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Unit 13: Macro Economic Policies: Monetary Policy

securities, open market operations including ‘repo’ and ‘reverse repo’ operations emerged for Notes
the first time as an instrument of monetary control. Bank Rate acquired a new role in the
changed context. The Nineties paved the way for the emergence of monetary policy as an
independent instrument of economic policy.
Monetary policy in the 1990s had also to be conducted in the context of the financial sector
reforms. The need to reduce non-performing assets and to conform to the new prudential norms
put the banking industry under great strain. While introducing banking sector reforms, care had
to be taken to ensure that there was no compromise with the basic objectives of monetary
policy.

Developments in Monetary Policy in India

In its annual monetary policy review for 2010-11, RBI increased its policy rates.

Repo rate and Reverse repo rate increased by 25 bps to 5.25% and 3.75% respectively, with immediate
effect. Impact: Repo is the rate at which banks borrow from RBI and Reverse Repo is the rate at
which banks deploy their surplus funds with RBI. Both these rates are used by financial system
for overnight lending and borrowing purposes. An increase in these policy rates imply borrowing
and lending costs for banks would increase and this should lead to overall increase in interest
rates like credit, deposit, etc. The higher interest rates will in turn lead to lower demand and
thereby lower inflation. The move was in line with market expectations
Cash reserve ratio (CRR) increased by 25 bps to 6.00%, to apply from fortnight beginning from 24 April
2010. Impact: When banks raise demand and time deposits, they are required to keep a certain
percent with RBI. This percent is called CRR. An increase in CRR implies banks would be
required to keep higher percentage of fresh deposits with RBI. This will lead to lower liquidity
in the system. Higher liquidity leads to asset price inflation and also leads to build up of
inflationary expectations. Before the policy, market participants were divided over CRR. Some
felt CRR should not be raised as liquidity would be needed to manage the government borrowing
program, 3-G auctions and credit growth. Others felt CRR should be increased to check excess
liquidity into the system which was feeding into asset price inflation and general inflationary
expectations. Some in the second group even advocated a 50 bps hike in CRR.

By increasing the rate by 25 bps, RBI has signalled that though it wants to tighten liquidity it also
wants to keep ample liquidity to meet the outflows. Governor’s statement added that in 2010-11,
despite lower budgeted borrowings, fresh issuance will be around 342300 cr compared to
251000 cr last year.
Table 13.1: RBI’s Domestic Outlook for 2010-11

2009-10 targets 2009-10 2010-11 targets
(Jan 10 Policy) Actual Numbers (Apr 10 Policy)
GDP 7.5 Expected at 7.2 by 8 with an upward
CSO bias
Inflation (based on WPI, 8.5 9.9 5.5
for March end)
Money Supply (March 16.5 17.3 17
end)
Credit (March end) 16 17 20
Deposit (March end) 17 17.1 18
Source: RBI

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