Monetary Policy in India

Topics: Monetary policy, Central bank, Inflation Pages: 8 (2632 words) Published: April 13, 2011
MONETARY POLICY Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being expansionary, or a contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and a contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. Monetary policy is contrasted with fiscal policy, which refers to: taxation, government spending, and associated borrowing. Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.


Objectives and Framework
In India, the objectives of monetary policy evolved as maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. With progressive liberalisation and increasing globalisation of the economy, maintaining orderly conditions in the financial markets emerged as an additional policy objective. Thus, monetary policy in India endeavours to maintain a judicious balance between price stability, economic growth and financial stability. The monetary policy framework in India from the mid-1980s till 1997-98 can be characterized as a monetary targeting framework on the lines recommended by Chakravarty Committee (1985). Because of the reasonable stability of the money demand function, the annual growth in broad money (M3) was used as an intermediate target of monetary policy to achieve the final objectives. Monetary management involved working out M3 growth consistent with projected GDP growth and a tolerable level of inflation. In practice, however, the monetary targeting approach was used in a flexible manner with ‘feedback’ from the developments in the real sector. For example, if the real GDP growth was expected to be higher, M3 projection was revised upwards. In the 1990s, the increasing market orientation of the financial system and greater capital inflows imparted instability to the money demand function. Consequently, there was a shift to multiple indicators approach in the late 1990s. Under this approach, interest rates or rates of return in different markets along with movements in currency, credit, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange – available on a high frequency basis – are juxtaposed with output data for drawing policy perspectives. The multiple indicators approach continued to evolve and was augmented by forward looking indicators and a panel of parsimonious time series models. The forward looking indicators are drawn from the Reserve Bank’s industrial outlook survey, capacity utilization survey,...
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