Monetary policy involves central banks controlling the supply of money and interest rates to influence economic activity like prices and employment. It works through expanding or contracting investment and consumption spending. The objectives of monetary policy in India are to achieve rapid economic growth, price stability, exchange rate stability, balance of payments equilibrium, full employment, and an equal distribution of income. Some tools used in monetary policy include adjusting the bank rate, conducting open market operations, and varying reserve requirements to influence the money supply and credit conditions. Both quantitative and qualitative tools are used to target monetary policy objectives.

1. Monetary Policy
According to Prof. Harry Johnson,
"A policy employing the central banks control of the supply of money as an instrument for
achieving the objectives of general economic policy is a monetary policy."
Meaning of monetary policy
Monetary policy is the management of money supply and interest rates by central banks to
influence prices and employment. Monetary policy works through expansion or contraction of
investment and consumption expenditure. Monetary policy is the process by which the
government, 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 interest
In 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 a
contractionary policy decreases the total money supply. Expansionary policy is traditionally used
to combat unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates in order to combat inflation. Monetary policy is contrasted with
fiscal policy, which refers to government borrowing, spending and taxation.Credit policy is not
only a policy concerned with changes in the supply of credit but it can be and is much more than
this.Credit is not merely a matter of aggregate supply, but becomes more important factor since
there is also issue of its allocation among competing users. There are various sources of credit
and 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 issuing
currency through banks which are tied to a central bank, the monetary authority has the ability to

2. alter the money supply and thus influence the interest rate in order to achieve policy
goals.Monetary policy, also described as money and credit policy, concerns itself with the supply
of money as so of credit to the economy
Objectives of Monetary Policy
The objectives of a monetary policy in India are similar to the objectives of its five year plans. In
a nutshell planning in India aims at growth, stability and social justice. After the Keynesian
revolution in economics, many people accepted significance of monetary policy in attaining
following 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 Distribution
These are the general objectives which every central bank of a nation tries to attain by employing
certain tools (Instruments) of a monetary policy. In India, the RBI has always aimed at the
controlled expansion of bank credit and money supply, with special attention to the seasonal
needs of a credit.

3. 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 Keynes's
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

4. 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

5. in for just one policy in April end. However a review of the policy does take place later in
the year.
INSTRUMENT IN MONETORY POLICY
The instrument of monetary policy are tools or devise which are used by the monetary
authority in order to attain some predetermined objectives. There are two types of
instruments 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. These
tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit
control are also called as General Tools for credit control. They are designed to regulate or
control the total volume of bank credit in the economy. These tools are indirect in nature and are
employed for influencing the quantity of credit in the country. The general tool of credit control
comprises of following instruments.
1. Bank Rate Policy (BRP)
The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for
influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at
which the central bank (i.e RBI) rediscounts bills and prepares of commercial banks or provides
advance to commercial banks against approved securities. It is "the standard rate at which the
bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for
purchase under the RBI Act". The Bank Rate affects the actual availability and the cost of the
credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit
available to commercial banks. If the RBI increases the bank rate than it reduce the volume of
commercial banks borrowing from the RBI. It deters banks from further credit expansion as it

6. becomes a more costly affair. Even with increased bank rate the actual interest rates for a short
term lending go up checking the credit expansion. On the other hand, if the RBI reduces the bank
rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit
creation. Thus any change in the bank rate is normally associated with the resulting changes in
the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a
tool of monetary policy depends on existing banking network, interest elasticity of investment
demand, 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 term
securities by the RBI in the open market. This is very effective and popular instrument of the
monetary policy. The OMO is used to wipe out shortage of money in the money market, to
influence the term and structure of the interest rate and to stabilize the market for government
securities, etc. It is important to understand the working of the OMO. If the RBI sells securities
in an open market, commercial banks and private individuals buy it. This reduces the existing
money supply as money gets transferred from commercial banks to the RBI. Contrary to this
when the RBI buys the securities from commercial banks in the open market, commercial banks
sell it and get back the money they had invested in them. Obviously the stock of money in the
economy increases. This way when the RBI enters in the OMO transactions, the actual stock of
money gets changed. Normally during the inflation period in order to reduce the purchasing
power, the RBI sells securities and during the recession or depression phase she buys securities
and makes more money available in the economy through the banking system. Thus under OMO
there is continuous buying and selling of securities taking place leading to changes in the
availability 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.

7. 3. Variation in the Reserve Ratios (VRR)
The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash
Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of
these cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity and
controlling 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 bank's
net demand and time liabilities which commercial banks have to maintain with the central bank
and SLR refers to some percent of reserves to be maintained in the form of gold or foreign
securities. In India the CRR by law remains in between 3-15 percent while the SLR remains in
between 25-40 percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a
change in commercial banks reserves positions. Thus by varying VRR commercial banks lending
capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of
commercial banks and thus it can affect the banks credit creation multiplier. RBI increases VRR
during the inflation to reduce the purchasing power and credit creation. But during the recession
or 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. These
tools are not directed towards the quality of credit or the use of the credit. They are used for
discriminating between different uses of credit. It can be discrimination favoring export over
import or essential over non-essential credit supply. This method can have influence over the
lender and borrower of the credit. The Selective Tools of credit control comprises of following
instruments.

8. 1. Fixing Margin Requirements
The margin refers to the "proportion of the loan amount which is not financed by the bank". Or
in other words, it is that part of a loan which a borrower has to raise in order to get finance for
his purpose. A change in a margin implies a change in the loan size. This method is used to
encourage 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 other
needy sectors. Example:- If the RBI feels that more credit supply should be allocated to
agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given.
2. Consumer Credit Regulation
Under this method, consumer credit supply is regulated through hire-purchase and installment
sale of consumer goods. Under this method the down payment, installment amount, loan
duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a
country.
3. Publicity
This is yet another method of selective credit control. Through it Central Bank (RBI) publishes
various reports stating what is good and what is bad in the system. This published information
can help commercial banks to direct credit supply in the desired sectors. Through its weekly and
monthly bulletins, the information is made public and banks can use it for attaining goals of
monetary policy.

9. 4. Credit Rationing
Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount
available for each commercial bank. This method controls even bill rediscounting. For certain
purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help
in lowering banks credit expoursure to unwanted sectors.
5. Moral Suasion
It implies to pressure exerted by the RBI on the indian banking system without any strict action
for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during
inflationary periods. Commercial banks are informed about the expectations of the central bank
through a monetary policy. Under moral suasion central banks can issue directives, guidelines
and suggestions for commercial banks regarding reducing credit supply for speculative purposes.
6. Control Through Directives
Under this method the central bank issue frequent directives to commercial banks. These
directives guide commercial banks in framing their lending policy. Through a directive the
central bank can influence credit structures, supply of credit to certain limit for a specific
purpose. The RBI issues directives to commercial banks for not lending loans to speculative
sector such as securities, etc beyond a certain limit.
7. Direct Action

10. Under this method the RBI can impose an action against a bank. If certain banks are not adhering
to the RBI's directives, the RBI may refuse to rediscount their bills and securities. Secondly, RBI
may refuse credit supply to those banks whose borrowings are in excess to their capital. Central
bank can penalize a bank by changing some rates. At last it can even put a ban on a particular
bank 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 these
tools is limited by the availability of alternative sources of credit in economy, working of the
Non-Banking Financial Institutions (NBFIs), profit motive of commercial banks and
undemocratic nature off these tools. But a right mix of both the general and selective tools of
monetary 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 free
from certain limitations. Its scope is limited by certain peculiarities, in developing countries such
as India. Some of the important limitations of the monetary policy are given below.
1. There exist a Non-Monetized Sector
In 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 monetary
type. Similarly, due to non-monetized sector the progress of commercial banks is not up to the
mark. This creates a major bottleneck in the implementation of the monetary policy.
2. Excess Non-Banking Financial Institutions (NBFI)

11. As the economy launch itself into a higher orbit of economic growth and development, the
financial 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 not
come under the purview of a monetary policy and thus nullify the effect of a monetary policy.
3. Existence of Unorganized Financial Markets
The financial markets help in implementing the monetary policy. In many developing countries
the financial markets especially the money markets are of an unorganized nature and in
backward conditions. In many places people like money lenders, traders, and businessman
actively take part in money lending. But unfortunately they do not come under the purview of a
monetary policy and creates hurdle in the success of a monetary policy.
4. Higher Liquidity Hinders Monetary Policy
In rapidly growing economy the deposit base of many commercial banks is expanded. This
creates excess liquidity in the system. Under this circumstances even if the monetary policy
increases the CRR or SLR, it dose not deter commercial banks from credit creation. So the
existence of excess liquidity due to high deposit base is a hindrance in the way of successful
monetary policy.
5. Money Not Appearing in an Economy
Large 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

12. shadow money is used for buying precious metals like gold, silver, ornaments, land and in
speculation. This type of lavish spending give rise to inflationary trend in mainstream economy
and the monetary policy fails to control it.
6. Time Lag Affects Success of Monetary Policy
The success of the monetary policy depends on timely implementation of it. However, in many
cases unnecessary delay is found in implementation of the monetary policy. Or many times
timely directives are not issued by the central bank, then the impact of the monetary policy is
wiped out.
6. Monetary & Fiscal Policy Lacks Coordination
In order to attain a maximum of the above objectives it is unnecessary that both the fiscal and
monetary policies should go hand in hand. As both these policies are prepared and implemented
by 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 controlled
or kept within limit, then the monetary policy can give expected results. Thus though the
monetary policy suffers from these limitations, still it has an immense significance in influencing
the process of economic growth and development.
Reforms in the Indian Monetary Policy During 1990s

13. The Monetary policy of the RBI has undergone massive changes during the economic reform
period. After 1991 the Monetary policy is disassociated from the fiscal policy. Under the reform
period 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.

14. ANALYTICS OF MONETARY POLICY IN INDIA SINCE INDEPENDENCE
Introduction
Very useful insights on the causes and events that shaped the direction and pace of an event can
be gained by studying its evolutionary process. It is also useful in guiding the current actions and
future plans. This logic tempts to undertake a purposeful analytical review of policy trends in the
sphere of monetary policy in India, since Independence. Over the last five decades, the conduct
of monetary policy in India has undergone sharp transformation and the present mode of
monetary policy has evolved over time with numerous modifications. In this chapter, we shall
trace 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 theoretical
underpinnings and empirical realities. This will serve as a useful guide for the empirical analysis
in the following chapters. The discussion on the historical developments of monetary policy in
India can be carried out with different ways of periodisation. Our method of periodisation is
primarily based on the policy environment. Based on the policy framework, broadly two distinct
regimes can be delineated in the monetary policy history of India, since Independence. The first
regime refers to the credit-planning era followed since the beginning upto the mid-1980s. The
second is the regime started with adoption of 'money-multiplier' framework, implemented as per
recommendations of Chakravarty Committee (RBI 1985). However, both the regimes command
appropriateness under
the circumstances and institutional structure existed during the respective periods. In
the first regime, there was a shift towards a tightly regulated regime for bank credit
and interest rates since the mid-1960s with emergence of a differential and regulated
interest rate regime since 1964, adoption of the philosophy of social control in analytics of
monetary policy in india December 1967, the event 'bank nationalisation' in 1969, increasing
deficit financing by the government, etc. Similarly, The post-Chakravarty Committee regime
also can be separated into two sub-periods distinguished by the event of economic reforms of
1991-92. There was a radical shift from direct to indirect instruments and emergence of a broad,

15. deep and diversified financial market, with prevalence of greater autonomy, in the post-reform
period. Thus, the whole period since Independence can be divided into four subperiods in our
discussion 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 social
control since 1964 to 1984, (iii) New Regime of Monetary Targeting with Partial
Reforms, 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 India
could be classified as (a) issue of notes, acting in national interest by curtailing
excessive money supply and to overcome stringency where it mitigated production
activities, (b) public debt management, and (c) maintaining exchange value of the
Rupee. In the initial days of Independence, there were some challenges for monetary
operations due to the event of partition and consequent division of assets of RBI, and
its responsibility of currency and banking management in the transitory phase in the
two new Dominions. In Independent India, the advent of planning era with
establishment of Planning Commission in 1950 brought a directional change in all
parameters in the economic management. As bulk of the actions and responsibilities
pertaining to the economic policy rested with the Planning Commission, other entities
of policymaking including the monetary authority had a supplementary role.

16. However, setting the tone of monetary policy, the First Five Year Plan
envisaged, "judicious credit creation somewhat in anticipation of the increase in
production and availability of genuine savings" (GOI, 1951). During the First Five
Year Plan, monetary management witnessed a distinguished order with effective coordination
between the then Finance Minister Chintaman Deshmukh, a former
Governor of RBI and the then Governor of RBI Benegal Rama Rau. The RBI decided to
withdraw support to the gilt-edged market signifying the proof of an independent monetary
policy (da Costa, 1985). The initiatives of the Finance Minister to control government
expenditure with emphasis to enhance revenue and capital receipts facilitated such a move. A
mere 10.3 percent growth of money supply in the whole First Plan reflects restrictive monetary
policy during this period. In the next two five year plans, conduct of monetary policy faced
unprecedented challenges due to the new initiatives in the planning regime and The degree of
independence enjoyed by the RBI was heavily curtailed. At the beginning of the Second Five
Year Plan, both foreign exchange reserves and India's external credit were very high for easy
availability of required investments. In this backdrop, under the able leadership of Prof. P. C
Mahalanobis the plan exercise emphasised on heavy industries. Although, there were notable
success in the front of output expansion mainly lead by industrialisation during the Second Five
Year Plan, there were some setbacks for monetary policy operations. Firstly, finance minister T.
T. Krishnamachari emphasised on transforming sterling balances into investment goods since
1956-57. The foreign exchange assets depleted to the extent of Rs. 664 crores during a decade
since 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 35.0
per cent contrary to themagnificent control on it in the First Five Year Plan. 'Selective Credit
Control' was followed during this period as a remedy to overcome the dilemma of controlling
inflationary pressure and need for financing developmental expenditure (Iengar, 1958). Much
needed expenditure on infrastructure projects, which was not immediately productive exerted
upward pressure on the prices of consumer goods. On the other hand, the private sector was to be
provided credit for complementary expansion of investment. Hence, monetary policy did not

17. adopt general tightening or relaxation of credit but some sectors were provided preferential credit
and for some others the credit was made expensive.
In the Third Five Year Plan, the 1962 hostilities with China further added
pressure on monetary policy operations. This was mainly due to the credit
requirement of the government for the increasing defence and developmental
expenditure. Thus, money supply (Ml) during this period increased by as high as 57.9
percent. With only 11.8 percent growth of NNP in the Third Plan, prices rose by close to 32
percent. Thus, the conduct of monetary policy became a process of passive
accommodation of budget deficits, by early 1960s. The decade of 1960s witnessed a
gradual shift of priority from price stability to greater concerns for economic growth
and accompanying credit control. A new differential interest rates regime emerged
with a view to influence the demand for credit and imparting an element of discipline
in 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 towards
regulated 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 caused
by interventionist character of credit policy and external developments. The process of monetary
planning was severely constrained by heavily regulated regime consisting of priority sector
lending, administered interest rates, refinance to the banks at concessional rates to enable them to
lend 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 from
monetary causes. Hence, output expansion was thought to be anti-inflationary and emphasis was

18. attributed on the credit expansion to step up output. In the process, the government occupied the
pivotal 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. In
September 1964 a more stringent system for bank credit based on net liquidity position was
introduced and both deposit and credit rates were regulated. The introduction of Credit
Authorisation Scheme (CAS) in 1965 initiated rationing of bank credit (RBI, 1999). With
implementation of CAS, prior permission of RBI was required for sanctioning of large credit or
its augmentation. It served the twin objectives of mobilising financial resources for the Plans and
imparting better credit discipline. The degree of constraints on the monetary authority started
mounting up with the measures of 'social control' introduced by the Government of India in
December 1967, which envisaged a purposive distribution of credit with a view to enhance the
flow of credit to priority sectors like agriculture, small sector industries and exports coupled with
mobilisation of savings. Accordingly, National Credit Council was set up to provide a forum for
discussing and assessing the credit priorities. Credit to certain economic activities like exports
was provided with concessional rates since 1968. The transfer of financing of public
procurement and distribution and fertliser operations from government to banks in 1975-76
further constrained the banking operations. The rationalisation of CAS guided by
recommendations of Tandon Committee (1975), Chore Committee (1979) and Marathe
Committee (1983) subsequently refined the process of credit rationing. The event of
nationalisation of major commercial banks in July 1969 constitutes an important landmark in the
monetary history of India, which had significant bearings on the banking expansion and social
control of bank credit. The nationalisation of banks led to use of bank credit as an instrument to
meet socioeconomic needs for development. The RBI began to implement credit planning with
the basic objective of regulating the quantum and distribution of credit to ensure
credit flow to various sectors of the economy in consonance with national priorities
and targets. There was massive branch expansion in the aftermath of bank nationalisation with
the spread of banking facilities reaching to every nook and corner
of the country. The number of bank branches rapidly increased from 8,262 in 1969 to

19. 13,622 in 1972, which subsequently increased to 45,332 by 1984. These developments had
significant implications for financial deepening of the economy. During this period the growth of
financial assets was faster as compared to the growth of output. The volume of aggregate deposit
of scheduled commercial banks increased from Rs 4,338 crore in March 1969 to Rs 60,596 crore
in March 1984 and the volume of bank credit increased from Rs 3,396 crore to Rs 41,294 crore
in between the same period (Table II. 1). Particularly, non-food credit increased from Rs 3,915
crore in March 1970 to Rs 37,272 crore in March 1984. The average annual growth rate of
aggregate deposits markedly increased from 9.5 per cent for the period 1951-52 to 1968-69 to
19.3 per cent for the period 1969-70 to 1983-84. In between the same period, bank credit
increased from annual average of 10.9 per cent to 18.2 per cent. This period also witnessed
growing volume of priority sector lending, which had not received sufficient attention by the
commercial banks prior to nationalisation.
The share of priority sector advances in the total bank credit of scheduled commercial
banks rose from 14 per cent in 1969 to 36 per cent in 1982. The share of medium and
large industries in the bank credit had come down from 60.6 per cent in 1968 to 37.6
per 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 the
scheduled commercial banks, as they had high proportion of bank
deposits and timely available data. Emphasis on demand management through control
of money supply was not in much evidence upto mid-1980s. Reserve money was not
considered for operational purposes as the major source of reserve money creation -
RBI's credit to the government - was beyond its control. Due to lack of control on the
reserve money and establishment of direct link between bank credit and output, credit
aggregates were accorded greater importance as indicators of the stance of monetary
policy and also as intermediate targets.

20. Among the policy instruments, SLR was mainly used to serve the purpose of
raising resources for the government plan expenditure from the banks. The level of
SLR had progressively increased from the statutory minimum of 25 per cent in
February 1970 to 36 per cent in September 1984 (Table II.2). Banks were provided
funds through standing facilities such as 'general refinance' and 'export refinance' to
facilitate developmental financing as per credit plans. The instrument of CRR was
mainly used to neutralise the inflationary impact of deficit financing. The CRR was
raised from its statutory minimum of 3 per cent since September 1962 to 5 per cent in
June 1973 (Table 11.2). Gradually it was hiked to 9 per cent by February 1984. During
this period, the Bank Rate had a limited role in monetary policy operations.
The year 1976 constitutes one of the most eventful period in the monetary
thinking in India, when a heated debate surfaced on the issue of validity of the then
prevailing monetary policy procedure. The first dissenting note came from S.B. Gupta
with his seminal article advocating in favour of 'money-multiplier' approach. Gupta
(1976a) argued that, the then practice of RBI's money supply analysis simply sums up
its various components, and hence merely an accounting or ex post analysis. It was
accused of being tautological in nature. He suggested, money supply analysis based
on some theory of money supply like money multiplier approach could provide better
understanding of the determinants of money supply. He also highlighted the
difference in monetary impact of financing government expenditure through credit
from RBI versus investment of the banks in government securities.

21. However, RBI economists rejected Gupta's analysis as mechanistic and
unsatisfactory in theory and useless in practice (Mujumdar, 1976) and claimed that,
RBI's analysis provides an economic explanation of money supply in India.
Mujumdar (1976) questioned the basic ingredients of 'money-multiplier approach'
such 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 postulated
relationship, one has to explain away the situation by saying that the multiplier itself
has changed". He also claimed that, RBI analysis takes into account both primary
money supply through the RBI and secondary expansion through commercial banks
and 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 supply
analysis. 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 currency
and bank deposits, but as a policy controlledvariable it depends on the monetary authority's
perception about the appropriate level of primary and secondary money. Thus, they refuted any
simple and mechanical relationship between reserve money and money supply. They completely
rejected the appropriateness of projecting monetary aggregates based on money-multiplier in the
short-term due to erratical behaviour of related coefficients, but they do not rule out usefulness of
long-term projections. On the issue of the relationship between reserve money and money
supply, Shetty et al (1976) asserted that, "it is incorrect of Gupta to state that the RBI is ignorant
of the significance of reserve money in monetary analysis. The RBI, however, does not consider
it 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

22. 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. According
to Khatkhate (1976), "Gupta is quite right in suggesting this line, but the difficulty is
that it has no connection with the RBI presentation of monetary data. And what is
even worse is that Gupta does no better than the RBI in proposing his alternative."
Towards end of 1970s, there were resentments regarding the way monetary
management is operated in the policy circle. With large part of the monetary reserve
outside the control of monetary authority, the channel of credit allocation to few
pockets of the commercial sector could transmit very limited influence to the real
economic variables. The neglect of issues related to monetary targeting viewed as an
unnecessary byproduct of the preoccupation with credit targeting.The period 1979-82 witnessed
a turbulent phase for Indian economy. During 1979-80 adverse weather conditions caused record
downfall in foodgrains production. It was accompanied by a setback in industrial production.
The budget nonetheless continued to be expansionary. The budgetary deficit as percentage of
GDP was 2.13 per cent in 1979-80 and 1.82 per cent in 1980-81. The external sector added to
further deterioration of the situation with hike in prices of petroleum products and fertilisers. All
these contributed together towards prevalence of a widespread general inflation. Reserve money
growth was explosive and financial crowding out threatened long run prospects of stable growth.
These macroeconomic developments made the conduct of monetary policy extremely difficult
and 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 prevailing
economic conditions, it was imperative to comprehensively review the functioning of

23. the monetary system and carry out necessary changes in the institutional set up and
policy framework of the monetary policy. This was materialised by setting up a high
level 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, emphasis
on the objectives of price stability and economic growth, coordination between
monetary and fiscal policy to reduce the fiscal burden on the former and suggestion of
a scheme of interest rates in accordance with some valid economic criteria. Clarifying
the stand on monetary targeting with feedback, Rangarajan (2002) asserts that, c*the
scheme of fixing monetary targets based on expected increase in output and the
tolerable level of inflation is far removed from the Friedmanite or any other version of
monetarism." The Committee endorsed the use of bank reserves as the main operating
target of monetary policy and laid down guidelines relating to the optimal order of the
growth of money supply in view of stability in demand for money.
The recommendations of Chakravarty Committee guided far-reaching
transformation in the conduct of monetary policy in India. There was a shift to a new
policy framework in the conduct of monetary policy by introducing monetary
targeting. In addition, recommendations of the Report of the Working Group on
Money Market, 1987 (Chairman: Vaghul) and subsequent move to activate the money
market by introducing new financial instruments such as 182-day Treasury Bills
(TBs), Certificates of Deposit (CDs), Commercial Paper (CP) and Participation

24. Certificates, and, establishment of Discount and Finance House of India (DFHI) in
April 1988 created new institutional arrangements to support the process of monetary
targeting. It was felt that, the complex structure of administered interest rate and
crosssubsidisation resulted in higher lending rates for the non-concessional commercial
sector. The concessional rates charged to the priority sector necessitated maintaining
the cost of funds i.e. deposit rates at a low level. Nevertheless, there was a move to
activate money market with new instruments to serve as a transmission channel of
monetary policy, within this administered regime. Gradually, the complex lending
rate structure in the banking sector was simplified in 1990. By linking the interest rate
charged to the size of loan, the revised structure prescribed only six slabs
(Rangarajan, 2002). However, credit rationing continued with its due importance in
the new framework to support the growth process. The share of priority sectors in
total non-food credit rose from 36.9 per cent in 1980-81 to the peak of 43.6 per cent in
1986-87. But, inadequacy of this system slowly emerged due to problems in the
monitoring of credit thereby causing delays in the sanctioning of bank credit. With the
strengthening of the credit appraisal systems in banks, the CAS lost its relevance
through the 1980s, eventually leading to its abolition in 1988.
During this period, the primitive structure of the financial markets impeded
their effective functioning. The money market lacked depth, with only the overnight
interbank call money market in place. The interest rates in the government securities

25. market and credit market were tightly regulated. The dispensation of credit to the
government took place via SLR stipulations, where commercial banks were made to
set aside a substantial portion of their liabilities for investments in government
securities at below market rates, known in the literature as 'financial repression'. The
SLR had touched the peak of 38.5 by September 1990 (Table 11.2). As increasing SLR
was not adequate, the RBI was forced to be a residual subscriber. The process of
financing the government deficit involved 'automatic monetisation', in terms of
providing short-term credit to the government that slipped into the practice of rolling
over the facility. The situation was aggravated as the government's fiscal balance
rapidly deteriorated. The process of creating 91-day ad hoc TBs and subsequently
funding them into non-marketable special securities at a very low interest rate
emerged as the principal source of monetary expansion. In addition, RBI had to
subscribe dated securities those not taken up by the market. As a result, the net RBI
credit to the Central Government which constituted about 77 per cent of the monetary
base 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 of
neutralising the inflationary impact of the growing deficit by raising CRR from time
to time. CRR was mainly being used to neutralise the financial impact of the
government's 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

26. triggered by a balance of payment difficulty. This crisis was converted to an
opportunity by introducing far-reaching reforms in terms of twin programs of
stabilisation and structural adjustment. The financial sector received its due share of
attention in the reform process mainly guided by the influential recommendations of
Narasimham Committee - I (1991) and - II (1998). To curtail the excessive fiscal
dominance on the monetary policy in the spirit of the recommendations of the
Chakravarty Committee (RBI, 1985) and Narasimham Committee (RBI, 1991), the
memorandum of understanding (MoU) was signed between the Government of India
and the RBI in 1994. Consequently, the issuance of ad hoc TBs was eliminated with
effect from April 1, 1997. Instead, Ways and Means Advances (WMA) was
introduced to cope with temporary mismatches. This was a momentous step and
necessary condition towards greater autonomy in the conduct of monetary policy. As
a result, the proportion of net RBI credit to government to reserve money has
substantially come down to close to 50 per cent in recent years (Table II. 1).
Interestingly, this period witnessed the new problem of coping with increasing
inflow 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 to
US $ 25.18 billion in March 1995. Presently, foreign exchange reserves with RBI
stand at close to US $ 82 billion. Hence, increase in foreign exchange assets had a
sizeable contribution to raise reserve money in this period. As a proportion of reserve
money, the share of net foreign assets is increased from 9.1 per cent in 1990-91 to

27. 38.1 per cent in 1995-96 and subsequently reached 78.1 per cent in 2001-02 (Table
II. 1). To negate the effect of large and persistent capital inflows, RBI absorbed excess
liquidity through outright OMO and repos under liquidity adjustment facility (RBI,
2003a).
In the post reforms era, emphasis was placed to develop and deepen various
components of the financial market such as money market, government securities
market, forex market, which has significant implication for the monetary policy to
shift from direct to indirect instruments of monetary control. To widen the money
market in terms of improving short term liquidity and its efficient management, new
instruments such as inter-bank Participation Certificates, CDs and CP were further
activated and new instruments in the form of TBs of varying maturities (14-, 91- and
364-day) were introduced. The DFHI was instrumental to activate the secondary
market in a range of money market instruments, and the interest rates in money
market instruments left to be market determined.
The government securities market witnessed radical transformation towards
broadening its base and making the yields market determined. Major initiatives in this
direction include introducing the system of auctions to impart greater transparency in
the operations, setting up a system of Primary Dealers (PDs) and Satellite Dealers
(SDs) to trade in Gilts, introducing a delivery versus payment (DvP) system for
settlement, adopting new techniques of flotation, introducing new instruments with
special features like zero coupon bonds, partly paid stock and capital-indexed bonds,

28. 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 the
statutory minimum of 25 per cent since October 1997, far below than its peak of 38.5
per cent in February 1992 (Table II.2). Also, the CRR has been gradually brought
down to the current level of 4.5 per cent (effective from June 2003) from 10 per cent
in January 1997 and 15 per cent in October 1992. Certain initiatives to reform the
foreign exchange market include, inter alia, moving to full convertibility of Rupee in
the current account since August 1994, greater freedom to Authorised Dealers (ADs)
to manage their foreign exchanges, activation of the forward market and setting up a
High Level Committee (Chairman: S.S. Tarapore) to provide a roadmap for capital
account convertibility. All these measures acted towards making the foreign exchange
rate market-determined and linking it to the domestic interest rates.
In the process of reforms, the interest rate structure was rationalised in the
banking sector and there is greater emphasis on prudential norms. Banks are given
freedom to determine their domestic term deposit rates and prime lending rates
(PLRs), except certain categories of export credit and small loans below 2 lakh
Rupees. All money market rates were set free. The 'Bank Rate' was reactivated in
Because of all these reforms, we find today, interest rates in various segments
of the financial market are determined by the market and there is close association in
their movement, as discussed in detail in Chapter 5. The developments in all the

29. segments have led to gradual broadening and deepening of the financial market. This
has created the enabling conditions for a smooth move towards use of indirect
instruments of monetary policy such as open market operations (OMO) including
repos and reverse repos. The operation of LAF has been used as an effective
mechanism to withdraw or inject liquidity on day-to-day basis and providing a
corridor for call money rate. In June 2002, RBI has come out with its Short Term
Liquidity Forecasting Model to evaluate the short term interaction between the
monetary policy measures and the financial markets, which will be immensely helpful
for imparting discipline once started operation. Because of reforms in the financial
market, new interest rate based transmission channels have opened up. Importantly,
this period has witnessed emergence of monetary policy as an independent instrument
of economic policy (Rangarajan, 2002).