Monetary Policy Introduced

Setting the Context: In this week’s article, we shall go over “What Monetary Policy exactly means? What are the types of monetary policies at the bay of the Central Bank? What are the challenges that arise in implementing them successfully? Then finally, a mini snapshot is presented on India’s policy response to the pandemic.

What is Monetary Policy?

Monetary Policy refers to the the collective actions taken by the Central Bank in order to control the money and credit supply in the economy to achieve: (a) stable and positive economic growth levels and (b) positive, low and stable levels of inflation. The monetary policy utilised to achieve this goal can be expansionary or contractionary depending on the current economic scenario.

Expansionary Economic Policy: As the name suggests, expands the supply of money and is aimed at stimulating the economy when there’s a slump in demand, fall in consumption and an overall slowdown in a country’s economic well-being. Examples of certain Expansionary Policies include:

  • Cutting of interest rates (Repo and Reverse Repo rates)
  • Decreasing the Cash Reserve Requirement (CRR)
  • Printing Money to buy financial assets
  • Routing money directly into the people’s accounts.

Contractionary Monetary Policy: This is employed when the CB senses overheating inflation levels in the economy. The rationale? Well if Inflation is way too high, the value of the money in your pocket decreases. To elaborate, if you had 1000 dollars in your bank account, which you had saved up to purchase furniture for your new house, high inflation would cause the value of those 1000 dollars to decrease and thereby, you won’t be able to purchase as many items as you had initially planned to. Now, imagine this on a large scale level, the money supply in the entire economy would be worth lesser because it’s excessive in supply. Thereby, the CB takes on contractionary monetary policy to control this.

Contractionary Monetary policy as the name suggests is aimed at contracting the money supply in the nation and thereby bringing down the level of inflation. Examples of Contractionary Monetary Policy include:

  • Increasing interest rates, thereby making borrowing more expensive
  • Increasing the Cash Reserve Requirement

Challenges to implementing Monetary Policy:

While the Central Banks have great power over the level of interest rates set and the policies dictating the reserve requirement levels in the banks, they cannot quite literally manipulate the banks and people to behave in line with their Plan-Of-Action in order to achieve the economic target.

To elaborate, during an economic slowdown, even though the CB cuts rates, they cannot force banks to extend credits more generously and at lower rates to people (when easy credit availability would actually foster spending and hence pull up the economy).

Additionally, the CB cannot control the psychology of people to SPEND and not hoard cash in times of economic slowdowns. Although that’s fundamentally what the consumption-deprived economy is craving for, more credit and more people spending!

What’s the rationale behind this? More the banks lend, more the people spend, one person’s expense is another person’s income, income levels rise overall, consumption increases, demand increases and the economy is back on its happy rally. But all of this doesn’t perfectly go as planned more often than not and in short, the powers of CB are therefore limited.

Snapshot: India’s Policy Response to COVID-19

Ten Second Definitions:

  • CRR – Cash Reserve Ratio is the ratio of cash the banks are supposed to maintain as a percentage of their total deposits.
  • SLR – Statutory Liquidity Ratio is the ratio of gold and cash reserves the commercial banks are supposed to maintain.
  • Repo Rates: The rates at Central Bank lends money to banks.
  • Reverse Repo Rates: The rate at which the Central Bank can borrow reserve from the banks.
  • MSF: Marginal Standing Facility is the rate at which the banks are able to borrow overnight funds from RBI.

Mini Snapshot:

“Since March 27, the Reserve Bank of India (RBI) reduced the repo and reverse repo rates by 115 and 155 basis points (bps) to 4.0 and 3.35 percent, respectively, and announced liquidity measures across three measures comprising Long Term Repo Operations (LTROs), a cash reserve ratio (CRR) cut of 100 bps, and an increase in marginal standing facility (MSF) to 3 percent of the Statutory Liquidity Ratio (SLR), now extended till end-September”

Source: IMF

Explanation: So basically, the RBI slashed interest rates, in order to encourage banks to pass on the lower rates to debtors. Additionally, the decrease in Cash Reserve Ratio, would basically increase the amount of liquidity the banks have, allowing them to lend out more! Plus, increasing the MSF would enable the banks to borrow lesser amounts in form of overnight funds from the central bank.