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Macro Economics

Notes In the wake of the economic crisis in 1991 triggered by a difficult balance of payments situation,
the Government introduced far reaching changes in India’s economic policy. Monetary policy
was used effectively to overcome the balance of payments crisis and promptly restore stability.
An extremely tight monetary policy was put in place to reap the full benefits of the devaluation
of the rupee that was announced. However, it did not stop with that. Financial sector reforms
became an integral part of the new reform programme. Reform of the banking sector and capital
market was intended to help and accelerate the growth of the real sector. Banking sector reforms
covered a wide gamut.
The most important of the reforms was the prescription of prudential norms including capital-
adequacy ratio. In addition, certain key changes were made with respect to monetary policy
environment which gave to commercial banks greater autonomy in relation to the management
of their liabilities and assets.
First and foremost, the administered structure of interest rates was dismantled step by
step. Banks in India today enjoy the complete freedom to prescribe the deposit rates and
interest rates on loans except in the case of very small loans and export credit.
Second, the Government began borrowing at market rates of interest. The auction system
was introduced both in relation to Treasury Bills and dated securities.
Third, with the economic reforms emphasising a reduction in fiscal deficit, pre-emptions
in the form of cash reserve ratio and statutory liquidity ratio were steadily brought down.
Fourth, while the allocation of credit for the priority sector credit continued, the extent of
cross subsidisation in terms of interest rates was considerably brought down because of
the reform of the interest rate structure.
Monetary policy in the 1990s in India had to deal with several issues, some of which traditional
but some totally new in the context of the increasingly open economy in which the country had
to operate. In the first few years, monetary policy had to contend with the consequences of
devaluation and the need to quickly restore price stability to obtain the full benefits of
devaluation. While the fiscal deficit was being brought down, the question of monetisation of
the deficit continued to remain an issue and a solution had to be found. This eventually led to a
new agreement between Government and RBI on financing deficit.
The system of ad-hoc Treasury Bills under which Government of India could replenish its cash
balances by issuing Treasury Bills in favour of the Reserve Bank and which had the effect of
monetising deficit was phased out. It was replaced by a system of Ways and Means advances
which had a fixed ceiling. The Reserve Bank of India continued to subscribe to the dated securities
at its discretion.

Did u know? During 1993 and 1994, for the first time monetary policy had to deal with the
monetary impact of capital inflows with the foreign exchange reserves increasing sharply
from $9.2 billion in March 1992 to $25.1 billion in March 1995. In 1995–96, the change in
perception with reference to exchange rate after a prolonged period of nominal exchange
rate stability vis-à-vis the US dollar brought into play the use of monetary policy to
stabilise the rupee — an entirely new experience for the central bank. Similar situations
arose later on also at the time of the East Asian crisis.
Monetary policy had begun to operate within a changed institutional framework brought about
by the financial sector reforms. It is this change in the institutional framework that gave a new
dimension to monetary policy. New transmission channels opened up. Indirect monetary controls
gradually assumed importance. With the progressive dismantling of the administered interest
rate structure and the evolution of a regime of market determined interest rate on Government

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