Monetary Policy Objectives for Economic Stability and Growth

Monetary policy is a critical economic tool central banks use to manage and control a country’s economy. It is essential to comprehend how central banks manage economic conditions and respond to fluctuations. The blog will help you understand the objectives and instruments of monetary policy. Get a comprehensive understanding of the instruments and objectives of India’s Monetary Policy. Check out how the Reserve Bank of India uses these tools to control inflation, ensure economic growth, and maintain financial stability.

Content

• Meaning of Monetary Policy
• Key Highlights of RBI Monetary Policy
• Objectives of Monetary Policy in India
• Monetary Policy Instruments
• Challenges in Implementing Monetary Policy
• Key Takeaways

Meaning of Monetary Policy

Monetary policy is a financial tool used by a country’s central bank (RBI in India) to control the money supply. This policy helps to promote sustainable economic growth through strategically planned goals. 

Monetary policy regulates macroeconomic factors such as inflation and unemployment to help manage a country’s economy and ensure financial stability.

The above diagram suggests how the central banks contribute towards improving the economy. 

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D.C. Rowan, an Australian economist who has authored several books on macroeconomics, suggests –

“The monetary policy is defined as a discretionary act undertaken by the authorities designed to influence –

1. The supply of money
2. Cost of money or rate of interest
3. Availability of money for achieving specific objectives.

Key Highlights of RBI Monetary Policy (2024-2025)

Objectives of Monetary Policy in India

Listed below are the major objectives of the monetary policy in India –

Regulation of Money Supply in the Economy

Monetary policy is designed to regulate the money supply in the economy by credit expansion or credit contraction. 

• Credit expansion – With credit expansion, which means issuing more loans, banks can expand the money supply.
• Credit contraction – With credit contraction, meaning giving fewer loans, banks can limit the money supply. 

Reserve Bank of India aims to control the money supply to meet economic growth needs and contracts it to curb inflation.

Attaining Price Stability

A primary objective of monetary policy in India is to maintain price stability, which means controlling inflation. The money supply affects the price level. Monetary policy regulates the money supply to maintain price stability. 

Promoting Economic Growth

The monetary policy aims to make money and credit available for the country’s economic growth. Those sectors significant for economic growth are provided with adequate credit availability. 

Encouraging Savings and Investments

Monetary policy promotes saving and investment by regulating the interest rate and checking inflation. Higher interest rates promote saving and investment. 

Controlling Business Cycles

Monetary policy controls booms and depressions, the main phases of the business cycle. In the boom period, credit is contracted to reduce the money supply and thus check inflation. In the depression period, credit is expanded to increase the money supply and thus promote aggregate demand in the economy. 

Promoting Employment

The monetary policy promotes employment by providing concessional loans to productive sectors, small and medium entrepreneurs, and special loan schemes for unemployed youth. 

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Promoting Exports and Substituting Imports

Monetary policy encourages such industries by providing concessional loans to export-oriented and import-substitution units. It also helps to improve the balance of payments. 

Managing Aggregate Demand

Monetary authority tries to balance aggregate demand with the aggregate supply of goods and services. If aggregate demand is to increase, credit expands, and the interest rate comes down. Because of low interest rates, more people take loans to buy goods and services, increasing aggregate demand and vice versa. 

Ensuring More Credit for the Priority Sector

Monetary policy aims to provide more funds to priority sectors by lowering interest rates for these sectors. The priority sector includes agriculture, small-scale industry, and weaker sections of society. 

Developing Infrastructure

Monetary policy aims at developing infrastructure. It provides concessional funds for developing infrastructure. 

Regulating and Expanding Banking

RBI regulates the economy’s banking system and has expanded banking to all parts of the country. Through monetary policy, RBI issues directives to different banks to set up rural branches to promote agricultural credit. The government has also set up cooperative and regional rural banks. 

Monetary Policy Instruments

 

Open Market Operations

Open market operations involve the sale and purchase of securities in the money market by the country’s central bank. When prices go up and the need to control them arises, the central bank sells securities. This reduces the reserves of commercial banks, and they cannot lend more to businesses or individuals.

Changes in Reserve Ratios

Cash Reserve Ratio (CRR) – The percentage of total deposits a bank must have in cash for a risk-free operation.

Statutory Liquidity Ratio (SLR) – An obligatory reserve that commercial banks must maintain as approved securities per a specific percentage of the net demand and time liabilities.

Repo Rate

Repo Rate is the rate at which the central bank lends short-term money to the banks against securities. A reduction in the repo rate helps banks get money cheaper, while an increase in the repo rate discourages banks from getting money as it will cost more.

Bank Rate

Bank rate also called the discount rate, is the interest rate that a central bank charges on its loans to commercial banks. Commercial banks can borrow from the central bank when they need funds, and the rate at which they borrow is the bank rate. 

By lowering the discount rate, the central bank encourages banks to borrow more, increasing the money supply. Raising the discount rate has the opposite effect.

Reverse Repo Rate

The reverse repo rate is the interest rate at which the central bank borrows money from commercial banks. It provides a return to commercial banks for their surplus funds deposited with the central bank. A higher reverse repo rate means that commercial banks get a higher return on their deposits, which can encourage them to deposit more funds with the central bank, reducing the money supply in the economy.  

Challenges in Implementing Monetary Policy

Though implementing monetary policy is crucial for governments, they do face some challenges. Check them out -

External Economic Shocks:

Examples: Global oil price fluctuations and the COVID-19 pandemic negatively affected India's economy.

Challenge: These external financial shocks often affect inflation and exchange rates, and make it difficult to implement or adjust the monetary policy.

Inflationary Pressures:

Example: Food price volatility in India due to monsoon dependency.

Challenge: High inflation impacts the economy, but controlling it without affecting growth is not easy.

Coordination with Fiscal Policy:

Example: If the fiscal deficit is high, mainly because of excessive government borrowings, this can be in conflict with RBI's monetary goals.

Challenge: If monetary and fiscal policy happens to be misaligned, its effectiveness gets diluted.

Transmission of Policy Rates:

Example: Even when RBI has lowered its interest rates, because of very high NPAs, banks may not pass it down to consumers.

Challenge: Since banks wont be able to pass down lower interest rates to the consumers, it would limit the effectiveness of monetary policy in stimulating demand.

Global Economic Integration:

Example: Capital outflows during global crises impact the value of the rupee.

Challenge: It is a challenge to manage currency exchange rates while maintaining domestic economic stability.

Dual Objectives:

Example: Balancing inflation control and economic growth can be conflicting goals.

Challenge: Achieving both objectives simultaneously is often tricky.

Key Takeaways

1. Price Stability: Price stability is one of the central objectives of monetary policy. The RBI manipulates the money supply to ensure that prices are stable and that the cost of living is under control.

2. Economic Growth: The RBI induces production and investments by providing credit to major sectors and industries, leading to sustainable economic growth.

3. Facilitates Saving and Investment: Monetary policy impacts interest rates, influencing saving and investment habits. Increased interest rates induce individuals to save more, whereas lower rates can stimulate investments.

4. Boosts Employment: The monetary policy stimulates employment by channelling credit to employment-generating sectors such as MSMEs and infrastructure.

5. Targets Sectoral Growth and Infrastructure Development: The policy especially targets priority sectors like rural development, small industries, and agriculture. It enables these sectors to receive concessional credit to help with inclusive growth and construct necessary infrastructure.