Monetary policy controls the supply of money in circulation and in the market. The RBI is tightening the monetary policy. This is being done with the view to bring Indian Economy to equilibrium in terms of inflation. The Indian Economy has been facing persistent price rise and a comfortable growth in the factory output.The following is an attempt to explain the monetary policy and actions taken by RBI for the same.
The RBI ( Reserve Bank of India ) is in control of the monetary policy within the country. If the RBI increases the supply of money in the market the direct impact is observed on the interest rates which tend to fall. Here the demand for money happens to be less than the supply of money and hence the reduction in interest rates. This affects the overall economy as aggregate demand increases further causing an increase in GDP. On the other hand when the RBI reduces the supply of money in the market, the direct impact is increase in interest rates.
The RBI will review its monetary policy on the 27th of July 2010. The RBI has to consider the high input costs and rising prices of most manufactured goods while making a policy decision. All of this has added another dimension to an already worrying level of inflation in the economy.
The Rationale behind the government to take the tightening of monetary policy is as follows.
On the domestic front, the revised growth estimates by the Central Statistical Organization (CSO) for 2009-10 and for Quarter 4 of 2009-10 suggest that the recovery is consolidating.
The manufacturing sector has recorded robust growth in recent months, aided among others, by expanding exports. The strong underlying growth momentum is also evidenced by the sharp upturn in the capital goods sector, acceleration in credit growth and the widening current account deficit.
The monsoon situation so far has been decidedly better than during last year holding prospects for good agriculture growth. In its April policy review, the Reserve Bank projected real GDP growth for 2010-11 at 8 per cent with an upside bias. More recent data suggest that the upside bias has largely materialised. The growth projection will be reviewed in the First Quarter Review on July 27, 2010.
The developments on the inflation front, however, raise several concerns.Overall inflation increased to 10.2 in May 2010, up from 9.6 per cent in April 2010.
Food price inflation and consumer price inflation remain at elevated levels. More importantly, the prices of non-food manufactured goods and fuel items have accelerated in recent months.
Although entirely justified in terms of long-term fiscal and energy conservation objectives, the recent increase in fuel prices will have an immediate impact of around one percentage point on inflation, with second round effects being felt in the months ahead. Significantly, around two-thirds of inflation in the month of May 2010 was contributed by non-food items suggesting that inflation is now very much generalized and the effect of demand-side pressure is quite evident.
Measures taken by RBI to follow the monetary policy:
RBI, on an assessment of the current macroeconomic situation, has decided to take the following monetary policy measures as a part of the calibrated exit from the expansionary monetary policy:
• To increase the repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points from 5.25 per cent to 5.50 per cent with immediate effect.
(Repo rate is the interest rate paid by the banks when they borrow money from RBI)
• To increase the reverse repo rate under the LAF by 25 basis points from 3.75 per cent to 4.0 per cent with immediate effect.
(Reverse repo rate is the rate at which RBI borrows from banks)
Overall Impact.
In an already inflated economy it would be difficult to understand how the rise in the interest rates further will help. However, The following may be a possible explanation
1. The RBI engages in open market operations and tightens the monetary policy reducing the ank reserves.
2. Decrease in bank reserves leads to an increase in repo rates.
3. Other short term rates increase as well. Other interest rates in the economy increases as banks have less amount of currency to lend and consumers are still in need to funds. As supply for loanable fund decreases the equilibrium rate for loans increases.
4. Longer term rates , which are viewed as short-term rates plus a premium fr expected inflation increases aswell
5. The increase in rates makes the investment in other countries less attractive and rupee value increases.
6.The increase in interest rates will cause less business loans and hence less business expansions. As funds are costly people tend to borrow less and invest less on plant equipment , property,etc.
7. This is actually a slowing down of growth or inflationary cycle. Consumers react to the increase in the interest rates on consumer loans by reducing the purchases of goods that are typically financed such as houses,automobiles and appliances.
8. The appreciation on indian rupee makes Indian goods less attractive to foreigners.
9. In sum, the decrease in business investment, consumer purchases of durable goods,
and exports all together tend to decrease aggregate demand
10. The decrease in aggregate demand puts a downwards pressure on both the price level
( decreasing inflation) and GDP.
However, in practice this monetary policy may not follow and bring about the intended effects as there is a loose link between short-term interest rates and long term rates that RBI can influence.
Also monetary policy affects the economy with a significant amount of time lag. By the time an effect actually occurs the economy may have passed the phase of inflation or recession. Hopefully, This time in view, the government policy seems to be on time and we expect a reduction in price levels in the future.
