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What is the Monetary Policy?

The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy. These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.

When is the Monetary Policy announced?

Historically, the Monetary Policy is announced twice a year - a slack season policy (AprilSeptember) and a busy season policy (OctoberMarch) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year.

What are the objectives of the Monetary Policy?

The objectives are to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy. Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while the financial markets are also impacted through short-term implications.

Terms related to monetary policy

Cash reserve ratio Statutory liquidity ratio Bank rate Inflation Money supply Repo rate Open market operation

A case for easing monetary policy in India

In January 2007, a meeting with all bank chiefs , the Finance Minister requested them to soften interest rates, so as to maintain the current growth rates. While oil prices continue to move upwards, Central Banks have to exercise their monetary policy levers by keeping a balance between the - growth and inflation.

In early 2007, with inflation threatening to touch 7% and the Government facing coalition uncertainty,RBI was facing a difficult situation. The rising inflation in the early part of the year, coupled with the surge in foreign investments, both FDI and FPI, resulting in rising forex reserves raised major concerns within both the RBI and the Government.

The RBI responded with a series of monetary tightening measures. The repo rate (at which RBI lends to banks) rose to 7.75%. the CRR went up to 7.5%.

This monetary tightening has yielded results in the last six months, as inflation has been brought down below 4%. This means the RBI should ease the monetary controls and encourage investment. It is the time for aggressively cutting rates. A loose monetary policy which is essential for sustaining the high 9-10% growth rates.

The US and Europe are easing their monetary policy out of compulsions arising from the sub-prime mortgage related credit squeeze and the imminent dangers of a recession. In an increasingly integrated global economy, any US recession and low interest rates presents a great opportunity for India to sustain high economic growth without inflationary pressures.

A hard landing in the US and recession elsewhere in the developed world, will cause a fall in global aggregate demand, which will adversely affect the export-led growth economies. This will in turn dampen global oil, energy, food, and other commodity prices, and force down inflationary trends and lower import costs.

1. Low interest rates are critical for sustaining the rapidly increasing investment rate. Indian economic growth is extremely interest rate sensitive. The limitations imposed on accessing external borrowings, also increases the dependence on local bank credit.

A recession in the US and elsewhere will reduce consumption demand and hence lower aggregate demand, which in turn is likely to put downward pressure on import prices. 6. In the event of a recession in the US causing drop in FII inflows into emerging markets, a loose monetary policy could help provide the internal thrust to sustain and stabilize the stock markets.

In the event of a capital flight into emerging markets, low interest rates will reduce the incentives for financial market distortions that could encourage undesirable, hot money inflows. By making rupee investments less attractive compared to the other currencies, low interest rates will reduce capital inflows and thereby control the exchange rate appreciation of rupee.

A low rate will leave the RBI with enough flexibility to maneuver without compromising on growth concerns, when the economy starts overheating. The prevailing high interest rate regime had crowded in the overwhelming share of domestic savings into bank deposits, and crowded out the development of alternate investment avenues in the financial markets. A low rate regime could provide the opportunity for development of such market.

A lower rate will ease the demand for External Commercial Borrowings, which crossed $30 bn in 2007. While ECBs are to be welcomed as a source of investment alternatives, an over reliance on them, especially on certain categories, can have harmful medium and long term implications .

The low interest rates will give a fillip to consumption growth as hire purchase and home loan markets will go up. The importance of the consumption driven growth multiplier for the economy is enormous. x