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Parameters & Operating Procedures in India

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Project on Monetary policy - Parameters & operating procedures in India
Introduction & Basic Concepts Explained

Module: 1 - Introduction & Basic Conceps Explained
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Introduction & Basic Conceps Explained


Definition of Important Monetary Policy Terms




In recent years, particularly in the 1990s, there has been an upsurge of interest in the operational framework of monetary policy. With the growing perception that the explanatory power of intermediate target regimes is getting eroded under the impact of globalisation and financial innovations, attention has shifted to the development of simple and flexible rules whereby monetary policy can directly achieve its objectives. Under these conditions, monetary policy operates with constrained discretion. The performance of a small, operational model for monetary policy in India suggests that under constrained discretion, monetary policy can be directed towards revitalising output growth in the short-run. The long-run inflationary consequences of current monetary policy action, however, need to be taken into account. Threshold inflation, i.e., growth-maximising inflation rate is estimated at 5 per cent. There are potential output losses involved in further disinflation. Sacrifice ratio estimates suggest that, in a low inflation environment, a one percentage point reduction in inflation leads to a decline in output by 2 percentage points below its potential. The interest rate channel is rapidly emerging as the dominant transmission mechanism, supported and reinforced by the credit channel. At this juncture, more evidence needs to be accumulated and fundamental analytical issues resolved before the new analytical framework for monetary policy can be validated.

Several landmark initiatives have been recently announced to correct for the known time inconsistency in the conduct of monetary policy. The decision to divest ownership functions in commercial banking, development of finance and securities trading entities, separation of supervisory functions in regard to co-operative banks, separation of public debt management function from monetary policy, changes in the operational conduct of monetary and fiscal policies suggested by Advisory Group on Transparency in Monetary and Financial Policies (Chairman: Shri M. Narasimham) and the tabling of the Fiscal Responsibility and Budget Management Legislation mark a new phase in the evolution of monetary policy in India in the new millennium.

The conduct of the monetary policy in India would continue to involve the constant rebalancing of objectives in terms of the relative importance assigned, the selection of instruments and operating frameworks, and a search for an improved understanding of the working of the economy and the channels through which the monetary policy operates.

[Source: Concluding Remarks of Chapter -5 - titled "Growth, Inflation and The Conduct of Monetary Policy" - RBI Report on Currency & Finance 2001-2002]

Monetary & Credit Policy Announcements by RBI

The Reserve Bank of India announced its biannual Monetary and Credit Policy for the first half of the financial year 2004-05 on Tuesday, May 18. The text of the policy statement consisted of three parts, as under-

  1. Review of Macroeconomic and Monetary Developments during 2003-04,

  2. Stance of Monetary Policy for 2004-05, and

  3. Financial Sector Reforms and Monetary Policy Measures.

The objectives and ambit of the Policy Statement are well brought out in the initial paragraph, which is quoted as under:

"The policy documents of the Reserve Bank provide a framework for the monetary and other relevant measures that are taken from time to time and capture the rationale or the underlying factors at work that affect its macroeconomic assessments. The documents also set out the logic, intentions and actions related to structural and prudential aspects of the financial sector. This Statement broadly follows the pattern already set in previous years. It delineates and elaborates on various areas in which RBI has been taking measures from time to time and provides a focus on broad policies that are intended to be pursued for the year 2004-05, while retaining the flexibility to take specific measures promptly and effectively as the evolving circumstances warrant."

After releasing the annual policy statement on May 18, 2004, The Governor RBI on 26th October, 2004 announced "Mid-term Review of Annual Policy for the year 2004-05". While presenting the Policy Review statement the Governor again reiterated as under:-

"The policy documents of the Reserve Bank capture the rationale of monetary, structural and prudential measures introduced from time to time against the background of an assessment of macroeconomic and monetary developments. In the process, the approach of greater transparency and better communication contributes towards an effective consultation process in policy making. This Statement on Mid-term Review of the Annual Policy for the year 2004-05 follows the pattern already set in the previous years."

The Policy Review statement also consisted of three parts, as under:-

  1. Mid-term Review of Macroeconomic and Monetary Developments in 2004-05;

  2. Stance of Monetary Policy for the Second Half of 2004-05; and

  3. Financial Sector Reforms and Monetary Policy Measures.

Rationale of Monetary & Credit Policy Announcement by RBI

The Monetary and Credit Policy statement, traditionally announced by RBI twice a year, through which the Central Bank seeks to ensure price stability for the economy and easy access to credit supply for all productive sectors of the economy. The scope of the Policy Statement includes information on- money supply, interest rates and inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy. This term is explained further in the next article under "definitions".

The second part of the Policy statement covers norms for the banking and financial sector viz. banks, financial institutions, non-banking financial institutions, and primary dealers (money markets) and dealers in the foreign exchange (forex) market.

Differentiation Between Monetary & Fiscal Policies

Monetary and Fiscal Policies announced respectively by the RBI and the Government of India are the two important pillars of regulatory/correctional measures intended to influence/shape macroeconomic changes in the countries economy. The Monetary Policy regulates the supply of money and the cost and availability of credit in the economy to sustain productive ventures. It deals with both the lending and borrowing rates of interest for commercial banks. The Monetary Policy further aims, as already stated, to maintain price stability, full employment and economic growth. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements to carry out this objective.

The Monetary Policy is, however, different from Fiscal Policy as the former brings about a change in the economy by altering money supply and interest rate, whereas fiscal policy is a broader tool with the Central Government. The Fiscal Policy can be used to overcome recession and control inflation. It may be defined as a deliberate change in government revenue and expenditure to influence the level of national output and prices. By way of an example, at the time of recession the government can increase expenditures or cut taxes in order to generate demand. On the other hand, the government can reduce its expenditures or raise taxes during inflationary times. Fiscal policy aims at changing aggregate demand by suitable changes in government spending and taxes. The annual Union Budget showcases the government's Fiscal Policy.

Historically, the Monetary Policy was being announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. Since 1998-99 RBI has moved in for just one policy in April-end followed by a mid-year a review of the policy carried out later in the year during October. The Monetary Policy has over the years become dynamic in nature due to diverse features like opening of the economy, liberalisation and gloablisation process etc. The RBI, therefore, reserves its right to alter it from time to time, depending on the state of the economy.


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