What is a clear explanation of monetary policy and its effect on India economy?

July 12, 2018

Who is the most influential person in India whose decision affects millions of people in our country? Any guesses?



This 54 years man is currently serving as 24th Governor of Reserve Bank of India

RBI is the central bank of India. RBI has two important jobs:

  1. Regulate the Banks

  2. Conduct Monetary policy. (Increasing or decreasing the money supply to speedup or slowdown the overall economy.)

Monetary policy is what makes The RBI so influential. why?

Let's start with interest rates.

An interest rate is the price of borrowing money. When banks lend money, they expect to be repaid the amount they lent, which is called the principle, and a percentage of the principle to cover inflation and to make some profit. That percentage is called the interest rate. The number of car loans, student loans, home loans, and business loans that get made depends on interest rates. When interest rates are low, borrowers will find it easier to pay back loans so they will borrow more and spend more. When interest rates are high, borrowers borrow less and therefore spend less. RBI doesn't have the power to tell banks what interest rate to charge customers. So instead, The RBI manipulates interest rates by changing the money supply.

  • If The RBI increases the money supply, there'll be plenty of money for banks to loan out. Borrowers will shop around for the best deal on a loan, and banks will be forced to lower interest rates because they're gonna have to compete or else no one's gonna borrow from them.

  • A decrease in money supply has the opposite effect. Less money supply means the banks have less money to loan out, so they're gonna try and get the highest interest rate possible. So 

    less money > higher interest rates.

If the central bank wants to speed up the economy, they can increase the money supply, which will decrease interest rates, and lead to more borrowing and spending. That's called Expansionary Monetary Policy. If the central bank wants to slow down the economy, they decrease the money supply -- less money available will increase interest rates and decrease spending. That's called Contractionary Monetary Policy.


Let’s take an example:




After the Dot Com bust and then 9-11, the U.S. economy was in a slump or a recessionary gap. Output was low, and unemployment was high. To speed up the economy, The Fed boosted the money supply, which lowered interest rates. This made borrowing easier, which increased spending, and as a result, the economy began growing again, albeit slowly.

There are two things that keep the banking system healthy -

  1. Confidence

  2. Liquidity.

When customers deposit money in a bank, they need to feel confident they're gonna get their money back. In the early years of The Great Depression, The Fed allowed several large bank to fail, which caused widespread panic and bank runs in other banks. The result was a third of all banks collapsed.


The banks failed because they didn't have Liquid Assets, which is a fancy way of saying the banks had stock, bonds, mortgages, but not cash money. So when depositors rushed to take money out, the banks couldn't pay. The Fed gets blamed for prolonging The Depression because it didn't give banks emergency loans, which would've increased the liquidity in banks and the money supply in general.

The question is:

How does RBI change the money supply?

There are three main ways.

1) Fractional Reserve Banking: When you deposit money in a bank, the bank holds a portion of deposits and loans the rest out. This is called Fractional Reserve Banking. The fraction deposits the banks are required to hold in reserves is conveniently called the Reserve Requirement.

Example: If you have deposited 1000 Rs. in banks then Bank can lend only up-to the excess amount left over after meeting the reserve requirements (like Cash Reserve Ratio, SLR, Provisions etc) prescribed by Reserve Bank of India . To put in simple Words, Rs. 1000 Deposit - Rs. 230 (i.e; 23% SLR) - Rs. 40 (CRR) - Rs. 100 (Provisions assumed at 10%) = Rs. 630/- is the lend able funds.


The first way The RBI can change the money supply is by changing that requirement. Decreasing the Reserve Requirement will increase the money supply, and increasing the Reserve Requirement decreases the money supply.


2) Decreasing REPO rate: The RBI is the banker's bank, so if a commercial bank needs money, they can borrow from The RBI and RBI charge interest, that interest rate is called the REPO rate. Decreasing the REPO Rate will make it easier for banks to borrow, and that'll increase the money supply. Increasing that rate will decrease the money supply.


3) Open Market Operations: This is when The RBI buys or sells short term government bonds. Now a government bond, or something called a treasury bill, is an IOU issued by the government that says, "I'll pay you back later." Banks hold those bonds because they earn interest and are generally less risky than stocks. If The RBI buys these previously issued government bonds from a bank, it increases that bank's liquidity and increases the money supply. If The RBI issues more bonds, the banks will have less liquidity and less money to loan out, and that'll decrease the money supply.


Note: During the 2008 financial crisis, when the economy was in severe recession, The Fed went straight to work, buying massive of bonds. Boosting the money supply and dropping interest rates to practically zero. But it wasn't enough because the economy was in really bad shape.



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