Monetary policy is the policy of the Central Bank for maintaining its control over the money supply for the realisation of general economic goals. But in a developing economy, monetary policy cannot remain confined only to controlling the supply of money. In the context of such economies, monetary policy must play a positive role.
The first Plan aptly remarked: Central banking in a planned economy can hardly be confined to the regulation of the overall supply of credit.
It would have to create the machinery needed for financing the developmental activities all over the country and in ensuring that the finance available flows in the directions needed.
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Accordingly the functions of the Reserve Bank have been expanded from merely discharging the traditional central banking functions to performing an active, developmental and promotional role in meeting the demands of the expanding Indian economy.
In the Indian context, the objective of monetary policy has been to accelerate economic development in an environment of reasonable price stability.
The monetary authority has to ensure that no legitimate productive activity is hampered by shortage of finance but, at the same time, the funds shall not become excessive to cause inflation. In other words, Reserve Bank’s responsibility is not merely one of credit restriction.
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In a growing economy there has to be a continuous expansion of money supply and bank credit and the central bank has the duty to see that legitimate credit requirements are met.
The Bank’s responsibility in the circumstances is mainly to moderate the expansion of credit and money supply in such a way up to ensure the legitimate requirements of industry and trade and curb the use of credit for unproductive and speculative purposes.
That is why the monetary policy adopted by the Reserve Bank is known as that of controlled monetary expansion. Controlled monetary expansion implies two aspects: (i) Expansion of money supply and (ii) Restraint on the secondary expansion of credit.
In a developing economy money supply has to be expanded sufficiently to match the growth of real national income.
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In India the rate of increase in money supply has been far in excess of the rate of growth of real national income and, as a result, there has been a consistent inflationary pressure in the economy.
Government budgetary deficit for financing a part of investment outlays is an important source of monetary expansion in India. Under such circumstances an important aim of monetary policy is to restrain the secondary expansion of credit.
While exercising restraint, due attention is given to the fact that legitimate requirements of production and trade are not affected adversely. RBI is empowered to use the usual instruments of monetary policy.
The Bank rate is used to influence the availability and cost of credit. The Bank rate was raised to 12 per cent on October 8, 1991. The effectiveness of bank rate is very limited because a large portion of credit is made available in the market by non- banking institutions.
Secondly, a large part of bank credit is being advanced to the priority sectors at concessional rates of interest which is immune to the effect of change in the bank rate.
The open market operations have not been used much as an instrument of monetary policy to curb inflationary pressures but have been carried out with the particular object of keeping the prices of government securities stable.
The Reserve Bank uses the variable reserve requirements to control credit in India. The cash reserve requirements are of two kinds: (a) Cash reserve ratio (CRR) and (b) Statutory liquidity ratio (SLR).
The scheduled banks are required to maintain with the Reserve Bank a certain proportion of their aggregate demand and time liabilities.
The Reserve Bank can vary the cash ratio between 3 per cent and 15 per cent of the total demand and time liabilities. With effect from May 15, 1993, CRR has been 14 per cent.
Statutory liquidity ratio refers to that portion of total deposits of a commercial bank which it has to keep with itself in the form of cash reserves. The RBI has been empowered to raise the SLR to 40 per cent. On March 23, 1990 SLR was raised to 38.5 per cent.