General Studies IIIEconomyRBI

Monetary Policy Committee (MPC)

About Monetary Policy Committee (MPC):

  • The Monetary Policy Committee (MPC) is a committee constituted by the Reserve Bank of India and led by the Governor of RBI. 
  • The Monetary Policy Committee is responsible for fixing the benchmark interest rate (repo rate) to restrain inflation within the particular target level.
  • The meetings of the Monetary Policy Committee are held at least 4 times a year (specifically, at least once BIMONTHLY) and it publishes its decisions after each such meeting.
  • The committee comprises six members –
    • three officials of the Reserve Bank of India and
    • three external members nominated by the Government of India. They need to observe a “silent period” seven days before and after the rate decision for “utmost confidentiality”.
    • The Governor of Reserve Bank of India is the chairperson ex officio of the committee. Decisions are taken by majority with the Governor having the casting vote in case of a tie.
  • The current mandate of the committee is to maintain 4% annual inflation until 31 March 2021 with an upper tolerance of 6% and a lower tolerance of 2%.
  • The Reserve Bank of India Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC which will bring more transparency and accountability in fixing India’s Monetary Policy.
  • The monetary policy are published after every meeting with each member explaining his opinions. The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive quarters

Establishment and purpose

  • Key decisions pertaining to benchmark interest rates used to be taken by the Governor of Reserve Bank of India alone prior to the establishment of the committee. The Governor of RBI is appointed and can be disqualified by the Government anytime. This led to uncertainty and resulted in friction between the Government and the RBI, especially during the times of low growth and high inflation. Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets and public finance advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in nature.
  • The setting up of a committee to decide on Monetary Policy was first proposed by the Urjit Patel Committee. The Committee suggested a five-member MPC – three members from the RBI and two nominated by the Government. The Government initially proposed a seven-member committee – three from the RBI and four nominated by it. Subsequent negotiations led to the current composition of the committee, with the external members having a four-year term.
  • The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy. Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate. The Financial Markets Operations Department (FMOD) operationalises the monetary policy, mainly through day-to-day liquidity management operations. The Financial Markets Committee (FMC) meets daily to review the liquidity conditions so as to ensure that the operating target of monetary policy (weighted average lending rate) is kept close to the policy repo rate. Monetary Policy Committee came into force on 27 June 2016.

Committee related to MPC

  • YV Reddy committee proposed to establish a MPC in 2002,
  • Then Tarapore committee in 2006,
  • Percy Mistry committee in 2007,
  • Raghuram Rajan committee in 2009
  • and then Urjit Patel Committee in 2013.

Objectives of Monetary Policy

Monetary Policy was implemented with an initiative to provide reasonable price stability, high employment, and a faster economic growth rate. The major four objectives of the Monetary Policy are mentioned below:

  1. To stabilize the business cycle.
  2. To provide reasonable price stability.
  3. To provide faster economic growth.
  4. Exchange Rate Stability.

Instruments of monetary policy of RBI

RBI uses various instruments of monetary policy for achieving the inflation target. These can be categorised into quantitative instruments and qualitative instruments.

1.    Quantitative instruments used by RBI

Quantitative instruments are the general tools of monetary policy which are used to control the quantity of money supply in the market. The quantitative tools are also known as general tools of credit control which are indirect in nature and are used to influence the quantity of credit in the economy.

  • Liquidity adjustment facility- liquidity adjustment facility is used to inject or absorb liquidity from the market using repo rate and reverse repo rate. The repo rate injects liquidity in the market, while the reverse repo rate absorbs the liquidity from the economy.
  • Repo rate (repurchase agreement rate)- repo rate is the interest rate at which RBI provides funds to commercial banks for short periods of time against the guarantee of government securities. The RBI purchases government bonds at a fixed rate from the banks with an agreement to sell them back at the at the fixed date. The government securities can include long term treasury notes ( 2 to 30 years) or short term treasury bills (91 days, 182 days or 364 days). The main objective of the repo rate is to inject liquidity in the market. Reduction in repo rate makes cheaper for banks to borrow money which ultimately reduces the interest rates charged by banks on their loans.
  • Reverse repo rate- it is the interest rate at which RBI borrows funds from the commercial banks for short periods. It is used as a tool to absorb liquidity from the banking system. Banks use this facility by depositing their extra funds with RBI and earn interest on it. Increasing the reverse repo rate, RBI reduces liquidity from the banking system.
  • Cash reserve ratio (CRR)- it refers to the certain proportion of deposits in the form of cash which all the scheduled commercial banks and cooperative banks are required to deposit with RBI. This feature comes from the section 42(1) of Reserve Bank of India Act, 1934. Banks do not earn interest from RBI on these deposits. The present cash reserve ratio is 4%. All the banks have to maintain a minimum cash reserve ratio up to 95% of their average daily required CRR. If banks fail to maintain these reserves, RBI charges an interest rate of 3% above the bank rate on the amount by which the bank reserves fall short.
  • Statutory liquidity ratio- It refers to the minimum proportion of total Net Demand and Time Liabilities in the form of liquid assets such as gold, government securities, approved securities etc that every bank has to maintain. This amount has to be maintained with the banks itself and is not required to be deposited with RBI. The current statutory liquidity ratio as 19.5%. The RBI has the authority to increase the statutory liquidity ratio to a maximum of 40%.
  • Bank rate- it refers to the interest rate at which the Reserve Bank of India provides long term loans to the commercial bank, cooperative banks, and Development Banks etc. It is a long term measure of RBI to control money supply in the market. Collateral is not required by the banks for borrowing money under the bank rate. Collateral securities are required for borrowing under the repo rate. Also, the bank rate is higher than the repo rate. The current bank rate is 6.5 %.
  • Marginal standing Facility- it is the new window created by RBI under its credit policy of May 2011. Under this facility, the banks can borrow funds from RBI by pledging government securities within the limits of the statutory liquidity ratio. Whereas, under the repo rate facility, banks pledge government securities above the statutory liquidity ratio. The interest rate charged is 1% above the repo rate. The maximum borrowing limit is up to 1% of the net demand and time liabilities of the bank. The minimum amount is rupees one crore and it’s multiples thereof.
  • Open market operations- it refers to the actions of purchase and sale of government securities by the Reserve Bank of India. RBI sells government securities in the market to suck out excess liquidity (rupee) from the economy. In case of liquidity crunch, RBI buys government securities from the market which increases liquidity in the economy.
  • Bank base rate-it is the minimum interest rate at which the banks can give the loan to its customers. Banks cannot lend money to its customers below the base rate except in cases allowed by the RBI. Bank base rate was introduced by RBI from 1st July 2011 as the new benchmark rate for lending operations of banks. It was introduced to bring transparency in the bank lending rates of the banking system.

2.    Qualitative instruments

Qualitative instruments are used by RBI for discriminating between different uses of credit. It can be used to discriminate by favouring exports over imports, or essential credit supply over nonessential lendings. It is not directed towards the quality of credit supply.

  • Marginal requirement- It refers to the proportion of loan which the borrower has to raise in order to get finance for his purpose. RBI can increase the marginal requirements for those activities for which credit supply is to be restricted.
  • Rationing of credit- RBI can put a maximum limit on loans and advances that can be made by banks for specific categories. This method of rationing is used for checking credit flow, particularly for speculative activities.
  • Direct action- RBI has the authority to take direct strict action against any bank if it refuses to obey the directions given by RBI. RBI can put restrictions on advancing loans on such banks.
  • Moral suasion- it refers to the request and suggestions of Reserve Bank of India to the banks to take certain actions as per the emerging trends of the economy. It is mainly an informal and psychological means of credit control. RBI can ask the commercial banks not to give certain kinds of loans and advances.

The Monetary Policy Framework (MPF)

While the Government of India sets the Flexible Inflation Targeting Framework in India, it is the Reserve Bank of India (RBI) which operates the Monetary Policy Framework of the country.

  • The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to operate the monetary policy framework of the country.
  • The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation, and modulation of liquidity conditions to anchor money market rates at or around the repo rate.
  • Note: Repo rate changes transmit through the money market to the entire financial system, which, in turn, influences aggregate demand – a key determinant of inflation and growth.
  • Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating target – the weighted average call rate (WACR) – around the repo rate.

Use of Monetary Policy

  • Monetary Policy is the process of regulating the supply of money in an economy by the monetary authority of the country. 
  • The Monetary Policy, generally, adjusts the inflation rates or interest rates to sustain the price stability and to maintain the predictable exchange rates with foreign currencies. 
  • The Reserve Bank of India is the central banking authority of India, which controls the monetary policy in conjunction with the central government’s developmental agenda. 
  • The Reserve Bank of India is authorized to make monetary policy under the Reserve Bank of India Act, 1934.
  • Monetary policy is either contractionary or expansionary and is often seen separate from the fiscal policy which deals with taxation, spending by government, and borrowing. 
  • When the total money supply is increased rapidly than normal, it is called an expansionary policy, while a slower increase or even a decrease of the same refers to a contractionary policy.


Source: RBI


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