Monetary policy deals with management and supply of money and credit in the economy.
It refers to the actions of a central bank or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates and economic growth.
It is so designed to maintain the price stability and direct economic growth in the economy.
In India, the central monetary authority is the Reserve Bank of India (RBI).
The RBI announces a credit policy every periodically, which aims to balance economic growth through actions by increasing the interest rate, or changing repo rates (rates at which the RBI lends to banks in the short run) and reverse repo rates (rates at which banks lend to the RBI.)
Objectives of a monetary policy review
The main objective of a monetary policy review is to attain economic growth, price stability, trade balance and exchange rate stability.
Why is it necessary to review?
Often, inflation in an economy like India spirals out of control. In such cases it is necessary for the RBI to tame inflation by increasing repo rates, which generally nudge interest rates upward.
When interest rates move up, people borrow less and hence it is possible to reign in inflation.
However, inflation cannot be controlled only by monetary measures, as there could be supply side issues. The problem with controlling inflation using monetary tools, is that it invariably hits growth.
So, when the RBI increases repo rates to fight inflation, it increases interest rates, which could slow economic growth.
The predicament central banks face during a monetary policy review is how to balance growth and inflation.
Reducing interest rates could spur growth, but could lead to inflation. On the other hand increasing rates could lower inflation, but reduce growth rates in an economy, as people borrow less when interest rates are high.
The other tools that are used include the cash reserve ratio (CRR), which is used by the RBI to control liquidity pressures in the banking system.
When there is a severe liquidity crunch in the banking system the RBI cuts the cash reserve ratio (a proportion of bank deposit aggregates that banks have to keep with the RBI).
When this requirement is reduced it infuses fresh liquidity into the banking system. The CRR rate at present is 4.75%, a 50 basis points cut leads to infusion into the banking system
Statutory Liquidity Ratio (SLR) is also a vital tool for RBI, where in the financial institution must maintain liquid assets such as precious metals like gold or other approved securities as reserves other than the cash with the RBI.
The reduction in SLR will infuse liquidity and boost the economic growth. Recently, the RBI cut SLR by 100 basis points to 23% to increase liquidity that can help bankers cut lending rates.