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Monetary Policy Instruments and Monetary Policy Committee (MPC) of RBI

news-details Image Source Apr 03, 2021 21:45 IST · 4 min read

The Centre has decided to retain the inflation target of 4 per cent, with a tolerance band of +/- 2 percentage points for the Monetary Policy Committee of the Reserve Bank of India for the coming five year (April 1, 2021, to March 31, 2026).

Monetary Policy Committee (MPC)

Monetary Policy Committee (MPC) was constituted by ammending the Reserve Bank of India Act, 1934 through Finance Act, 2016 - to bring more transparency and accountability in fixing Monetary Policy.

The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India. The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.

The committee comprises six members - three officials of the Reserve Bank of India and three external members nominated by the Government of India.

They need to observe a "silent period" seven days before and after the rate decision for "utmost confidentiality".

The Governor of RBI is the chairperson ex officio of the committee, decisions are taken by majority with the Governor having the casting vote in case of a tie.

The current mandate of the committee is to maintain 4% annual inflation until 31 March 2021 with an upper tolerance of 6% and a lower tolerance of 2%.

Monetary Policy Instruments

Quantitative instruments includes -Open Market Operations, Bank Rate, Repo Rate, Reverse Repo Rate, Cash Reserve Ratio, Statutory Liquidity Ratio, Marginal standing facility and Liquidity Adjustment Facility (LAF).

Qualitative Instruments includes - Direct action, change in the margin money and moral suasion.

Open Market Operations

Open Market Operations (OMOs) are market operations conducted by RBI by way of sale/purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market.

If there is excess liquidity, RBI resorts to sale of securities to sucks out the rupee liquidity. Similarly, when the liquidity conditions are tight, RBI buys securities from the market to release liquidity into the market.

Repo rate

Repo rate is the rate at which the central bank of a country (RBI) lends money to commercial banks in the event of any shortfall of funds. It is also used by monetary authorities to control inflation.

In the event of inflation, RBI increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

The central bank takes the contrary position by decreasing repo rate in the event of a fall in economic activities or recession. The decrease in repo rates is to aim at bringing in growth and improving economic development in the country.

Reverse repo rate

Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.

An increase in the reverse repo rate will decrease the money supply and vice-versa. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.

Bank Rate

Repo rate is the rate at which the RBI lends to commercial banks by purchasing securities while bank rate is the lending rate at which commercial banks can borrow from the RBI without providing any security.

Liquidity adjustment facility (LAF)

Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements.

Liquidity adjustment facility (LAF) helps banks to quickly borrow money in case of any emergency or for adjusting in their Statutory Liquidity Ratio (SLR)/Cash Reserve Ratio (CRR) requirements.

The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998).

Marginal standing facility (MSF)

Marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely.

The Marginal Standing facility allows banks to borrow money with an interest rate above the repo rate and can be termed as the Marginal standing facility rate.

Under MSF, banks can borrow funds overnight up to 1% (100 basis points) of their net demand and time liabilities (NDTL) i.e. 1% of the aggregate deposits and other liabilities of the banks.

What is inflation targeting

Inflation targeting is a policy followed by the central regulator in the monetary policy and is adjusted to achieve a specified annual rate of inflation.

The strategy is based on the belief that long-term economic growth is best achieved by maintaining price stability that can be achieved by controlling inflation.

The central bank employs all tools that are available to it for this purpose ranging from open market operations to increasing and decreasing interest rates.

The central bank raises interest rates to slow inflation in order to slow the economic growth whereas the interest rates are decreased to boost inflation and economic growth.

The Flexible Inflation Target (FIT) was adopted in 2016. This has put India on par with other nations in terms of flexible inflation targeting.

The Reserve Bank of India Act, 1934 was amended to provide a statutory basis for a Flexible Inflation Target (FIT) framework.

The amended Act provides for the inflation target to be set by the Government, in consultation with the RBI, once every five years.

India adopted a flexible inflation targeting mandate of 4 (+/-2) percent and headline consumer price inflation was chosen as a key indicator.

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