Monetary Policy, Fiscal Policy, Budget

 RBI

MONETARY POLICY (Money, currency, interest rates)

It refers to actions that the central banks take to pursue objectives such as price stability and maximum employment.

Economic policy includes Monetary Policy and Fiscal Policy:

Monetary policy	Fiscal policy
RBI	GoI
It refers to the actions that the central bank takes to pursue objectives such as price stability and maximum employment.	It refers to govt’s revenue collection and spending decisions
Money, currency, interest rates	Taxation, public spending, public borrowing

 

Fiscal policy is inspired by JM Keynes in response to the Great Depression.

Objectives of fiscal policy:

Private sector	Public sector
To incentivise the private sector to scale up their operation to directly or indirectly improve the economy of a country.	Public asset creation- ·         Roads and railways ·         Public health and safety ·         Education ·         Salary and pension ·         Subsidy

 

·         Economic growth

·         Price stability

·         Full employment

·         Equitable distribution

·         External stability

·         Capital formation

·         Regional balance

Two variables of fiscal policy:

Govt can influence fiscal policy in two ways:

Taxation (revenue)	Govt. spending (expenditure)
Govt. increases or decreases the disposable cash in hands of the public. ·         Tax increases decreases the disposable cash in hands of the public. ·         Tax decreases increases the disposable cash in hands of the public.	·         Govt. promotes infrastructure ·         Govt promotes social welfare schemes which influences development in the economy. When economy shows negative growth then the private investors begin to lose faith. When economy lacks growth then the public tends to save their money and avoid spending. Govt. increases spending in those times  to create public demand in the market.

 

Disposable income

If a person earns Rs 100 and 8% is the tax then the disposable income is Rs (100-8 = 92).

 

Expansionary fiscal policy

Govt. decreases taxes                                                                              Govt. spending increases

This increases aggregate demand in economy

 

Contractionary Fiscal Policy

Govt increases tax                                                                                    Govt decreases spending

This decreases aggregate demand in economy

Control inflation during boom.

Fiscal neutral policy

Govt. spending = Taxation

 

Tools of fiscal policy

Stabilize economy during inflationary pressures.

Macro-economic stabilization during short term	Long term
Regulate spending and taxes	Suitable growth and poverty reduction

 

Good fiscal policy =

Raise confidence of private investors =

Private investors will expand=

Investments will flow into the economy=

Driving demand

 

Aims

Income equality means-

1.       Levy direct taxes on high income individuals

Subsidize production items of low-income household

2.       Vanity and luxury items are taxed

Necessary items like food and fuel are subsized

 

A good fiscal policy helps the govt. to maintain a balance of receipts and payments.

 

Why is it necessary?

A free market without govt. control is not good.

Reasons- It is difficult for govt. to control the economy and help to grow it during tough times.

Ex- COVID.

 

Cons of fiscal policy: Appeasement of voters

Freebies politics: To win elections, govt diverts money to unnecessary voter appeasement.

Rising tax becomes a burden for the middle class when inflation rises. The rich class does not feel as burdened by increased taxes as the middle class.   Govt does not want to increase taxes hence reduces govt. spending.

Tax cuts and other policy decisions benefit the middle class. Middle classes are the largest section of the country so revenue received by govt. decreases.

 

Policy-makers makes mistakes in policy making. They make decisions without understanding the needs of people and situation. So, these initiatives become unsuccessful and bring about a  decline in the economy.

 

Basics of budget

A budget is a spending plan based on income and expenses.

How much money one will make or spend during a certain period of time?

 

Meaning and component of govt. budget

Act 112- Annual Financial Statement

Financial year- 1^st April to 31^st March

Present a statement of estimated receipts and expenditures of govt. in front of the Parliament.

 Objectives of govt budget

1.       Reallocation of resources

2.       Reducing inequalities in income and wealth

3.       Economic stability

4.       Growth of the economy

5.       Employment opportunities

6.       Management of public enterprises

7.       Reducing regional disparities

 

Allocation function of govt budget

Public goods:

Govt provides certain goods and services which the market mechanism cannot provide.

Ex- National defense, road govt administration, etc.

Free riders- Many people do not pay taxes. So, it is difficult to collect fees for the public goods.

 

Redistribution of govt budget

National income goes to:

1.       Firms- Private sector

2.       Private income- household

3.       Govt. sector- public income

 

Private income ---

Reaches the household ---

Personal income ---

Tax is deducted ---

Total disposable income ---

(The income that the household can spend)

 

Personal disposable income is controlled by govt sector by-

Redistribution function:

1.       Making transfers (eg. subsidy)

2.       Collecting taxes

Govt. changes income distribution to create a fair distribution for the society.

 

Stabilization function of govt. budget

At an aggregate level,

Employment and prices

>>depend on>> 

aggregate demand

>> demand on >>

Spending decisions of

1.       Millions of private economic agents

2.       Govt.

>> depend on>>

Income and credit availability

 

Stabilization function

1.       Govt. can increase demand

2.       Govt. can decrease demand

 

Why should govt raise aggregate demand?

Demand can exceed available production level. This creates situations of high employment. But, it also gives rise to inflation.

 

Components of budget in India

 

Revenue receipts (Jo dhan man ko shant karta ho)

It is the revenue that the govt expects to receive from the citizens in the upcoming financial year.

Example-

1.       Tax, GST, Excise duty (Taxable sources)

2.       Interest payments, profits, fees accumulated from govt. sources, penalties

 

Capital receipts (Jo dhan pana man ko ashant karta hai)

1.       Capital receipts increase govt liabilities

2.       Capital receipts decrease financial assets of govt.

Ex-

Govt receives loans from public states/ UTs/ foreign bodies/ RBI.

Recovery debts

Selling treasury bills

Govt. sold off AIR India to private owners.

Ex-

India has given some money as loan to Bangladesh. Will govt. receive capital receipt or revenue receipt?

When Bangladesh gives interest on that loan to India, it is revenue receipt.

When Bangladesh returns the principal amount to India, it is capital receipt. (It increases financial assets of India).

That loan that India gave to Bangladesh forms the financial asset of India.

 

 

Tax Revenue

Income tax

This is a tax on the income of individuals, firms, etc. other than companies under the Income Tax Act, 1961.

Other taxes:

1.       Securities transaction tax:

Levied on transactions in listed securities undertaken on stock exchanges (share market).

2.       Corporation tax:

Income Tax Act 1961: Companies have to pay corporation tax.

3.       GST:

It is levied on goods and services except alcohol for consumption of fuel.

GST was introduced on 1^st July, 2017.

4.       Custom duty:

Levied on international cross-border trade of goods.

5.       Excise duty:

Levied on the manufacture of some goods. Since 2017, those goods on which GST is not levied is covered under excise duty.

6.       Wealth tax:

·         Tax on stock of wealth owned at a particular time.

·         It also defines:

v  Which assets are taxable

v  How to calculate tax on taxable assets

2015-16: Wealth tax was abolished.

·         Reason:

v  Insufficient revenue collection

v  High cost of collection

 

 Non-Tax Revenue

 

Interest receipts

Union govt receives this interest on loans made to states and UTs.

 

Dividends and profits

This is the amount that the govt receives when public sector enterprises and RBI further transfer their income to the govt.

 

Other non-tax revenue

Changes levied by govt for particular services

·         Economic services

·         General services

Ex are revenues earned on railways or civil aviation or postal fees.

 

Non-debt capital receipts

 

Revenue expenditure (Jo kharcha sir dard badhaye)

Expenses the govt expects to incur for the daily functioning of the economy and to provide citizens with the essential public services facilities and amenities.

 

Includes various operational expenses:

·         Maintaining govt offices

·         Salaries to govt officials

·         Providing subsidies to citizens

Capital expenditure (Jo kharcha sirdard kam kare athwa khushiyan laye)

Creating long term assets.

Ex-

·         Developing and maintaining equipment and infrastructure

·         Constructing roads, schools, hospitals

·         Granting loans to states and UTs

Capital expenditure	Revenue expenditure
Govt makes the expenditure to develop fixed assets.	Govt. makes this expenditure to build recurring assets or decrease liabilities in a recurring manner.
Govt. repays loan	Govt. pays salaries, pensions and administrative expenses
If an item has a useful life of more than one year, it is to be capitalized (i.e., can be considered CapEx.)	If an item has a useful life of less than one year, it should not be capitalized and should not be considered CapEx
Capital expenditure is a payment for goods or services recorded- or capitalized- on the balance sheet	Revenue expenditure must be expensed on the income statement.

 

Govt’s estimated revenue= Govt’s proposed expenditure

 

Balanced budget

·         Virtue of living within one’s means

·         Anticipated expenses and receipts are different from real values. So, it is practically impossible to implement such a budget.

Deficit budget

Receipt < Expenditure

·         Govt makes excessive expenditure to enhance employment.

·         Demand for the good increases which helps to revive economy.

·         From where does govt get the excessive money to make expenditure? Govt issues bonds to borrow from the public.

Method of budgeting

1.       Zero based budgeting

Previous year’s budget is not considered.

2.       Traditional budgeting

Changes done based on:

·         Inflation rate

·         Consumer demand

·         Market situation

 

3.       Activity based budgeting

Cost drivers are considered

 

4.       Incremental budgeting

Present year’s budget is prepared by considering past year’s budget and inflation factor is considered.

 

 Traditional budgeting

·        Began a century ago

·        It is usually followed

Incremental budgeting

Current period’s budget or actual performance is used as a base. Then the assets are adjusted by increasing amounts. To create increment the rate of inflation is used as a guide for the adjustment factor when creating incremental budget.

 

Activity based budgeting

·         Activities are thoroughly analyzed to predict costs.

·         Historical factors are not considered.

·         3 min steps:

o   Identifying cost drivers

o   Projecting total units

o   Estimating the cost per unit

It looks at costs more thoroughly than the traditional methods.

 

Gender budgeting

·         Allocates funds and responsibilities on the basis of gender.

·         Socio-economic disparities are reduced

·         It is a public governance tool

Gender budgeting started in India with Union Budget of 2006-7.

Rs. 28,737 crore dedicated to women.

Created under budgeting cells in 32 ministries and departments.

 

Gender budgeting helps ensure that the budget promotes priorities related to gender equality like:

·         Reducing gender pay gap

·         Closing gender gap in labour market

·         Bridging social and economic gains

 

OECD best practices for gender budgeting

1.       Strengthening the link between budgeting and key gender budgeting and key gender equality objectives

2.       Gender budgeting should be sustainable beyond political cycles.

3.       Incorporate gender equality into over-arching budget framework, with leadership from central budget authority.

4.       Embedding gender budgeting tools at the stages of budget cycles.

5.       Underpining gender budgeting with strong data and analysis.

6.       Capacity building

7.       Reinforce govt. transparency and accountability

 Measures of govt deficit

 

Fiscal deficit

Difference between total revenue and total expenditure of the govt is called fiscal deficit.

·         It indicates total borrowings needed by the govt

·         Borrowings are not included while calculating total revenue

·         A fiscal deficit can be funded by-

o   Issuing govt bonds

o   Increasing taxes

o   Running down foreign exchange reserves

What happens if govt runs a fiscal deficit for an extended period?

Debt accumulates>> Inflation may increase

 

Is having a fiscal deficit a good sign for an economy?

Having a fiscal deficit for a developing nation means a good thing. It is important to finance better infrastructure and develop resources for the developing economy. It is also important to invest in skill formation and healthcare facility of the population for developing the human resource of the country. This fiscal deficit helps to improve the income of the population in the future hence developing the economy in the long run.

 

Fiscal deficit= Total expenditure – Total receipt

Gross fiscal deficit= Total expenditure – Total receipt excluding borrowings

Total receipts= revenue receipts + non-debt creating capital receipts + debt – creating capital receipts

Gross fiscal deficit= Total expenditure – (Revenue receipt + Non debt creating capital receipts)

 

Net fiscal deficit

·         Gross Fiscal Deficit – Net Domestic Lending

·         The Central govt makes capital disbursement as loans to the different segments of the economy

Primary deficit

·         Indicates the borrowing requirements of the govt, excluding interest

·         It does not include the total interest payment made.

Primary deficit = Fiscal deficit – Interest payments (of previous borrowings)

Fiscal deficit = Total expenditure – Total income of the govt

A shrinking primary deficit indicates progress towards fiscal health.

Primary deficit is decreasing>>

Less money is being borrowed>>

Economy has progressed

Revenue deficit

(It does not include the capital part)

The excess if expenses over receipts on revenue account is called revenue deficit.

Revenue deficit= Revenue expense- Revenue receipts

This includes those transactions that have a direct impact on the govt’s current income and expenditure.

It happens when the actual amount of revenue and /or the actual amount of spending do not correspond with the budgeted revenue and expenditure. 

 It is desired to make Revenue Deficit ‘zero’.

 

Effective Reverse Deficit

Grants for creation of capital assets (Centre can give grants to states so that can build their schools and hospitals).

This concept was introduced in Fiscal Responsibility and Budget Management Act, 2003 through the amendment in 2012.

It became financial indicator in 2012-13.

Effective Revenue Deficit signifies that amount of capital receipts that are being used for actual consumption expenditure by the govt.

The Act defines grants for creation of capital assets as grants-in-aid given by the central govt to state govt, autonomous bodies, local bodies, and other scheme implementing agencies for creation of capital assets which are owned by these entities.

Effective Revenue Deficit= Revenue Deficit – Grants in aid for capital assets

Grants in aid for capital assets: They contribute to development in an economy, hence, are productive. However, revenue deficits are considered unproductive. Therefore, the economy should strive to make Effective Revenue Deficit ‘zero’ and not the ‘Total revenue deficit’.

 

Budget Deficit	Monetized Deficit
It is that part of the govt’s deficit which is financed through short term borrowings.	Also known as net reserve bank credit to the govt, is that part of the govt deficit which is financed totally by borrowing from the RBI.
This money may be from the RBI or the other sources.

 Fiscal Responsibility and Budget Management Act (FRBM), 2003

Purpose of the Act: To ensure fiscal discipline.

It sets targets including reduction of fiscal deficits and elimination of revenue deficit.

It was a major legal step taken in the direction of fiscal consolidation of India.

The FRBM Act maintains a balance between govt and govt expenditure.

 

FRBM Act intended to bring:

1.       Fiscal deficit

2.       Efficient management of expenditure, revenue and debt.

3.       Macro-economic stability

4.       Better coordination between fiscal and monetary policy

5.       Transparency in fiscal operation of the govt

6.       Achieving a balanced budget

`Why was the FRBM Act needed?

During 1990s and the early 2000s, the borrowings level were very high. It has led to high fiscal deficit, high revenue deficit, and high debt-to-GDP ratio.

The high govt borrowing and the resultant debt had severely impacted the health of the Indian economy.

Moreover, the borrowings were more to pay interest than for any capital formation, which means we were on the verge of falling into a debt trap.

 

The main objectives of the Act were:

·         To introduce transparent fiscal management systems in the country.

·         To introduce a more equitable and manageable distribution of the country’s debts over the years.

·         To aim for fiscal stability for India in the long run.

·         The act gave flexibility to the RBI for managing inflation in India.

 

Fiscal indicators

·         Fiscal deficit at the % of GDP

·         Revenue deficit as a % of GDP

·         Primary deficit as a % of GDP

·         Tax revenue as a % of GDP

·         Non-tax revenue as a % of GDP

·         Central govt debt as a % of GDP

 

Initial FRBM targets (There targets were scheduled to be met by 2008-9)

Revenue Deficit (RD):

RD should be completely eliminated by 2009. The minimum annual reduction target was 0.5% of GDP.

Fiscal Deficit (FD):

FD should be reduced to 3% of GDP by 2009. The minimum annual reduction target was 0.3% of GDP.

Contingent Liabilities:

The Central govt shall not give incremental guarantees aggregating an amount exceeding 0.5% of GDP in any financial year beginning 2004-5.

Additional Liabilities:

Additional Liabilities should be reduced to 9% of the GDP by 2004-5. The minimum annual reduction target each subsequent year to be 1% of GDP.

RBI purchase of govt. bonds:

To cease from 1 April 2006. This indicates the govt not to borrow directly from the RBI.

The targets were not achieved:

So, the act was amended first in 2012 and then in 2015 to relax the realization of fiscal targets.

FRBM Act, 2003

 

N. K. Singh committed recommendations

Central govt believed that the targets are too rigid. So, it set up a committee under N. K. Singh to review the FRBM Act.

Targets: The committee suggested using debt as the primary target for fiscal policy and that the target must be achieved by 2023.

Fiscal council: The Committee proposed to create an autonomous Fiscal Council with a chairperson and two members appointed by the Centre ( not employees of the govt at the time of appointment).

Deviations: The committee suggested that the grounds for to govt to deviate from the FRBM Act targets should be clearly specified.

Borrowings: According to the suggestions of the committee, the govt must not borrow from the RBI, except when:

·         The centre has to meet a temporary shortfall in receipts

·         RBI subscribes to govt securities to finance any deviations

·         RBI purchases govt securities from the secondary market

 

Latest FRBM targets:

Fiscal deficit:

·         The central govt shall take appropriate measures to limit the fiscal deficit upto 3% of GDP by 2021.

·         The Central govt shall ensure that the general govt debt not exceed 60%.

·         The Central govt. Debt does not exceed 40% of GDP by the end of financial year 2024-25.

·         The Central govt. does not give additional guarantees with respect to any loan on security of the Consolidated Fund of India in excess of 0.5% of GDP, in any financial year.

 

FRBM Escape Clause:

The FRBM Act also allows invoking of an escape clause in situation of calamity and national security. In such situation, the govt can deviate from its annual fiscal deficit target.

Initial FRBM targets:

Additional liabilities:

Additional liabilities should be reduced to 9% of GDP by 2004-5. The minimum annual reduction target in each subsequent year to be 1% of GDP.

RBI purchase of govt bonds

To cease from 1 April 2006. This indicates the govt not to borrow directly from the RBI.

The targets were not achieved:

So, the Act was amended first in 2012 and then in 2015 to relax the realization of the fiscal deficit.

Fiscal Responsibility and Budget Management Act, 2003

The FRBM Act is a low enacted by the GoI in 2003 to ensure fiscal discipline: by setting targets including reduction of fiscal deficits and elimination of revenue deficit.

 It is considered as one of the major legal steps taken in the direction of fiscal consolidation in India.

FRBM Act is all about maintaining a balance between govt revenue and govt expenditure. This intention of the Act was to bring:

1.       Fiscal discipline

2.       Efficient management of expenditure, revenue and debt.

3.       Macroeconomic stability

4.       Better coordination between fiscal and monetary policy

5.       Transparency in the fiscal operation of the govt.

6.       Achieving a balanced budget

 

What was the FRBM Act needed?

During 1990s, and the early 2000s, the borrowing levels were very high. It had led to high fiscal deficit, high revenue deficit, and high debt-to-GDP ratio.

The high govt borrowing and the resultant debt had severely impacted the health of the Indian economy.

Moreover, the borrowings were more to pay interest than for any capital formation which means we were on the verge of falling into a debt trap.

 Internal Debt

·         It is the money that the govt borrows from its own citizens.

·         The govt borrows by issuing the govt bonds and t-bills.

·         When govt borrows form the domestic sources, the increases in inflation is less in comparison to simply printing the money.

 

Internal debt is categorized into marketable and non-marketable securities

·         Marketable govt securities include G-secs and T-Bills issued through auction. (A person can sell it to another).

·         Non-marketable securities include intermediate treasury bills issued to state govt and special securities issued to national Small Savings Fund among others. (State govt can’t sell it to another).

 

External debt

 

·         It refers to money borrowed from a source outside the country. It has to be paid back in the currency in which it is borrowed.

·         It can be obtained from foreign commercial banks, international financing institutions like IMF, World Bank, ADB etc and from the govt of foreign nations.

Over the years, the Union govt has followed a considered strategy to reduce its dependencies on foreign loans in its overall loan mix.

Internal debt constitutes more than 93% of the overall public debt.

External loans are not market loans. They have been raised from institutional creditors at concessional rates. Most of the external loans are fixed  rate loans, free from interest rate or currency volatility.

 

Monetary policy

Tools to implement monetary policy

·         Adjustment in interest rates

·         Purchase or sale of govt securities

·         Changing the amount of cash circulating in the economy

Monetary policy is a set of tools that a nation’s central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation’s banks, its consumers, and its businesses.

Fiscal policy	Monetary policy
Fiscal policy is nothing but money policy of the govt, i.e., generation of money and expenditure of money.	It is concerned with supply money, i.e., controlling inflation and ensuring liquidity.
It has two sides- income and expenditure	It is about supply and demand
It is generally formulated by the executive, i.e., the ministry of finance	It is formulated by Central banks of a country, eg. RBI
Its main tool is budget through which govt tried to bring dynamism in the economy.	It has its own tools like Repo rate, Revere repo rate, OMO, etc
Expenditure reforms: FRBM Act Income side reforms: GST	Monetary Policy Reforms- Monetary committee

 

Monetary Policy

The RBI in India’s monetary authority responsible for monetary policy. This responsibility is explicitly mandated under the RBI Act, 1934.

The monetary policy dept of the RBI assists the Monetary Policy Committee (MPC) in formulating the monetary policy of the nation.

For this, the RBI uses a variety of tools to carry out monetary policy, including OMO, bank rate policy, reserve system, credit control policy, and moral persuasion.

Objectives of Monetary Policy

Monetary policy is concerned with making money available to the market at reasonable rates and in sufficient quantities at the appropriate time in order to achieve

·         Price stability

·         Accelerating the growth of the economy

·         Exchange rate stabilization

·         Balancing savings and investments

·         Generating employment

·         Financial stability

 

Types of Monetary Policy

Expansionary Monetary Policy	Contractionary Monetary Policy
Increase economic growth	Decrease economic growth
During COVID	During economic boom
Interest rates lower >>  Money supply increases >>  Demand increases >> Production increases >>  Employment increases	Interest rates rise >> Money supply decreases >> Demand decreases >>  Production decreases >>  Employment decreases
Dove-ish stance of RBI	Hawk-ish stance of RBI

 

Expansionary policy

An expansionary policy boosts economic activity during slow downs or recessions.

It increases the total money supply in an economy.

The money supply in the economy is increased by lowering the general interest rates on loans and other forms of debt.

When there are low-interest rates, people tend to save less, and consumer spending and borrowing increase. Thus, it is used to stimulate economic growth.

 

Contractionary policy

Contractionary policy decreases the total supply of money in the economy by increasing the interest rates.

It is used to reduce prices caused by an excess money supply.

The primary goal for monetary policy is to maintain price stability, while keeping growth in mind. Price stability is a pre-requisite for long term growth. To maintain price stability, inflation must be kept under control.

Every five years, the Indian govt sets an inflation target. The RBI plays an important role in the consultation process for inflation targeting.

The current inflation-targeting framework in India is flexible in nature.

 

The Monetary Policy Framework

In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.

 Monetary Policy

·         Monetary Policy Instruments (MPI)

·         Monetary Policy Committee (MPC)

·         Monetary Policy Process (MPP)

·         Monetary Policy Framework (MPF)

·         Flexible Inflation Targeting Framework (FITF)

Under Section 45ZA, the Central Govt in consultation with RBI, determines the inflation target in terms of the CPI once in 5 year and notifies in the official gazette.

Section 45ZB of the RBI Act provides for the constitution of a six-member Monetary Policy Committee (MPC) to determine the policy rate required to achieve the inflation.

Current Inflation Target

The Central govt has notified 4% CPI inflation as the target for the period from Aug 5, 2016 to March 31, 2021, with the upper tolerance limit of 6% and the lower tolerance limit of 2%.

On March 31, 2021, the Central govt retained the inflation target and the tolerance band for the next 5-year period- April 1, 2021 to March 31, 2026.

The Central govt has notified the following as the factors that constitute failure to achieve the inflation target.

a.       The average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters.

b.       The average inflation is less than the lower tolerance level for any three consecutive quarters.

If these conditions are not met then RBI is supposed to have failed.

 

The Monetary Policy Framework

Where the Bank fails to meet the inflation target, it shall sell our in a report to the Central govt.

·         The reasons for failure to achieve the inflation target.

·         Remedial actions proposed to be taken by the bank.

·         An estimate of time period within which the inflation target shall be achieved pursuant to timely implementation of proposed remedial action.

 

The Monetary Policy Committee

Section 45ZB of the amended RBI Act, 1934 provides for an empowered 6 member Monetary Policy Committee (MPC) to be constituted by the Central govt by notification in the official gazette. The first such MPC was constituted on Sept 29,2016.

The MPC determines the policy repo rate required to achieve inflation target.

The MPC is required to meet at least four times in a year. The quorum for the meeting of the MPC is four members.

Each member of the MPC has one vote, and in the event of equality of votes, the govt. has a second or casting vote.

Each member of the MPC writes a statement specifying the reasons for voting in favour of, or against proposed resolution.

To meet inflation targets, there is the MPC. It determines the policy interest rate required to achieve the inflation target.

The RBI’s Monetary Policy Dept (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy and analytical work of the RBI contribute to the process of arriving at the decision of the policy repo rate.

The Financial Markets Operations Dept (FMOD) operationalizes the monetary policy, mainly through day-to-day liquidity management operations.

The Financial Market Committee (FMC) meets daily to review the liquidity conditions so as to ensure the operating target of monetary policy (weighted average lending rate) is to keep close to the policy repo rate. The parameter is also known as the Weighted Average Call Money Rate (WACR). 

Instruments of Monetary Policy

Basis	Quantitative Instruments	Qualitative Instruments
Meaning	They affect the overall supply of money/credit in the economy	They regulate the direction of credit
Alternative name	Traditional methods of control	Selective methods of control
Instruments	Bank rate Repo rate Reverse Repo rate Open Market Operation Cash Reserve Ratio Statutory Liquidity Ratio	Marginal requirements Moral suasion Selective credit control

 

 

Cash Reserve Ratio (CRR)

It is the amount of money that the banks have to keep with the RBI in cash form. The cash reserve either stored in the bank’s vault or is sent to RBI.

The cash balance that is to be maintained by the scheduled banks with the RBI should not be less than such percent of its NDTL that the RBI can notify from time to time in the Gazette of India.

In terms of Section 42 (1) of the RBI, 1934, the RBI in regard to the needs of security the monetary stability in the country, prescribed SCBs without any floor or ceiling rate.

Banks have to maintain cash balances with the RBI to meet the prescribed CRR on average during the fortnight, subject to daily cash balances not falling below 90% of the amount required for CRR.

RBI does not pay interest on deposits held by banks to meet the CRR, even the deposits are in excess of minimum required by RBI. CRR, hence, effectively increase cost of deposits to the banking sector.

NDTL refers to the total demand and time liabilities (deposits that are held by the banks of public and with other banks).

The CRR to be calculated on the basis of DTL, with a lag of one fortnight, i.e., on the reporting Friday, the DTL as at the end of the previous fortnight will form the basis for CRR calculation.

Main components of DTL are:

 ·         Demand Deposits (held in current and savings accounts, margin money for LCs, overdue fixed deposits, etc.)

·         Time Deposits (fixed deposits, recurring deposits, reinvestment deposits, etc.)

·         Overseas borrowings

·         Foreign outward remittances in transit

·         Other demand and time liabilities (accrued interest, credit balances in suspense account, etc.)

Statutory Liquidity Ratio (SLR)

Every bank must have a specified portion of their NDTL in the form of cash, gold, or other liquid assets by the day’s end. The ratio of these liquid assets to the NDTL is called SLR.

The RBI can increase this ratio by up to 40%. When this ratio increases, the bank can inject lesser money into the economy.

Section 24 and Section 56 of the Banking Regulation Act, 1949, mandates all scheduled commercial banks, local area banks, Primary (Urban) Co-operative banks (UCBs), state co-operative banks and Central cooperative banks in India to maintain SLR.

RBI employs SLR regulations to have control over the bank credit. SLR ensures that there is solvency in commercial banks and assures that banks invest in govt securities.

RBI raises SLR to control the bank credit during the time of inflation. Similarly, it decreases the SLR during the time of recession to increase bank credit.