Monetary PolicyAccording to Prof. Harry Johnson,"A policy employing the central banks control of the supply of money as an instrument forachieving the objectives of general economic policy is a monetary policy."Meaning of monetary policyMonetary policy is the management of money supply and interest rates by central banks toinfluence prices and employment. Monetary policy works through expansion or contraction ofinvestment and consumption expenditure. Monetary policy is the process by which thegovernment, central bank (RBI in India), or monetary authority of a country controls:(i) The supply of money(ii) Availability of money(iii) Cost of money or rate of interestIn order to attain a set of objectives oriented towards the growth and stability of the economy.Monetary theory provides insight into how to craft optimal monetary policy.Monetary policy is referred to as either being an expansionary policy, or a contractionary policy,where an expansionary policy increases the total supply of money in the economy, and acontractionary policy decreases the total money supply. Expansionary policy is traditionally usedto combat unemployment in a recession by lowering interest rates, while contractionary policyinvolves raising interest rates in order to combat inflation. Monetary policy is contrasted withfiscal policy, which refers to government borrowing, spending and taxation.Credit policy is notonly a policy concerned with changes in the supply of credit but it can be and is much more thanthis.Credit is not merely a matter of aggregate supply, but becomes more important factor sincethere is also issue of its allocation among competing users. There are various sources of creditand other aspects of credit that need to be looked into are its cost and other terms and conditions,duration, renewal, risk of default etc. Thus the potential domain of credit policy is very wide.Where currency is under a monopoly of issuance, or where there is a regulated system of issuingcurrency through banks which are tied to a central bank, the monetary authority has the ability to
alter the money supply and thus influence the interest rate in order to achieve policygoals.Monetary policy, also described as money and credit policy, concerns itself with the supplyof money as so of credit to the economyObjectives of Monetary PolicyThe objectives of a monetary policy in India are similar to the objectives of its five year plans. Ina nutshell planning in India aims at growth, stability and social justice. After the Keynesianrevolution in economics, many people accepted significance of monetary policy in attainingfollowing objectives. 1. Rapid Economic Growth 2. Price Stability 3. Exchange Rate Stability 4. Balance of Payments (BOP) Equilibrium 5. Full Employment 6. Neutrality of Money 7. Equal Income DistributionThese are the general objectives which every central bank of a nation tries to attain by employingcertain tools (Instruments) of a monetary policy. In India, the RBI has always aimed at thecontrolled expansion of bank credit and money supply, with special attention to the seasonalneeds of a credit.
Let us now see objectives of monetary policy in detail :- 1. Rapid Economic Growth : It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability. 2. Price Stability : All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy suffers from recession the monetary policy should be an easy money policy but when there is inflationary situation there should be a dear money policy. 3. Exchange Rate Stability : Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. 4. Balance of Payments (BOP) Equilibrium : Many developing countries like India suffers from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the BOP Surplus and the BOP Deficit. The former reflects an excess money supply in the domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. 5. Full Employment : The concept of full employment was much discussed after Keyness publication of the "General Theory" in 1936. It refers to absence of involuntary unemployment. In simple words Full Employment stands for a situation in which
everybody who wants jobs get jobs. However it does not mean that there is a Zero unemployment. In that senses the full employment is never full. Monetary policy can be used for achieving full employment. If the monetary policy is expansionary then credit supply can be encouraged. It could help in creating more jobs in different sector of the economy.6. Neutrality of Money : Economist such as Wicksted, Robertson have always considered money as a passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized on the ground that if money supply is kept constant then it would be difficult to attain price stability.7. Equal Income Distribution : Many economists used to justify the role of the fiscal policy is maintaining economic equality. However in resent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.When is the Monetary Policy announced? Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles.These cycles also coincide with the halves of the financial year.Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves. Its right to alter it from time to time, depending on the state of the economy. However, with the share of credit to agriculture coming down and credit towards the industry, being granted whole year around, the RBI since 1998-99 has moved
in for just one policy in April end. However a review of the policy does take place later in the year.INSTRUMENT IN MONETORY POLICYThe instrument of monetary policy are tools or devise which are used by the monetaryauthority in order to attain some predetermined objectives. There are two types ofinstruments of the monetary policy as shown below.A) Quantitative Instruments or General Tools ↓The Quantitative Instruments are also known as the General Tools of monetary policy. Thesetools are related to the Quantity or Volume of the money. The Quantitative Tools of creditcontrol are also called as General Tools for credit control. They are designed to regulate orcontrol the total volume of bank credit in the economy. These tools are indirect in nature and areemployed for influencing the quantity of credit in the country. The general tool of credit controlcomprises of following instruments. 1. Bank Rate Policy (BRP)The Bank Rate Policy (BRP) is a very important technique used in the monetary policy forinfluencing the volume or the quantity of the credit in a country. The bank rate refers to rate atwhich the central bank (i.e RBI) rediscounts bills and prepares of commercial banks or providesadvance to commercial banks against approved securities. It is "the standard rate at which thebank is prepared to buy or rediscount bills of exchange or other commercial paper eligible forpurchase under the RBI Act". The Bank Rate affects the actual availability and the cost of thecredit. Any change in the bank rate necessarily brings out a resultant change in the cost of creditavailable to commercial banks. If the RBI increases the bank rate than it reduce the volume ofcommercial banks borrowing from the RBI. It deters banks from further credit expansion as it
becomes a more costly affair. Even with increased bank rate the actual interest rates for a shortterm lending go up checking the credit expansion. On the other hand, if the RBI reduces the bankrate, borrowing for commercial banks will be easy and cheaper. This will boost the creditcreation. Thus any change in the bank rate is normally associated with the resulting changes inthe lending rate and in the market rate of interest. However, the efficiency of the bank rate as atool of monetary policy depends on existing banking network, interest elasticity of investmentdemand, size and strength of the money market, international flow of funds, etc. 2. Open Market Operation (OMO)The open market operation refers to the purchase and/or sale of short term and long termsecurities by the RBI in the open market. This is very effective and popular instrument of themonetary policy. The OMO is used to wipe out shortage of money in the money market, toinfluence the term and structure of the interest rate and to stabilize the market for governmentsecurities, etc. It is important to understand the working of the OMO. If the RBI sells securitiesin an open market, commercial banks and private individuals buy it. This reduces the existingmoney supply as money gets transferred from commercial banks to the RBI. Contrary to thiswhen the RBI buys the securities from commercial banks in the open market, commercial bankssell it and get back the money they had invested in them. Obviously the stock of money in theeconomy increases. This way when the RBI enters in the OMO transactions, the actual stock ofmoney gets changed. Normally during the inflation period in order to reduce the purchasingpower, the RBI sells securities and during the recession or depression phase she buys securitiesand makes more money available in the economy through the banking system. Thus under OMOthere is continuous buying and selling of securities taking place leading to changes in theavailability of credit in an economy.However there are certain limitations that affect OMO viz; underdeveloped securities market,excess reserves with commercial banks, indebtedness of commercial banks, etc.
3. Variation in the Reserve Ratios (VRR)The Commercial Banks have to keep a certain proportion of their total assets in the form of CashReserves. Some part of these cash reserves are their total assets in the form of cash. Apart ofthese cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity andcontrolling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR)and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial banksnet demand and time liabilities which commercial banks have to maintain with the central bankand SLR refers to some percent of reserves to be maintained in the form of gold or foreignsecurities. In India the CRR by law remains in between 3-15 percent while the SLR remains inbetween 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out achange in commercial banks reserves positions. Thus by varying VRR commercial banks lendingcapacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves ofcommercial banks and thus it can affect the banks credit creation multiplier. RBI increases VRRduring the inflation to reduce the purchasing power and credit creation. But during the recessionor depression it lowers the VRR making more cash reserves available for credit expansion. (B) Qualitative Instruments or Selective Tools ↓The Qualitative Instruments are also known as the Selective Tools of monetary policy. Thesetools are not directed towards the quality of credit or the use of the credit. They are used fordiscriminating between different uses of credit. It can be discrimination favoring export overimport or essential over non-essential credit supply. This method can have influence over thelender and borrower of the credit. The Selective Tools of credit control comprises of followinginstruments.
1. Fixing Margin RequirementsThe margin refers to the "proportion of the loan amount which is not financed by the bank". Orin other words, it is that part of a loan which a borrower has to raise in order to get finance forhis purpose. A change in a margin implies a change in the loan size. This method is used toencourage credit supply for the needy sector and discourage it for other non-necessary sectors.This can be done by increasing margin for the non-necessary sectors and by reducing it for otherneedy sectors. Example:- If the RBI feels that more credit supply should be allocated toagriculture sector, then it will reduce the margin and even 85-90 percent loan can be given. 2. Consumer Credit RegulationUnder this method, consumer credit supply is regulated through hire-purchase and installmentsale of consumer goods. Under this method the down payment, installment amount, loanduration, etc is fixed in advance. This can help in checking the credit use and then inflation in acountry. 3. PublicityThis is yet another method of selective credit control. Through it Central Bank (RBI) publishesvarious reports stating what is good and what is bad in the system. This published informationcan help commercial banks to direct credit supply in the desired sectors. Through its weekly andmonthly bulletins, the information is made public and banks can use it for attaining goals ofmonetary policy.
4. Credit RationingCentral Bank fixes credit amount to be granted. Credit is rationed by limiting the amountavailable for each commercial bank. This method controls even bill rediscounting. For certainpurpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can helpin lowering banks credit expoursure to unwanted sectors. 5. Moral SuasionIt implies to pressure exerted by the RBI on the indian banking system without any strict actionfor compliance of the rules. It is a suggestion to banks. It helps in restraining credit duringinflationary periods. Commercial banks are informed about the expectations of the central bankthrough a monetary policy. Under moral suasion central banks can issue directives, guidelinesand suggestions for commercial banks regarding reducing credit supply for speculative purposes. 6. Control Through DirectivesUnder this method the central bank issue frequent directives to commercial banks. Thesedirectives guide commercial banks in framing their lending policy. Through a directive thecentral bank can influence credit structures, supply of credit to certain limit for a specificpurpose. The RBI issues directives to commercial banks for not lending loans to speculativesector such as securities, etc beyond a certain limit. 7. Direct Action
Under this method the RBI can impose an action against a bank. If certain banks are not adheringto the RBIs directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBImay refuse credit supply to those banks whose borrowings are in excess to their capital. Centralbank can penalize a bank by changing some rates. At last it can even put a ban on a particularbank if it dose not follow its directives and work against the objectives of the monetary policy.These are various selective instruments of the monetary policy. However the success of thesetools is limited by the availability of alternative sources of credit in economy, working of theNon-Banking Financial Institutions (NBFIs), profit motive of commercial banks andundemocratic nature off these tools. But a right mix of both the general and selective tools ofmonetary policy can give the desired results.Obstacles In Implementation of Monetary Policy ↓Through the monetary policy is useful in attaining many goals of economic policy, it is not freefrom certain limitations. Its scope is limited by certain peculiarities, in developing countries suchas India. Some of the important limitations of the monetary policy are given below.1. There exist a Non-Monetized SectorIn many developing countries, there is an existence of non-monetized economy in large extent.People live in rural areas where many of the transactions are of the barter type and not monetarytype. Similarly, due to non-monetized sector the progress of commercial banks is not up to themark. This creates a major bottleneck in the implementation of the monetary policy. 2. Excess Non-Banking Financial Institutions (NBFI)
As the economy launch itself into a higher orbit of economic growth and development, thefinancial sector comes up with great speed. As a result many Non-Banking Financial Institutions(NBFIs) come up. These NBFIs also provide credit in the economy. However, the NBFIs do notcome under the purview of a monetary policy and thus nullify the effect of a monetary policy. 3. Existence of Unorganized Financial MarketsThe financial markets help in implementing the monetary policy. In many developing countriesthe financial markets especially the money markets are of an unorganized nature and inbackward conditions. In many places people like money lenders, traders, and businessmanactively take part in money lending. But unfortunately they do not come under the purview of amonetary policy and creates hurdle in the success of a monetary policy. 4. Higher Liquidity Hinders Monetary PolicyIn rapidly growing economy the deposit base of many commercial banks is expanded. Thiscreates excess liquidity in the system. Under this circumstances even if the monetary policyincreases the CRR or SLR, it dose not deter commercial banks from credit creation. So theexistence of excess liquidity due to high deposit base is a hindrance in the way of successfulmonetary policy. 5. Money Not Appearing in an EconomyLarge percentage of money never come in the mainstream economy. Rich people, traders,businessmen and other people prefer to spend rather than to deposit money in the bank. This
shadow money is used for buying precious metals like gold, silver, ornaments, land and inspeculation. This type of lavish spending give rise to inflationary trend in mainstream economyand the monetary policy fails to control it. 6. Time Lag Affects Success of Monetary PolicyThe success of the monetary policy depends on timely implementation of it. However, in manycases unnecessary delay is found in implementation of the monetary policy. Or many timestimely directives are not issued by the central bank, then the impact of the monetary policy iswiped out. 6. Monetary & Fiscal Policy Lacks CoordinationIn order to attain a maximum of the above objectives it is unnecessary that both the fiscal andmonetary policies should go hand in hand. As both these policies are prepared and implementedby two different authorities, there is a possibility of non-coordination between these two policies.This can harm the interest of the overall economic policy.These are major obstacles in implementation of monetary policy. If these factors are controlledor kept within limit, then the monetary policy can give expected results. Thus though themonetary policy suffers from these limitations, still it has an immense significance in influencingthe process of economic growth and development.Reforms in the Indian Monetary Policy During 1990s
The Monetary policy of the RBI has undergone massive changes during the economic reformperiod. After 1991 the Monetary policy is disassociated from the fiscal policy. Under the reformperiod an emphasis was given to the stable macro economic situation and low inflation policy.The major changes in the Indian Monetary policy during the decade of 1990. 1. Reduced Reserve Requirements : During 1990s both the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) were reduced to considerable extent. The CRR was at its highest 15% plus and additional CRR of 10% was levied, however it is now reduced by 4%. The SLR is reduced form 38.5% to a minimum of 25%. 2. Increased Micro Finance : In order to strengthen the rural finance the RBI has focused more on the Self Help Group (SHG). It comprises small and marginal farmers, agriculture and non-agriculture labour, artisans and rural sections of the society. However still only 30% of the target population has been benefited. 3. Fiscal Monetary Separation : In 1994, the Government and the RBI signed an agreement through which the RBI has stopped financing the deficit in the government budget. Thus it has seperated the Monetary policy from the fiscal policy. 4. Changed Interest Rate Structure : During the 1990s, the interest rate structure was changed from its earlier administrated rates to the market oriented or liberal rate of interest. Interest rate slabs are now reduced up to 2 and minimum lending rates are abolished. Similarly, lending rates above Rs. Two lakh are freed. 5. Changes in Accordance to the External Reforms : During the 1990, the external sector has undergone major changes. It comprises lifting various controls on imports, reduced tariffs, etc. The Monetary policy has shown the impact of liberal inflow of the foreign capital and its implication on domestic money supply. 6. Higher Market Orientation for Banking : The banking sector got more autonomy and operational flexibility. More freedom to banks for methods of assessing working funds and other functioning has empowered and assured market orientation.
ANALYTICS OF MONETARY POLICY IN INDIA SINCE INDEPENDENCEIntroductionVery useful insights on the causes and events that shaped the direction and pace of an event canbe gained by studying its evolutionary process. It is also useful in guiding the current actions andfuture plans. This logic tempts to undertake a purposeful analytical review of policy trends in thesphere of monetary policy in India, since Independence. Over the last five decades, the conductof monetary policy in India has undergone sharp transformation and the present mode ofmonetary policy has evolved over time with numerous modifications. In this chapter, we shalltrace the evolution of institutional arrangements, changes in the policy framework, objectives,targets and instruments of monetary policy in India in the light of shifts in theoreticalunderpinnings and empirical realities. This will serve as a useful guide for the empirical analysisin the following chapters. The discussion on the historical developments of monetary policy inIndia can be carried out with different ways of periodisation. Our method of periodisation isprimarily based on the policy environment. Based on the policy framework, broadly two distinctregimes can be delineated in the monetary policy history of India, since Independence. The firstregime refers to the credit-planning era followed since the beginning upto the mid-1980s. Thesecond is the regime started with adoption of money-multiplier framework, implemented as perrecommendations of Chakravarty Committee (RBI 1985). However, both the regimes commandappropriateness underthe circumstances and institutional structure existed during the respective periods. Inthe first regime, there was a shift towards a tightly regulated regime for bank creditand interest rates since the mid-1960s with emergence of a differential and regulatedinterest rate regime since 1964, adoption of the philosophy of social control in analytics ofmonetary policy in india December 1967, the event bank nationalisation in 1969, increasingdeficit financing by the government, etc. Similarly, The post-Chakravarty Committee regimealso can be separated into two sub-periods distinguished by the event of economic reforms of1991-92. There was a radical shift from direct to indirect instruments and emergence of a broad,
deep and diversified financial market, with prevalence of greater autonomy, in the post-reformperiod. Thus, the whole period since Independence can be divided into four subperiods in ourdiscussion on the historical development of monetary policy in India.They are (i) Initial Formative Period, which extends since Independence upto 1963,(ii) Period of High Intervention (Regulation) and Banking Expansion with socialcontrol since 1964 to 1984, (iii) New Regime of Monetary Targeting with PartialReforms, from 1985 to 1991, and (iv) Post-Reform Period with Financial Deepening,since 1992.2.2 - Initial Formative Period (1947-1963)Prior to the Independence, the broad objectives of monetary policy in Indiacould be classified as (a) issue of notes, acting in national interest by curtailingexcessive money supply and to overcome stringency where it mitigated productionactivities, (b) public debt management, and (c) maintaining exchange value of theRupee. In the initial days of Independence, there were some challenges for monetaryoperations due to the event of partition and consequent division of assets of RBI, andits responsibility of currency and banking management in the transitory phase in thetwo new Dominions. In Independent India, the advent of planning era withestablishment of Planning Commission in 1950 brought a directional change in allparameters in the economic management. As bulk of the actions and responsibilitiespertaining to the economic policy rested with the Planning Commission, other entitiesof policymaking including the monetary authority had a supplementary role.
However, setting the tone of monetary policy, the First Five Year Planenvisaged, "judicious credit creation somewhat in anticipation of the increase inproduction and availability of genuine savings" (GOI, 1951). During the First FiveYear Plan, monetary management witnessed a distinguished order with effective coordinationbetween the then Finance Minister Chintaman Deshmukh, a formerGovernor of RBI and the then Governor of RBI Benegal Rama Rau. The RBI decided towithdraw support to the gilt-edged market signifying the proof of an independent monetarypolicy (da Costa, 1985). The initiatives of the Finance Minister to control governmentexpenditure with emphasis to enhance revenue and capital receipts facilitated such a move. Amere 10.3 percent growth of money supply in the whole First Plan reflects restrictive monetarypolicy during this period. In the next two five year plans, conduct of monetary policy facedunprecedented challenges due to the new initiatives in the planning regime and The degree ofindependence enjoyed by the RBI was heavily curtailed. At the beginning of the Second FiveYear Plan, both foreign exchange reserves and Indias external credit were very high for easyavailability of required investments. In this backdrop, under the able leadership of Prof. P. CMahalanobis the plan exercise emphasised on heavy industries. Although, there were notablesuccess in the front of output expansion mainly lead by industrialisation during the Second FiveYear Plan, there were some setbacks for monetary policy operations. Firstly, finance minister T.T. Krishnamachari emphasised on transforming sterling balances into investment goods since1956-57. The foreign exchange assets depleted to the extent of Rs. 664 crores during a decadesince then. There was increasing pressure on the RBI to provid credit to the government. Thus,when the real income (NNP) increased by 21.5 percent in Second Five Year Plan, money supply(Ml) increased by 29.4 per cent (daCosta, 1985). During this period, the prices increased by 35.0per cent contrary to themagnificent control on it in the First Five Year Plan. Selective CreditControl was followed during this period as a remedy to overcome the dilemma of controllinginflationary pressure and need for financing developmental expenditure (Iengar, 1958). Muchneeded expenditure on infrastructure projects, which was not immediately productive exertedupward pressure on the prices of consumer goods. On the other hand, the private sector was to beprovided credit for complementary expansion of investment. Hence, monetary policy did not
adopt general tightening or relaxation of credit but some sectors were provided preferential creditand for some others the credit was made expensive.In the Third Five Year Plan, the 1962 hostilities with China further addedpressure on monetary policy operations. This was mainly due to the creditrequirement of the government for the increasing defence and developmentalexpenditure. Thus, money supply (Ml) during this period increased by as high as 57.9percent. With only 11.8 percent growth of NNP in the Third Plan, prices rose by close to 32percent. Thus, the conduct of monetary policy became a process of passiveaccommodation of budget deficits, by early 1960s. The decade of 1960s witnessed agradual shift of priority from price stability to greater concerns for economic growthand accompanying credit control. A new differential interest rates regime emergedwith a view to influence the demand for credit and imparting an element of disciplinein the use of credit. Under the quota-cum-slab introduced in October 1960,minimum lending rates were stipulated. This was the beginning of a move towardsregulated regime of interest rates.Period of High Regulation and Bank Expansion (1964 - 1984)This period witnessed radical changes in the conduct of monetary policy predominantly causedby interventionist character of credit policy and external developments. The process of monetaryplanning was severely constrained by heavily regulated regime consisting of priority sectorlending, administered interest rates, refinance to the banks at concessional rates to enable them tolend at cheaper rates to priority sectors, high level of deficit financing, external oil price shocks,etc. Inflation was thought to be primarily caused by supply factors and not emanating frommonetary causes. Hence, output expansion was thought to be anti-inflationary and emphasis was
attributed on the credit expansion to step up output. In the process, the government occupied thepivotal role in monetary management and the RBI was pushed down to the secondary position.Since the mid-1960s, regulation of the domestic interest rates became ubiquitous in India. InSeptember 1964 a more stringent system for bank credit based on net liquidity position wasintroduced and both deposit and credit rates were regulated. The introduction of CreditAuthorisation Scheme (CAS) in 1965 initiated rationing of bank credit (RBI, 1999). Withimplementation of CAS, prior permission of RBI was required for sanctioning of large credit orits augmentation. It served the twin objectives of mobilising financial resources for the Plans andimparting better credit discipline. The degree of constraints on the monetary authority startedmounting up with the measures of social control introduced by the Government of India inDecember 1967, which envisaged a purposive distribution of credit with a view to enhance theflow of credit to priority sectors like agriculture, small sector industries and exports coupled withmobilisation of savings. Accordingly, National Credit Council was set up to provide a forum fordiscussing and assessing the credit priorities. Credit to certain economic activities like exportswas provided with concessional rates since 1968. The transfer of financing of publicprocurement and distribution and fertliser operations from government to banks in 1975-76further constrained the banking operations. The rationalisation of CAS guided byrecommendations of Tandon Committee (1975), Chore Committee (1979) and MaratheCommittee (1983) subsequently refined the process of credit rationing. The event ofnationalisation of major commercial banks in July 1969 constitutes an important landmark in themonetary history of India, which had significant bearings on the banking expansion and socialcontrol of bank credit. The nationalisation of banks led to use of bank credit as an instrument tomeet socioeconomic needs for development. The RBI began to implement credit planning withthe basic objective of regulating the quantum and distribution of credit to ensurecredit flow to various sectors of the economy in consonance with national prioritiesand targets. There was massive branch expansion in the aftermath of bank nationalisation withthe spread of banking facilities reaching to every nook and cornerof the country. The number of bank branches rapidly increased from 8,262 in 1969 to
13,622 in 1972, which subsequently increased to 45,332 by 1984. These developments hadsignificant implications for financial deepening of the economy. During this period the growth offinancial assets was faster as compared to the growth of output. The volume of aggregate depositof scheduled commercial banks increased from Rs 4,338 crore in March 1969 to Rs 60,596 crorein March 1984 and the volume of bank credit increased from Rs 3,396 crore to Rs 41,294 crorein between the same period (Table II. 1). Particularly, non-food credit increased from Rs 3,915crore in March 1970 to Rs 37,272 crore in March 1984. The average annual growth rate ofaggregate deposits markedly increased from 9.5 per cent for the period 1951-52 to 1968-69 to19.3 per cent for the period 1969-70 to 1983-84. In between the same period, bank creditincreased from annual average of 10.9 per cent to 18.2 per cent. This period also witnessedgrowing volume of priority sector lending, which had not received sufficient attention by thecommercial banks prior to nationalisation.The share of priority sector advances in the total bank credit of scheduled commercialbanks rose from 14 per cent in 1969 to 36 per cent in 1982. The share of medium andlarge industries in the bank credit had come down from 60.6 per cent in 1968 to 37.6per cent in 1982. During this period, monetary policy of the RBI mainly focused on bank credit,particularly non-food credit, as the policy indicator. Basically, the attention was limited to thescheduled commercial banks, as they had high proportion of bankdeposits and timely available data. Emphasis on demand management through controlof money supply was not in much evidence upto mid-1980s. Reserve money was notconsidered for operational purposes as the major source of reserve money creation -RBIs credit to the government - was beyond its control. Due to lack of control on thereserve money and establishment of direct link between bank credit and output, creditaggregates were accorded greater importance as indicators of the stance of monetarypolicy and also as intermediate targets.
Among the policy instruments, SLR was mainly used to serve the purpose ofraising resources for the government plan expenditure from the banks. The level ofSLR had progressively increased from the statutory minimum of 25 per cent inFebruary 1970 to 36 per cent in September 1984 (Table II.2). Banks were providedfunds through standing facilities such as general refinance and export refinance tofacilitate developmental financing as per credit plans. The instrument of CRR wasmainly used to neutralise the inflationary impact of deficit financing. The CRR wasraised from its statutory minimum of 3 per cent since September 1962 to 5 per cent inJune 1973 (Table 11.2). Gradually it was hiked to 9 per cent by February 1984. Duringthis period, the Bank Rate had a limited role in monetary policy operations.The year 1976 constitutes one of the most eventful period in the monetarythinking in India, when a heated debate surfaced on the issue of validity of the thenprevailing monetary policy procedure. The first dissenting note came from S.B. Guptawith his seminal article advocating in favour of money-multiplier approach. Gupta(1976a) argued that, the then practice of RBIs money supply analysis simply sums upits various components, and hence merely an accounting or ex post analysis. It wasaccused of being tautological in nature. He suggested, money supply analysis basedon some theory of money supply like money multiplier approach could provide betterunderstanding of the determinants of money supply. He also highlighted thedifference in monetary impact of financing government expenditure through creditfrom RBI versus investment of the banks in government securities.
However, RBI economists rejected Guptas analysis as mechanistic andunsatisfactory in theory and useless in practice (Mujumdar, 1976) and claimed that,RBIs analysis provides an economic explanation of money supply in India.Mujumdar (1976) questioned the basic ingredients of money-multiplier approachsuch as stability of the relationship between money supply and reserve money,controllability of reserve money and endogeneity of money-multiplier, and stated that,"... in certain years if the expansion in M does not confirm to the postulatedrelationship, one has to explain away the situation by saying that the multiplier itselfhas changed". He also claimed that, RBI analysis takes into account both primarymoney supply through the RBI and secondary expansion through commercial banksand provides a total explanation of variations in money supply. As against this,multiplier approach explains only the secondary expansion through the moneymultiplier.Shetty,Avadhani and Menon (1976) supplemented Mujumdar in defendingRBFs money supplyanalysis. They argued that, money supply is both an economicand a policy controlled variable.As an economic variable it may be determined by the behaviour of the public to hold currencyand bank deposits, but as a policy controlledvariable it depends on the monetary authoritysperception about the appropriate level of primary and secondary money. Thus, they refuted anysimple and mechanical relationship between reserve money and money supply. They completelyrejected the appropriateness of projecting monetary aggregates based on money-multiplier in theshort-term due to erratical behaviour of related coefficients, but they do not rule out usefulness oflong-term projections. On the issue of the relationship between reserve money and moneysupply, Shetty et al (1976) asserted that, "it is incorrect of Gupta to state that the RBI is ignorantof the significance of reserve money in monetary analysis. The RBI, however, does not considerit as the single element for explanation of the sources of changes in money supply."At this point a reconciliatory note came from Khatkhate (1976). He
emphasised the usefulness of money-multiplier framework as suggested by Gupta(1976a), but was critical of him for accusing the RBI being not aware of it. Accordingto Khatkhate (1976), "Gupta is quite right in suggesting this line, but the difficulty isthat it has no connection with the RBI presentation of monetary data. And what iseven worse is that Gupta does no better than the RBI in proposing his alternative."Towards end of 1970s, there were resentments regarding the way monetarymanagement is operated in the policy circle. With large part of the monetary reserveoutside the control of monetary authority, the channel of credit allocation to fewpockets of the commercial sector could transmit very limited influence to the realeconomic variables. The neglect of issues related to monetary targeting viewed as anunnecessary byproduct of the preoccupation with credit targeting.The period 1979-82 witnesseda turbulent phase for Indian economy. During 1979-80 adverse weather conditions caused recorddownfall in foodgrains production. It was accompanied by a setback in industrial production.The budget nonetheless continued to be expansionary. The budgetary deficit as percentage ofGDP was 2.13 per cent in 1979-80 and 1.82 per cent in 1980-81. The external sector added tofurther deterioration of the situation with hike in prices of petroleum products and fertilisers. Allthese contributed together towards prevalence of a widespread general inflation. Reserve moneygrowth was explosive and financial crowding out threatened long run prospects of stable growth.These macroeconomic developments made the conduct of monetary policy extremely difficultand progressively brought a sharp shift in monetary policy.New Regime of Monetary Targeting (1985 - 1991)In the backdrop of intellectual debate as discussed above and prevailingeconomic conditions, it was imperative to comprehensively review the functioning of
the monetary system and carry out necessary changes in the institutional set up andpolicy framework of the monetary policy. This was materialised by setting up a highlevel committee in 1982, under the chairmanship of Prof. Sukhamoy Chakravarty.The major recommendations of the Chakravarty Committee include, inter alia,shifting to monetary targeting as the basic framework of monetary policy, emphasison the objectives of price stability and economic growth, coordination betweenmonetary and fiscal policy to reduce the fiscal burden on the former and suggestion ofa scheme of interest rates in accordance with some valid economic criteria. Clarifyingthe stand on monetary targeting with feedback, Rangarajan (2002) asserts that, c*thescheme of fixing monetary targets based on expected increase in output and thetolerable level of inflation is far removed from the Friedmanite or any other version ofmonetarism." The Committee endorsed the use of bank reserves as the main operatingtarget of monetary policy and laid down guidelines relating to the optimal order of thegrowth of money supply in view of stability in demand for money.The recommendations of Chakravarty Committee guided far-reachingtransformation in the conduct of monetary policy in India. There was a shift to a newpolicy framework in the conduct of monetary policy by introducing monetarytargeting. In addition, recommendations of the Report of the Working Group onMoney Market, 1987 (Chairman: Vaghul) and subsequent move to activate the moneymarket by introducing new financial instruments such as 182-day Treasury Bills(TBs), Certificates of Deposit (CDs), Commercial Paper (CP) and Participation
Certificates, and, establishment of Discount and Finance House of India (DFHI) inApril 1988 created new institutional arrangements to support the process of monetarytargeting. It was felt that, the complex structure of administered interest rate andcrosssubsidisation resulted in higher lending rates for the non-concessional commercialsector. The concessional rates charged to the priority sector necessitated maintainingthe cost of funds i.e. deposit rates at a low level. Nevertheless, there was a move toactivate money market with new instruments to serve as a transmission channel ofmonetary policy, within this administered regime. Gradually, the complex lendingrate structure in the banking sector was simplified in 1990. By linking the interest ratecharged to the size of loan, the revised structure prescribed only six slabs(Rangarajan, 2002). However, credit rationing continued with its due importance inthe new framework to support the growth process. The share of priority sectors intotal non-food credit rose from 36.9 per cent in 1980-81 to the peak of 43.6 per cent in1986-87. But, inadequacy of this system slowly emerged due to problems in themonitoring of credit thereby causing delays in the sanctioning of bank credit. With thestrengthening of the credit appraisal systems in banks, the CAS lost its relevancethrough the 1980s, eventually leading to its abolition in 1988.During this period, the primitive structure of the financial markets impededtheir effective functioning. The money market lacked depth, with only the overnightinterbank call money market in place. The interest rates in the government securities
market and credit market were tightly regulated. The dispensation of credit to thegovernment took place via SLR stipulations, where commercial banks were made toset aside a substantial portion of their liabilities for investments in governmentsecurities at below market rates, known in the literature as financial repression. TheSLR had touched the peak of 38.5 by September 1990 (Table 11.2). As increasing SLRwas not adequate, the RBI was forced to be a residual subscriber. The process offinancing the government deficit involved automatic monetisation, in terms ofproviding short-term credit to the government that slipped into the practice of rollingover the facility. The situation was aggravated as the governments fiscal balancerapidly deteriorated. The process of creating 91-day ad hoc TBs and subsequentlyfunding them into non-marketable special securities at a very low interest rateemerged as the principal source of monetary expansion. In addition, RBI had tosubscribe dated securities those not taken up by the market. As a result, the net RBIcredit to the Central Government which constituted about 77 per cent of the monetarybase during the 1970s, accentuated to over 92 per cent during the 1980s (Table II. 1).In such an environment, monetary policy had to address itself to the task ofneutralising the inflationary impact of the growing deficit by raising CRR from timeto time. CRR was mainly being used to neutralise the financial impact of thegovernments budgetary operations rather than an independent monetary instrument.2.5- Post-Reform Period with Financial Deepening (1992 Onwards)Indian economy experienced severe economic crisis in mid-1991, mainly
triggered by a balance of payment difficulty. This crisis was converted to anopportunity by introducing far-reaching reforms in terms of twin programs ofstabilisation and structural adjustment. The financial sector received its due share ofattention in the reform process mainly guided by the influential recommendations ofNarasimham Committee - I (1991) and - II (1998). To curtail the excessive fiscaldominance on the monetary policy in the spirit of the recommendations of theChakravarty Committee (RBI, 1985) and Narasimham Committee (RBI, 1991), thememorandum of understanding (MoU) was signed between the Government of Indiaand the RBI in 1994. Consequently, the issuance of ad hoc TBs was eliminated witheffect from April 1, 1997. Instead, Ways and Means Advances (WMA) wasintroduced to cope with temporary mismatches. This was a momentous step andnecessary condition towards greater autonomy in the conduct of monetary policy. Asa result, the proportion of net RBI credit to government to reserve money hassubstantially come down to close to 50 per cent in recent years (Table II. 1).Interestingly, this period witnessed the new problem of coping with increasinginflow of foreign capital due to opening up of the economy for foreign investment.Foreign exchange reserves increased from mere US $ 5.83 billion in March 1991 toUS $ 25.18 billion in March 1995. Presently, foreign exchange reserves with RBIstand at close to US $ 82 billion. Hence, increase in foreign exchange assets had asizeable contribution to raise reserve money in this period. As a proportion of reservemoney, the share of net foreign assets is increased from 9.1 per cent in 1990-91 to
38.1 per cent in 1995-96 and subsequently reached 78.1 per cent in 2001-02 (TableII. 1). To negate the effect of large and persistent capital inflows, RBI absorbed excessliquidity through outright OMO and repos under liquidity adjustment facility (RBI,2003a).In the post reforms era, emphasis was placed to develop and deepen variouscomponents of the financial market such as money market, government securitiesmarket, forex market, which has significant implication for the monetary policy toshift from direct to indirect instruments of monetary control. To widen the moneymarket in terms of improving short term liquidity and its efficient management, newinstruments such as inter-bank Participation Certificates, CDs and CP were furtheractivated and new instruments in the form of TBs of varying maturities (14-, 91- and364-day) were introduced. The DFHI was instrumental to activate the secondarymarket in a range of money market instruments, and the interest rates in moneymarket instruments left to be market determined.The government securities market witnessed radical transformation towardsbroadening its base and making the yields market determined. Major initiatives in thisdirection include introducing the system of auctions to impart greater transparency inthe operations, setting up a system of Primary Dealers (PDs) and Satellite Dealers(SDs) to trade in Gilts, introducing a delivery versus payment (DvP) system forsettlement, adopting new techniques of flotation, introducing new instruments withspecial features like zero coupon bonds, partly paid stock and capital-indexed bonds,
etc. All these measures have helped in creating a new treasury culture in the country,and today, the demand for the government securities is not governed by solely SLR.requirements but by considerations of treasury management. Now, the SLR is at thestatutory minimum of 25 per cent since October 1997, far below than its peak of 38.5per cent in February 1992 (Table II.2). Also, the CRR has been gradually broughtdown to the current level of 4.5 per cent (effective from June 2003) from 10 per centin January 1997 and 15 per cent in October 1992. Certain initiatives to reform theforeign exchange market include, inter alia, moving to full convertibility of Rupee inthe current account since August 1994, greater freedom to Authorised Dealers (ADs)to manage their foreign exchanges, activation of the forward market and setting up aHigh Level Committee (Chairman: S.S. Tarapore) to provide a roadmap for capitalaccount convertibility. All these measures acted towards making the foreign exchangerate market-determined and linking it to the domestic interest rates.In the process of reforms, the interest rate structure was rationalised in thebanking sector and there is greater emphasis on prudential norms. Banks are givenfreedom to determine their domestic term deposit rates and prime lending rates(PLRs), except certain categories of export credit and small loans below 2 lakhRupees. All money market rates were set free. The Bank Rate was reactivated inBecause of all these reforms, we find today, interest rates in various segmentsof the financial market are determined by the market and there is close association intheir movement, as discussed in detail in Chapter 5. The developments in all the
segments have led to gradual broadening and deepening of the financial market. Thishas created the enabling conditions for a smooth move towards use of indirectinstruments of monetary policy such as open market operations (OMO) includingrepos and reverse repos. The operation of LAF has been used as an effectivemechanism to withdraw or inject liquidity on day-to-day basis and providing acorridor for call money rate. In June 2002, RBI has come out with its Short TermLiquidity Forecasting Model to evaluate the short term interaction between themonetary policy measures and the financial markets, which will be immensely helpfulfor imparting discipline once started operation. Because of reforms in the financialmarket, new interest rate based transmission channels have opened up. Importantly,this period has witnessed emergence of monetary policy as an independent instrumentof economic policy (Rangarajan, 2002).