BQ Learning: What Is Monetary Policy? Why It Matters.

This is a series of explainers to educate and inform watchers of the economy. In association with CRISIL as knowledge partner.

In most countries, a central bank uses monetary policy to achieve objectives of supporting economic growth (or employment) and maintaining price stability in the economy.

It is used in conjunction with fiscal policy, which wields taxation and expenditure as tools, to influence aggregate demand in the economy. This, in turn, influences the level of inflation in the economy. Inflation is defined as the year-on-year change in prices of a basket of goods. High and volatile inflation can be damaging for an economy as it imposes a burden on consumers. This burden is disproportionately high for low income earners.

Monetary policy tries to influence demand conditions in the economy by adjusting the supply and cost of money.

This is done using instruments, such as policy interest rates, open market operations which buy and sell government bonds, changes in the proportion of reserves that banks are required to hold. Other specialised operations targeted at liquidity and specific sectors are also used from time to time.

Theoretically, changes in interest rates by a central bank are supposed to influence the cost of credit, how much people and businesses borrow and spend.

In India, the ‘repo’ (or repurchase option) rate is the key policy rate. This is the rate at which commercial banks borrow from the Reserve Bank of India.

An increase in the repo rate makes it costlier for banks to borrow from RBI and vice versa. That, in turn, sets the tone for a range of other interest rates charged by the banks, be it retail, auto or corporate loans, and interest earned on savings and fixed deposit accounts.

Central banks also conduct Open Market Operations (OMOs) to influence the size of the money supply. OMOs are essentially sale and purchase of government securities (or G-secs, issued by way of borrowing by the government) to and from the market. When the RBI purchases G-secs, it expands money supply. A sale has the opposite effect.

Quantitative easing (QE) is also used to alter money supply, through purchase of assets apart from G-Secs, such as corporate bonds and mortgage- backed securities. QE was recently used when the pandemic struck in 2020, and was also deployed earlier during the 2008-09 global financial crisis.

Whenever the benchmark policy rate is changed, it is intended to work its way through the ‘interest rate channel’.

For instance, if inflation is high and the central bank wants to lower it, it ‘tightens’ monetary policy through dialing up the policy rate. If this signal is transmitted in the financial markets smoothly, it would end up increasing borrowing costs for consumers and businesses, disincentivising purchases or investments, thereby softening demand, and consequently, prices.

But monetary policy has its limitations.

For instance, if inflation is driven by a supply shock, such as a spike in oil or food prices, then monetary policy may have a smaller role to play. However, even in such scenarios, monetary policy may be tightened to keep second round impact of inflation in check. Second round effects of inflation play out via the expectations channel. If inflation expectations are high, workers may demand higher wages to compensate for it, this in turn may further fuel inflation.

As such, monetary policy, together with supply side policies, help maintain a demand-supply balance to keep inflation at appropriate levels.

In India, the Reserve Bank of India (RBI) is entrusted with conduct of monetary policy.

India formally adopted a flexible inflation targeting framework in 2016, under which it targets to keep consumer price index-based (CPI) inflation at 4%, with an upper tolerance level of 6%, and lower tolerance level of 2%.

Under this framework, a six-member Monetary Policy Committee was set up. Three members of this committee are from the RBI while three other external members are appointed by the government. The MPC has the objective of achieving the 4% (+/-) 2%inflation target, and sets the benchmark policy repo rate, basis its assessment of domestic and global macroeconomic conditions and their outlook.

While maintaining inflation within target is MPC’s prime objective, certain other factors might also influence their decisions, for instance, an unexpected growth slowdown, or global shocks. Financial stability, a broadly defined term which encompasses financial conditions, is also taken into consideration.

Other central banks also target growth, unemployment and/or exchange rates.