with the RBI as a certain percentage of their demand and time liabilities. In the late 1980s there was a rapid growth of liquidity which resulted in higher inflation and thus the CRR was raised to its maximum limit of 15%, which resulted in higher interest rate and liquidity crunch in early 1990s when Prime Lending Rate was raised to as high as 17%.
Monetary policy in India has been formulated in the context of economic planning, whose main objective has been to accelerate the growth process in the country. In a country like India that has followed an expansionary fiscal policy which leads to inflationary conditions, to manage a monetary policy under these circumstances is like tightrope walk.
During the planning period prior to liberalisation, the RBI used higher CRR and SLR rates to control inflation. After 1992, the demand of the day was development and investment and the development sector was expanding and was and in need of money. Indian corporations had to compete with companies which were getting money at 4% to 5% interest rates. Then the RBI had to reduce CRR and SLR to reduce interest rates and to make available money for investment purposes.