Page 266 - DECO502_INDIAN_ECONOMIC_POLICY_ENGLISH

Indian Economic Policy

Notes It is for these reasons that open market operation was not used until the mid 1980s to control
money supply, nor was this tool effective when used. In fact, open market operation was not
used during the 1970s and the first half of the 1980s. The open market operation failed not only
in India but also in other developing economies. In a nutshell, open market operation did not
prove to be a very successful tool of monetary control. However, some important changes were
made in India on the recommendations of the Chakravarty Committee (1985). The interest rate
on Government securities was raised during the late 1980s and scheduled commercial banks
were granted freedom to determine their own prime lending rates. These two factors made
open market operation a fairly effective tool to control short-term credit.
After the economic reforms of 1991–92, OMO was assigned a greater role in monetary
management. “Since the onset of reforms,..., the Reserve Bank reactivated open market operations
(OMO) as an instrument of monetary management.... Active use of OMO for mitigating
inflationary pressures was undertaken during 1993-1995 in the wake of unprecedented capital
flows...”.
5. The Repo Rate : A New Monetary Tool Till the late 1980s, the RBI had been using the traditional
methods of monetary control. However, as mentioned above, on the recommendations of the
Chakravarty Committee (1985), some important changes were made in the monetary policy.
However, some major changes were introduced in the monetary policy only after the foreign
exchange crisis of 1990 and subsequent economic reforms. But the major problem that the RBI
continued to face was to control and regulate the high rise in money supply. The high rise in
money supply throughout was mainly due to monetization of the government’s deficit financing.
It was in 1991 that the World Bank and the IMF—the World Bodies that bailed India out of the
foreign exchange crisis—exerted pressure on the government to make certain major economic
reforms including monetary reforms. Some major monetary reforms and some new tools of
monetary management were introduced including the repo rate. We describe here briefly a new
monetary tool that is often used by the RBI, i.e., Repurchase Operation Rate — the repo rate.
In April 1997, the RBI introduced a new system, called Repurchase operation rate (abbreviated as
repo rate), to manage the short-run liquidity of the banking system. As mentioned above, under
the SLR system, the commercial banks are required to invest a certain percentage of their demand
and time deposits in government securities. This system blocks the bank money with the RBI,
often causing liquidity problem. The repo system provides a solution to this problem of liquidity.
Under the repo system, the RBI buys securities back from the banks and, thereby provides
funds to the banks. It is a form of lending money to the banks for a short period 1—14 days. The
rate of interest at which the RBI lends money to the bank is the repo rate. In contrast, there is
reverse repo rate. The reverse repo rate is the rate at which the banks can buy the securities or
deposit money with the RBI.
The operational rule of the repo rate is quite simple. When the central bank aims at increasing
liquidity or money supply, it buys back the securities at a low repo rate. This increase the funds
with commercial banks which can be used to create credit. On the other hand, when the objective
is to control the money supply, the RBI uses the reverse repo rate and increases the repo rate. In
June 1998, the repo rate was fixed at 5 percent. However, due to anticipated increase in liquidity
via Resurgent India bonds and East Asian crisis, the repo rate was raised to 8 percent in August
1998. But it was later reduced gradually to 4.5 percent in 2004, to 5 percent on April 28, 2005,
and to 6.25 percent on October 26, 2006. However, due to mounting inflationary pressure in the
economy, repo rate was increased to 7.25 percent m 2006-07. Along with the changes made in
the repo rate, the reverse repo rate was also simultaneously raised. In 2008, the Indian economy
was facing a 13-year high rate of inflation which was touching 12 percent. With the objective of
controlling inflation, the RBI kept increasing the repo rate. On July 29, 2008, the RBI raised the
repo rate from 8.5 percent in the previous week to 9 percent.
Evaluation of India’s Monetary Policy
At the end of the discussion, the question that arises about the monetary measures undertaken by the
RBI is : Has the monetary policy of India been successful ? This question takes us to the evaluation of

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