Monetary Policy

The Reserve Bank of India drafts the Monetary Policy, which influences interest rates, the availability of credit, business operations, and growth opportunities. It is derived from financial instruments and mechanisms. In this article, we cover what monetary policy is, its objectives, types, and how it is implemented.

What is Monetary Policy?

Monetary policy is part of a macroeconomic government policy drafted by the Reserve Bank of India. This policy covers measures taken to regulate the volume of credit created by the banks, the use of monetary instruments under the control of the central bank to achieve price stability, financial stability, and adequate availability of credit for growth. With greater digitalisation, individuals can also open a bank account online to access credit and banking services more easily, aligning with the RBI’s broader objective of financial inclusion.

What are the objectives of monetary policy?

The primary objectives of monetary policy are:

Price Stability – Keeping the general price level low and stable to preserve the currency’s purchasing power. Instability in prices creates uncertainty, discourages investment, and hinders sustainable economic growth. This is achieved by controlling inflation through setting interest rates and managing the money supply.

Full Employment – High unemployment can lead to economic instability and hardship for individuals. Monetary policy aims to reduce the level of unemployment by stimulating investment and production, which creates more jobs.

Economic Growth - Fostering sustainable, long-term economic expansion and development by ensuring sufficient availability of credit and money to key sectors of the economy.

Financial Stability – The RBI, through its monetary policy, works to maintain stability in financial markets, preventing systemic risks and supporting resilience in times of crisis.

Exchange Rate and External Value – The policy framework also involves stabilizing the external value of the rupee and facilitating stable foreign exchange conditions within the broader goal of macroeconomic stability.

Types of Monetary Policy

RBI drafts two types of monetary policy: Expansionary Monetary Policy and Contractionary Monetary Policy.

What is Expansionary Monetary Policy

Also referred to as Monetary Policy, the objective of Expansionary Monetary Policy is to increase the money supply in the economy through measures such as:

• Decreasing interest rates – It makes it less expensive for consumers to borrow money, thus increasing the money supply in the market.
• Reducing reserve requirements for banks – It leaves commercial banks with more money to lend to the public, which infuses more money into the economy.
• Purchasing government securities by central banks – The RBI buys government securities by paying cash. This means that the money available in the market increases.
• Economic Growth – This policy stimulates business activities and consumer spending and also helps to lower unemployment rates.

What is Contractionary Monetary Policy?

This policy is used to decrease the amount of money supply in the economy through measures such as:

• Raising interest rates – It makes it more expensive for consumers to borrow money, thus reducing the money supply in the market.
• Increasing the reserve requirements for banks -  It leaves commercial banks with less money to lend to the public, thus reducing the money supply in the economy.
• Selling bonds – The buyers of government securities pay cash to the RBI. This means that the money available in the market decreases.

Instruments of Monetary Policy

RBI uses different tools to draft the monetary policy to control the money supply, which can be categorized into two categories:

Quantitative Tools (controlling the cost and quantity of credit)

1. Open market Operation (OMO) - Buying and selling government securities to manage liquidity in the economy.
2. Bank rate - Adjusting the rate at which the RBI lends long-term funds to commercial banks, influencing lending rates.
3. Cash Reserve Ratio (CRR) – Requiring banks to keep a fixed percentage of deposits with RBI, reducing or increasing funds available for lending.
4. Statutory Liquidity Ratio (SLR) – Mandating banks to maintain a portion of deposits in liquid assets like cash, gold, or approved securities.
5. Liquidity adjustment facility (LAF) – Using repo and reverse repo operations to manage short-term liquidity and interest rates.

Qualitative Tools (controlling the use and direction of credit)

1. Publicity – Issuing guidelines and sharing policy intentions to influence the lending behaviour of banks.
2. Rationing of Credit – Restricting or capping the amount of credit flow to specific sectors.
3. Adjusting the margin of loan – Modifying the margin requirement to regulate how much banks can lend against securities.
4. Adjusting rate on Consumption Loan – Altering interest rates on loans for consumer goods to influence demand.
5. Moral suasion - Persuading banks through meetings or advisories to align with RBI’s policy objectives.
6. Direct action – Imposing penalties or restrictions on banks that do not comply with RBI’s policy objectives.

Monetary Policy Committee (MPC) of RBI: Role, Functions, and Composition

The Monetary Policy Committee (MPC), set up in 2016 under the RBI Act, is a statutory body that decides India’s benchmark interest rates. Its core mandate is to maintain price stability (inflation target of 4% ±2%) while fostering economic growth.

The MPC has six members: three from the RBI and three external experts appointed by the Central Government.

• RBI Governor: Chairperson with a casting vote.
• RBI Deputy Governor (Monetary Policy): Provides policy insights.
• One RBI official nominated by the Central Board.
• Three external members: Independent economists/finance experts, serving four years (non-renewable).

Decisions require a majority vote with at least four members present. Minutes of each meeting are published for public record.

How are monetary policy decisions made and implemented?

Once the Monetary Policy Committee finalises its decision, the RBI follows a structured process to implement it:

1. Announce the decision – The RBI publishes the outcome and rationale through a Monetary Policy Statement and press release.
2. Issue instructions – Circulars are sent to banks and financial institutions with details of rate changes and effective dates.
3. Adjust policy rates – Reop, reverse repo, and other rates are updated in the system and communicated to markets.
4. Manage Liquidity – The RBI conducts open market operations and repos to align market rates with the new stance.
5. Support transmission – It monitors whether banks pass on the changes and takes corrective steps if needed.
6. Track impact – Market indicators and inflation trends are reviewed, and reports are published for transparency.

Conclusion: The Future of Monetary Policy in India

The Reserve Bank of India, through its monetary policy, balances price stability with economic growth. As global and domestic conditions evolve, the Monetary Policy Committee will remain central to decision-making. For individuals, staying resilient during such shifts also means building a strong financial base. Choosing a DBS Bank Savings Account can help manage funds efficiently while the RBI works to ensure long-term financial stability.