Monetary Policies - Types, Monetary Policy Framework Agreement & Committee

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 Types of Monetary Policies

  • Broadly, monetary policy can be of two kinds Expansionary Monetary Policy and Contractionary Monetary Policy. Alternatively, they are also called as Cheap Money policy or Dear money policy respectively.
  • Expansionary monetary policy increases the supply of money in an economy by making credit supply easily available.
    • Money produced through such a policy is called as cheap money.
    • An expansionary monetary policy is utilized when an economy goes through a phase of recession accompanied by lower levels of growth and high levels of unemployment. For example, in 2008-09 the entire world including India adopted an expansionary monetary policy to counter slowdown/recession.
    • But expansionary monetary policy comes with its own risks, such as inflation.
    • Also, there is a time lag between the time when policy is announced and when it takes effect in the economy,
    • thus at times the expansionary monetary policy may not have desired impact on the economy in terms of growth.
  • Contractionary monetary policy on the other hand, decreases the supply of money in the economy.
    • Contractionary monetary is used to tackle the menace of inflation in the economy by raising the interest rates.
Who decides the Monetary Policy
  • Monetary policy decisions by central banks can have far-reaching implications for the economy, investors, savers and borrowers. Therefore, globally many governments have solved this problem by appointing a committee.
  • RBI (with the Governor as the focal point) would be subject to hectic lobbying ahead of each policy review and trenchant criticism after it.
  • The Governor of RBI is appointed and can be disqualified by the Government anytime. This led to uncertainty and resulted in friction between the Government and the RBI, especially during the times of low growth and high inflation.
  • The Government would clamour for lower rates while consumers bemoaned high inflation. Bank chiefs would want rate cuts, but pensioners would want high rates. RBI ended up juggling all these objectives and focussing on different indicators at different points in time.
  • Before the constitution of the MPC, a Technical Advisory Committee (TAC) on monetary policy with experts from monetary economics, central banking, financial markets and public finance advised the Reserve Bank on the stance of monetary policy. However, its role was only advisory in nature.
  • To resolve this, RBI set up an Expert Committee under Urijit Patel to revise the monetary policy framework, and it came up with its report in January 2014. It suggested that RBI abandon the ‘multiple indicator’ approach and make inflation targeting the primary objective of its monetary policy.
  • It also mooted having a Monetary Policy Committee so that these decisions could be made through majority vote.
  • It suggested a five-member MPC - three members from the RBI and two nominated by the Government. The Government (as per Financial Sector Legislative Reforms Commission report - FSLRC) initially proposed a seven-member committee- three from the RBI and four nominated by it.
  • Subsequent negotiations led to the current composition of the committee, with the external members having a four-year term.
  • Suggestions for setting up a Monetary policy committee is not new and goes back to 2002 when YV Reddy committee proposed to establish a MPC, then Tarapore committee in 2006, Percy Mistry committee in 2007, Raghuram Rajan committee in 2009 and then Urjit Patel Committee in 2014.
  • Having both Government and RBI members on the MPC was suggested for accountability. The Government would have to keep its deficit under check and RBI would owe an explanation for runaway inflation.
  • The MPC will ensure that decisions on interest rates are made through debate by a panel of experts. The many-heads-are-better-than-one approach may also help ensure that the decision isn’t easily influenced by bias or lobbying.
  • India’s shift to an MPC, driven by a clear inflation-targeting framework,
  • The public disclosure of MPC deliberations will also make it clear to public why its members batted for higher or lower rates.
Urjit Patel Committee
  • Formed by: RBI (and not finance ministry)
  • Official name: Expert Committee to Revise and Strengthen the Monetary Policy Framework
  • Chairman: Dr. Urjit Patel, Dy. Governor of RBI
  • Eight Members: economics professors, finance experts etc.
Main Recommendations are
  1. Choice of nominal anchor: Currently, RBI uses a, multiple indicator approach‟ to draw monetary policy perspective. The Committee made the following recommendations:
    • Inflation, as measured by Consumer Price Index (CPI) should be the nominal anchor for the monetary policy framework. This is because CPI, as an indicator of retail inflation, is the closest proxy of a true cost of living, and influences inflation expectations of households.
    • Nominal anchor will be targeted at 4% with a band of + 2%.
  2. Organisational Structure: The Committee recommended that monetary policy decision making be vested in a Monetary Policy Committee
  3. RBI should focus on Inflation control with growth rate in mind
  4. Fiscal deficit should be reduced to 3% of GDP
Monetary Policy Framework Agreement
  • Monetary Policy Framework Agreement is an agreement reached between Government and the central bank in India – The Reserve Bank of India (RBI) - on the maximum tolerable inflation rate that RBI should target to achieve price stability.
  • The Reserve Bank of India and Government of India signed the Monetary Policy Framework Agreement on 20 February 2015 which made inflation targeting and achieving price stability the responsibilities of RBI.
  • Subsequently, the government, while unveiling the Union Budget for 2016-17 in the Parliament, proposed to amend the Reserve Bank of India (RBI) Act, 1934 for giving a statutory backing to the aforementioned Monetary Policy Framework Agreement and for setting up a Monetary Policy Committee (MPC).
  • Vide this amendment, it was written into the preamble of the RBI Act that the primary objective of the monetary policy is to maintain price stability, while keeping in mind the objective of growth, and to meet the challenge of an increasingly complex economy, RBI would operate a Monetary Policy Framework.
  • India thereby formally joined the list of nations which tasks its central bank with the responsibility for inflation targeting.
Monetary Policy Committee
Constitution of the MPC
Altogether, the MPC will have six members, -
  • RBI Governor (Chairperson),
  • RBI Deputy Governor in charge of monetary policy,
  • One official nominated by the RBI Board and
  • The remaining three members would represent the Government of India.
These Government of India nominees are appointed by the Union Government based on the recommendations of a search cum selection committee consisting of
  • Cabinet secretary (Chairperson),
  • RBI Governor,
  • Secretary of the Department of Economic Affairs, Ministry of Finance, and
  • Three experts in the field of economics or banking as nominated by the Union Government.
  • The Three Union Government nominees of the MPC will hold office for a period of four years and will not be eligible for re-appointment.
  • These three Union Government nominees in MPC are mandated to be persons of ability, integrity and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy.
  • RBI Act prohibits appointing any Member of Parliament or Legislature or public servant, or any employee / Board / committee member of RBI or anyone with a conflict of interest with RBI or anybody above the age of 70 to the MPC.
  • Further, Union Government also retains powers to remove any of its nominated members from MPC subject to certain conditions and if the situation warrants the same.
Monetary Policy Committee (MPC) - Statutory body
  • Now in India, the policy interest rate required to achieve the inflation target is decided by the Monetary Policy Committee (MPC).
  • MPC is a six-member committee constituted by the Union Government (Section 45ZB of the amended RBI Act, 1934).
  • The MPC is required to meet at least four times in a year.
  • The quorum for the meeting of the MPC is four members. Each member of the MPC has one vote, and in the event of an equality of votes, the RBI Governor has a second or casting vote.
  • The resolution adopted by the MPC is published after the conclusion of every meeting of the MPC.
  • Once in every six months, the Reserve Bank is required to publish a document called the Monetary Policy Report to explain:
  • the sources of inflation and
  • the forecast of inflation for 6-18 months ahead.
The Union Government in September 2016 constituted the MPC with 6 members, 3 from RBI and 3 members appointed by government. After end of the first term of the MPC in August 2020, New Members were nominated by government in October 2020 for period of 4 years. (Till 2024)
  1. Governor of the Reserve Bank of India – Chairperson, ex officio;
  2. Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy – Member, ex officio;
  3. One officer of the Reserve Bank of India to be nominated by the Central Board – Member, ex officio;
  4. Ashima Goyal is a member of Prime Minister Narendra Modi’s economic advisory council. Goyal is a professor at the Indira Gandhi Institute of Development Research in Mumbai and was a visiting fellow at Yale University.
  5. Shashanka Bhide is a senior advisor at the National Council for Applied Economic Research, whose work has involved research into agriculture, poverty analysis and macroeconomics.
  6. Jayanth Varma, professor of finance and accounting at Indian Institute of Management, Ahmedabad, is an expert on the financial sector. He has served as part-time member of securities regulator SEBI for three years and a full-time member for one year.
Inflation Target
  • MPC will aim to maintain Inflation at 4% with a band of + 2% (i.e., 2 - 6%) RBI shall be deemed to have failed to meet the target if inflation is more than 6% or less than 2% for three consecutive quarters.
Failure
  • If RBI fails to meet the target it shall give the report to Union Government,
The report must contain
  • Reasons for failure to achieve the target.
  • Remedial Action proposed.
  • Estimated time period within which the target shall be achieved.
Dispute Settlement
  • Any dispute regarding interpretation or implementation of this agreement shall be resolved through meeting between RBI governor and Union Government.

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