Monetary Policy and Credit Control

In one line

Monetary policy is the Reserve Bank changing the price and quantity of money, and credit control is it telling banks how much they may lend and to whom.

In the wording a student can write in an exam: the instruments of monetary policy in India are quantitative and qualitative. The quantitative instruments are the cash reserve ratio under section 42 of the Reserve Bank of India Act, 1934, the statutory liquidity ratio under section 24 of the Banking Regulation Act, 1949, the bank rate under section 49 of the 1934 Act, the policy repo rate fixed by the Monetary Policy Committee under Chapter IIIF, and open market operations conducted under section 17. The qualitative or selective instruments operate under section 21 of the Banking Regulation Act, and include margin requirements, ceilings on credit, directives on the purposes of advances, and moral suasion.

What monetary policy is trying to do

Start with the mechanism, because the instruments are meaningless without it.

Banks create most of the money in the economy. Chapter 40 explained credit creation: a bank holds only a fraction of its deposits in cash, so each loan returns to the system as a deposit and supports further lending. The quantity of money is therefore mostly the quantity of bank credit.

So a central bank controls money by controlling bank credit, and it has two ways of doing it. It can change how much banks are able to lend, by taking cash out of their hands or putting it in. Or it can change what it costs them to obtain funds, so that they lend less because lending is dearer.

The statutory objective is now written down, which it was not for most of the Bank's life. Section 45ZA, worked in chapter 270, provides for the Central Government to determine the inflation target in consultation with the Bank, and the preamble to the Act was amended in 2016 to state that the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.

That amendment settled an old argument. Before it, the Bank pursued several objectives at once, growth, price stability, exchange rate management, and could be criticised for whichever it had subordinated. A stated primary objective with a numerical target makes the Bank accountable in a way discretion never did.

The cash reserve ratio: section 42

Section 42(1). "Every bank included in the Second Schedule shall maintain with the Bank an average daily balance the amount of which shall not be less than such per cent of the total of the demand and time liabilities in India of such bank as shown in the return referred to in sub-section (2), as the Bank may from time to time, having regard to the needs of securing the monetary stability in the country, notify in the Gazette of India."