Table of contents

Introduction

3 4 5 10 12 12

Approach and tools of RBI to monetary control Instruments for monetary control

Institutional Mechanism for Monetary Policy-making Conclusion Bibliography

Introduction
Monetary policy refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit. The goal is to achieve specific economic objectives, such as low and stable inflation and promoting growth. One of the most important functions of central banks is formulation and execution of monetary policy. In the Indian context, the basic functions of the Reserve Bank of India as enunciated in the Preamble to the RBI Act, 1934 are: to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. Thus, the Reserve Banks mandate for monetary policy flows from its monetary stability objective. The main objectives of monetary policy in India are: Maintaining price stability Ensuring adequate flow of credit to the productive sectors of the economy to support economic growth Financial stability Over time, the objectives of monetary policy in India have evolved to include maintaining price stability,ensuring adequate flow of credit to productive sectors of the economy for supporting economic growth, and achieving financial stability. Based on its assessment of macroeconomic and financial conditions, the Reserve Bank takes the call on the stance of monetary policy and monetary measures. Its monetary policy statements reflect the changing circumstances and priorities of the Reserve Bank and the thrust of policy measures for the future.Faced with multiple tasks and a complex mandate, the Reserve Bank emphasises clear and structured communication for effective functioning of the monetary policy. Improving transparency in its decisions and actions is a constant endeavour at the Reserve Bank. The Governor of the Reserve Bank announces the Monetary Policy in April every year for the financial year that ends in the following March. This is followed by three quarterly reviews in July, October and January. However, depending on the evolving situation, the

Reserve Bank may announce monetary measures at any point of time. The Monetary Policy in April and its Second Quarter Review in October consist of two parts: Part A provides a review of the macroeconomic and monetary developments and sets the stance of the monetary policy and the monetary measures. Part B provides a synopsis of the action taken and the status of past policy announcements together with fresh policy measures. It also deals with important topics, such as, financial stability, financial markets, interest rates, credit delivery, regulatory norms, financial inclusion and institutional developments.

Approach and tools of RBI to monetary control

The operating framework of RBI is based on a multiple indicator approach. This means that they monitor and analyse the movement of a number of indicators including interest rates, inflation rate, money supply, credit, exchange rate, trade, capital flows and fiscal position, along with trends in output as we develop our policy perspectives. To achieve its objectives RBI uses various tools in forms of direct and indirect instruments. It utilizes usch tolls from time to time to control the monetary flow in the economy and ultimately to regulate the economy. The Reserve Banks Monetary Policy Department (MPD) formulates monetary policy. The Financial Markets Department (FMD) handles day-to-day liquidity management operations. There are several direct and indirect instruments that are used in the formulation and implementation of monetary policy. The Reserve Bank traditionally relied on direct instruments of monetary control such as Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Cash Reserve Ratio indicates the quantum of cash that banks are required to keep with the Reserve Bank as a proportion of their net demand and time liabilities. SLR prescribes the amount of money that banks must invest in securities issued by the government. In the late 1990s, the Reserve Bank restructured its operating framework for monetary policy to rely more on indirect instruments such as Open Market Operations (OMOs). In addition, in the early 2000s, the Reserve Bank instituted Liquidity Adjustment Facility (LAF) to manage day-to-day liquidity in the banking system. These facilities enable injection or absorption of liquidity that is consistent with the prevailing monetary policy stance.The repo rate (at which liquidity is injected) and reverse repo rate (at which liquidity is absorbed) under the LAF have emerged as the main instruments for the Reserve Banks interest rate signalling in the
3

Indian economy. The armour of instruments with the Reserve Bank to manage liquidity was strengthened in April 2004 with the Market Stabilisation Scheme (MSS). The MSS was specifically introduced to manage excess liquidity arising out of huge capital flows coming to India from abroad. In addition, the Reserve Bank also uses prudential tools to modulate the flow of credit to certain sectors so as to ensure financial stability. The availability of multiple instruments and their flexible use in the implementation of monetary policy have enabled the Reserve Bank to successfully influence the liquidity and interest rate conditions in the economy. While the Reserve Bank prefers indirect instruments of monetary policy, it has not hesitated in taking recourse to direct instruments if circumstances warrant such actions. Often, complex situations require varied combination of direct and indirect instruments to make the policy transmission effective. The recent legislative amendments to the Reserve Bank of India Act, 1934 enable a flexible use of CRR for monetary management, without being constrained by a statutory floor or ceiling on the level of the CRR. The amendments to the Banking Regulation Act, 1949 also provide further flexibility in liquidity management by enabling the Reserve Bank to lower the SLR to levels below the pre-amendment statutory minimum of 25 per cent of net demand and time liabilities (NDTL) of banks.

Instruments for monetary control

Cash Reserve Ratio Every commercial bank has to keep certain minimum cash reserves with RBI. Consequent upon amendment to sub-Section 42(1), the Reserve Bank, having regard to the needs of securing the monetary stability in the country, RBI can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate ( [Before the enactment of this amendment, in terms of Section 42(1) of the RBI Act, the Reserve Bank could prescribe CRR for scheduled banks between 5% and 20% of total of their demand and time liabilities]. RBI uses this tool to increase or decrease the reserve requirement depending on whether it wants to effect a decrease or an increase in the money supply. An increase in Cash Reserve Ratio (CRR) will make it mandatory on the part of the banks to hold a large proportion of their
4

deposits in the form of deposits with the RBI. This will reduce the size of their deposits and they will lend less. This will in turn decrease the money supply. At the times of inflation in the economy when there is more money in the market, the RBI uses this tool in a way to restrict the banks to lend the money (as their limit to lend is decreased) and hence monetary flow in the economy is regulated.

Statutory Liquidated Ratio Statutory Liquidity Ratio refers to the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers. Here approved securities mean, bond and shares of different companies. Statutory Liquidity Ratio is determined and maintained by the Reserve Bank of India in order to control the expansion of bank credit. It is determined as percentage of total demand and percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers on there anytime demand. it is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form of gold,cash or other approved securities.Thus, we can say that it is ratio of cash and some other approved liabilities(deposits).It regulates the credit growth in India. The maximum limit of SLR is 40% and minimum limit of SLR is 23%. The RBI can increase the Statutory Liquidity Ratio to contain inflation, suck liquidity in the market, to tighten the measure to safeguard the customers money. In a growing economy banks would like to invest in stock market, not in Government Securities or Gold as the latter would yield less returns. One more reason is long term Government Securities (or any bond) are sensitive to interest rate changes. But in an emerging economy interest rate change is a common activity.

Refinance facility This Reserve Bank of India often provides monetary help to the sector specific banks. At times of crisis in any sector specific bank, the RBI owing the need of financing of such bank at its discretion provides financial help to such banks. For example, recently RBI has announced lines of credit worth Rs 5, 000 crore to the Export-Import Bank of India (Exim
5

Bank) to further on-lend to the export sector. This is because the tight position of credit market has also impacted Exim Bank that is facing difficulties in raising foreign currency funds to support exporters. The refinance facility by the apex regulator will ease the bank to extend foreign currency lines of credit to the exporters. RBI will provide funds in rupee which Exim Bank will swap in dollars and thereby disburse credit to the exporters.

Liquidity Adjustment Facility (LAF) Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity.The introduction of Liquidity adjustment facility in India was on the basis of the recommendations of Narsimham committee on banking sector reforms. In April 1999, an interim LAF was introduced to provide a ceiling and the fixed rate repos were continued to provide a floor for money market rates. .LAF consists of repo and reverse repo operations

Repo rate Repo means repurchase agreement. When RBI repurchases his issued govt. securities, it is called Repo transaction. With Repo transaction, RBI increases the liquidity in the market. Bank gets money for selling Govt. securities to RBI. These money can be used for loan issues to public. So, this way, liquidity will increase in the market. Always, Repo transaction is carried at repo rate which is changed by RBI from time to time. This repo rate is just like interest rate. Increase in repo rate, signals that deposit and advance rates of banks are likely to increase. Decrease in repo rate, indicates that deposit and advance rates of banks are likely to decline. Reverse repo Reverse Repo means reverse repurchase agreement. Actually, central bank RBI has power to issue the Govt. securities. But these securities are exchanged between bank and RBI from time to time. When RBI sells govt. securities to banks, it is called a reverse repo transaction. RBI will take decision to sell Govt. securities when RBI wants to absorb or decrease the liquidity in the market.An increase in Reverse repo rate can cause the banks to transfer more
6

funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system.

Open Market Operations (OMO): An open market operation is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy. The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation. The two
traditional type of OMOs used by RBI:

1. Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent). 2. Repurchase agreement (REPO): Is short term, and are subject to repurchase.[9]

Marginal Standing Facility (MSF) The Reserve Bank of India in its monetary policy for 2011-12, introduced the marginal standing facility (MSF), under which banks could borrow funds from RBI at 8.25%, which is 1% above the liquidity adjustment facility-repo rate against pledging government securities. The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Banks can borrow funds through MSF when there is a considerable shortfall of liquidity. This measure has been introduced by RBI to regulate short-term asset liability mismatches more effectively. The banks can borrow overnight from RBI at this rate.

Bank Rate RBI lends to the commercial banks through its discount window to help the banks meet depositors demands and reserve requirements for long term . The interest rate the RBI
7

charges the banks for this purpose is called bank rate. If the RBI wants to increase the liquidity and money supply in the market, it will decrease the bank rate and if RBI wants to reduce the liquidity and money supply in the system, it will increase the bank rate. As of 25 June 2012 the bank rate was 9 .0%

Market Stabilisation Scheme (MSS): Following the recommendations of Working Group of RBI on Instruments of Sterilisation (December 2003), the Government of India confirmed its intention to strengthen the RBI in its ability to conduct exchange rate and monetary management operations to maintain stability in the foreign exchange market and enable RBI to conduct monetary policy in accordance with its stated objectives. The scheme has been proposed in that background.

The intention of introducing MSS is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilisation from the day-to-day normal liquidity management operations. The total absorption of liquidity from the system by the Reserve Bank will continue to be in line with the monetary policy stance from time to time and accordingly, the liquidity absorption will get apportioned among the instruments of LAF, MSS and Other Market Operations(OMOs).

RBI proposed to the Govt to authorise issuance of existing debt instruments, viz., Treasury Bills and Dated Securities up to a specified ceiling to be mutually agreed upon between the Govt and the RBI by way of an MoU under the Market Stabilisation Scheme (MSS). The bills/bonds issued under MSS would have all the attributes of the existing Treasury Bills and dated securities.

The bills and securities will be issued by way of auctions to be conducted by the Reserve Bank. The Reserve Bank will decide and notify the amount, tenure and timing of issuance of such treasury bills and dated securities. Whenever such securities are issued by the Reserve Bank for the purpose of market stabilisation and sterilisation, a press release at the time of issue would indicate such purpose. For the present, the total outstanding obligations of the

Government by way of bills/securities thus issued under the MSS from time to time would not exceed Rs. 60,000 crore. The bills and securities issued for the purpose of MSS would be matched by an equivalent cash balance held by the Government with the Reserve Bank. Thus, there will only be a marginal impact on revenue and fiscal deficits of the Government to the extent of interest payment on bills/securities outstanding under the MSS. Further, the cost would be shown separately in the Budget. This would add transparency to the cost of sterilisation.

Institutional Mechanism for Monetary Policy-making

The Reserve Bank has made internal institutional arrangements for guiding the process of monetary policy formulation. Financial Markets Committee (FMC) Constituted in 1997, the inter-departmental Financial Markets Committee is chaired by the Deputy Governor in-charge of monetary policy formulation. Heads of various departments dealing with markets, and the head of the Monetary Policy Department (MPD) are its members. They meet every morning and review developments in money, foreign exchange and government securities markets. The FMC also makes an assessment of liquidity conditions and suggests appropriate market interventions on a day-to-day basis. Monetary Policy Strategy Group The Monetary Policy Strategy Group is headed by the Deputy Governor incharge of MPD. The group comprises Executive Directors (EDs) in-charge of different markets departments and heads of other departments. It generally meets twice in a quarter to review monetary and credit conditions and takes a view on the stance of the monetary policy. Technical Advisory Committee (TAC) on Monetary Policy The Reserve Bank had constituted a Technical Advisory Committee (TAC) on Monetary Policy in July 2005 with a view to strengthening the consultative process in the conduct of monetary policy. This TAC reviews macroeconomic and monetary developments and advises the Reserve Bank on the stance of the monetary policy and monetary measures that may be
9

undertaken in the ensuing policy reviews. The Committee has, as its members, five external experts and two Directors from the Reserve Banks Central Board. The external experts are chosen from the areas of monetary economics, central banking, financial markets and public finance. The Committee is chaired by the Governor, with the Deputy Governor incharge of monetary policy as the vice-chairman. The other Deputy Governors of the Reserve Bank are also members of this Committee. The TAC normally meets once in a quarter, although a meeting could be convened at any other time, if necessary. The role of the TAC is advisory in nature. The responsibility, accountability and time path of the decision making remains entirely with the Reserve Bank. Pre-Policy Consultation Meetings The Reserve Bank aims to make the policy making process consultative, reaching out to a variety of stakeholders and experts ahead of each Monetary Policy and quarterly Review. From October 2005, the Reserve Bank has introduced pre-policy consultation meetings with the Indian Banks Association (IBA), market participants, representatives of trade and industry, credit rating agencies and other institutions, such as, urban co-operative banks, micro-finance institutions, small and medium enterprises, non-banking finance companies, rural cooperatives and regional rural banks. In order to further improve monetary policy communication, the Governor also meets economists, journalists and media analysts. These meetings focus on macroeconomic developments, liquidity position, interest rate environment and monetary and credit developments. This consultative process contributes to enriching the policy formulation process and enhances the effectiveness of monetary policy measures. Resource Management Discussions The Reserve Bank holds Resource Management Discussions (RMD) meetings with select banks about one and a half months prior to the announcement of the Monetary Policy and the Second Quarter Review. These discussions are chaired by the Deputy Governor in-charge of monetary policy formulation. These meetings mainly focus on perception and outlook of bankers on the economy, liquidity conditions, credit outflows, developments in different market segments and the direction of interest rates. Bankers offer their suggestions for the policy. The feedback received from these meetings is analysed and taken as inputs while formulating monetary policy.

10

Conclusion
After going through the various functions performed by RBI, we can safely conclude that this institution holds the nerves of Indian economy. The monetary control of the RBI is very wide and it exercises its power to regulate the monetary perspective of the country. Being the head bank of the country, it regulates the functions of all other banks to control the flow of money in the economy through various policies framed from time to time. It has certain instruments through which it regulates the economy of the country. It uses such instruments and revises them from to time with changing condition of the economy to keep the economy on track. Hence, we can safely conclude that the monetary authority of RBI is the most important function performed by RBI.

Bibliography
1. L.C.Goyle, Law of Banking and Bankers, (Eastern Law House: New Delhi, 1995). 2. M. Hapgood, Pagets Law of Banking, (Butterworths: London, 1992). 3. M.L.Tannan, Tannans Banking Law and Practice in India, (21stEdn.,Wadhwa& Co:

Nagpur: 2005). 4. Official site of RBI http://www.rbi.org.in

11