INDIAN ECONOMY AND INDIAN FINANCIAL SYSTEM

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Module - B = ECONOMIC CONCEPTS RELATED TO BANKING

Unit-17 = MONETARY POLICY AND FISCAL POLICY

Monetary Policy:

● Tool used by the Central Bank to control the supply, availability, and cost of money.
● Aims to achieve economic growth and stability.
● RBI makes monetary policy statements on a bi-monthly basis.
● Expansionary policy increases money supply, while contractionary policy decreases
it.
● Expansionary policy used to combat unemployment by lowering interest rates, while
contractionary policy used to combat inflation by raising interest rates.

Fiscal Policy:

● Policy of the Government to influence macroeconomic conditions.

● Includes government spending and tax policies.
● Aims to boost the economy and control aggregate demand, inflation, and
employment levels.

Tools of Monetary Policy:

● Bank Rate is the rate at which RBI is willing to buy or rediscount bills of exchange or
other commercial papers
● MSF is a facility for scheduled commercial banks to borrow additional overnight
money from RBI
● CRR refers to the average daily balance that a bank is required to maintain with RBI
● CRR is used as a tool of credit control by regulating the lending capacity of banks
and controlling the money supply in the economy
● Changes in Bank Rate and MSF rates are used by central banks to control the
money supply in the country
● The bill market is under-developed in India, limiting the use of Bank Rate as a
monetary policy instrument
● Effective from May 21, 2022, the rate of CRR is 4.50% of NDTL

Statutory Liquidity Ratio (SLR):

● Banks in India are required to maintain a certain percentage of their demand and
time liabilities as cash, gold, or approved securities, known as the Statutory Liquidity
Ratio (SLR).
● SLR helps the Reserve Bank of India control the expansion of bank credit and
ensures the solvency of commercial banks.
 ● The RBI sets the percentage of SLR and requires banks to invest in government
securities like government bonds.

Standing Deposit Facility (SDF):

● The Standing Deposit Facility (SDF) is an additional tool for the RBI to absorb excess
cash from the economywithout giving government securities in return.
● Under the SDF, eligible entities can place deposits with the RBI on an overnight
basis, and the RBI retains the flexibility to absorb liquidity for longer tenors with
appropriate pricing.

Base Rate and Marginal Cost of Funds Based Lending Rate (MCLR):

● The Base Rate system, introduced in 2010, replaced the Benchmark Prime Lending
Rate (BPLR) system, and banks are required to price all categories of loans with
reference to the Base Rate.
● The Marginal Cost of Funds Based Lending Rate (MCLR) is a new methodology of
setting lending rates introduced in 2016, and banks must prepare an internal
benchmark lending rate based on their marginal cost of funds, negative carry on the
CRR, operating costs, and tenor premium.
● Repo rate is the rate at which the central bank lends short-term money to banks. An
increase in repo rate makes borrowing expensive for banks, while a decrease makes
it cheaper.
● Bank lending rates are influenced by the movement of repo rate, which is a policy
instrument of the central bank and changes from time to time based on its objectives.
● Tri-party repo (TREPS) is a form of repo contract involving three parties, including an
intermediary who facilitates collateral selection, payment and settlement, custody,
and management throughout the transaction.
● Term repos of different tenors have been introduced since 2013 to inject liquidity into
the interbank money market and set market-based benchmarks for pricing of loans
and deposits.
● Long-term repo operations (LTROs) and targeted long-term repo operations
(TLTROs) have been used as unconventional tools to provide liquidity to specific
sectors and entities experiencing liquidity stress
● Special long-term repo operations (SLTRO) were conducted to provide further
support to small business units, micro and small industries, and other unorganized
sector entities affected by the pandemic.
● Reverse repo rate is the rate at which banks park their short-term excess liquidity
with the central bank. An increase in reverse repo rate means that the central bank
will borrow money from the banks at a higher rate of interest, leading banks to prefer
keeping their money with the central bank.
● The variable rate reverse repo (VRRR) auction is a new instrument launched by the
central bank to absorb excess liquidity from the market and avert inflation. Banks can
participate in the auctions and park their money with the central bank at a variable
rate that is expected to be higher than the fixed reverse repo rate.
● In response to the global financial crisis of 2008, the Reserve Bank of India took
several conventional and unconventional measures to augment domestic and foreign
exchange liquidity and reduce policy rates.
 ● The actions taken by the Reserve Bank of India differed from those taken by many
advanced countries in that liquidity measures were largely channeled through banks
and collateral standards were not diluted.
● The Reserve Bank of India's experience in using pro-cyclical provisioning norms and
counter-cyclical regulations ahead of the global crisis helped to enhance financial
stability.

The Monetary Policy Committee (MPC):

● Determines the policy interest rate required to achieve the inflation target in the
economy.
● The primary objective of monetary policy in India is to maintain price stability while
keeping in mind the objective of growth.
● The amended RBI Act provides for the inflation target to be set by the Government of
India, in consultation with the Reserve Bank, once in every five years.
● The empowered six-member MPC is constituted by the Central Government and is
responsible for the monetary policy process.

Goals of the Monetary Policy

● The primary objective of monetary policy in India is to maintain price stability, while
keeping in mind, the objective of growth.
● In May 2016, the RBI Act, 1934 was amended to provide a statutory basis, for the
implementation of the flexible inflation targeting framework.
● The amended RBI Act also provides for the inflation target to be set by the
Government of India, in consultation with the Reserve Bank, once in every five years.
● Accordingly, the Central Government notified in the Official Gazette 4 per cent
Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016
to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance
limit of 2 per cent (4 ± 2 per cent). • On March 31, 2021, the Central Government
retained the inflation target and the tolerance band (4 ± 2 per cent) for the next
5-year period – April 1, 2021 to March 31, 2026.

HOW DID MONETARY POLICY IN INDIA RESPOND TO THE COVID-19 PANDEMIC

A. Liquidity Management:

● Targeted Long-Term Repo Operations (TLTROs) conducted auctions for fresh

deployment of liquidity in the system.
● Reduction in the Cash Reserve Ratio (CRR) of all banks by 100 basis points,
releasing primary liquidity of about Rs. 1,37,000 crores.
● Increased Marginal Standing Facility borrowing Limit from 2% to 3% to provide
additional liquidity support of Rs. 1,37,000 crore under the LAF window in times of
stress.
● Widening of the Monetary Policy Rate Corridor from 50 bps to 65 bps.
● Reduction in the Fixed-Rate Reverse Repo Rate from 4.0% to 3.75%.
● Special Liquidity Facility for Mutual Funds (SLF-MF) for Rs. 50,000 crores.
 ● Introduced G-SAP and VRRR to purchase government securities worth Rs. 1 lakh
crore in the first quarter of FY22 and withdraw liquidity at the short end and inject at
the long end.
● Targeted Long-Term Operations (TLTRO) 2.0 for an aggregate amount of Rs. 50,000
crores.
● On Tap TLTRO to allow banks to extend liquidity by pledging government securities
and invest the said liquidity back into the economy.
● Term Liquidity Facility to Ease Access to Emergency Health Services with an on-tap
liquidity window of Rs. 50,000 crores.

B. Regulation and Supervision:

● Lenders were allowed to give a 3-month moratorium on term loans, applicable to all
types of banks and financial institutions
● Lenders were permitted to recalculate drawing power by reducing margins and/or
reassessing working capitalcycle without asset classification downgrade
● The implementation of Net Stable Funding Ratio guidelines was deferred
● Deadline for meeting the last tranche of Capital Conservation Buffer was extended by
six months
● Special refinance facilities were provided for National Bank for Agriculture and Rural
Development, Small Industrial Development Bank of India, and National Housing
Bank
● Banks were advised not to pay out dividends from profits for the financial year ending
on March 31, 2020
● The Liquidity Coverage Ratio requirement for Scheduled Commercial Banks was
brought down from 100% to 80%
● An additional year was permitted for the extension of the date for commencement of
commercial operations in respect of all loans provided by NBFCs to the real estate
sector
● The maximum aggregate exposure threshold was enhanced from Rs. 25 crores to
Rs. 50 crores for MSMEs, non-MSME small businesses, and loans to individuals for
business purposes
● The moratorium/deferment/recalculation of the 'drawing power' is not to result in any
downgrade in asset classification
● The date for commencement for commercial operations was extended by an
additional year for loans to commercial real estate projects by NBFCs
● The WMA limit of the states was increased by 30% and further increased to 60%
● A moratorium of three months was allowed for all term loans including short-term
crop loans
● An additional three months' time was allotted to FPIs to fulfil the condition that at
least 75% of allotted limits be invested within three months
● New sectors were included in the PSL category and the limits for renewable energy
were increased
● The permissible LTV ratio for advances against gold ornaments and jewelry was
increased to 90% from 75%
● Stressed MSME borrowers were made eligible for debt restructuring under the
existing framework, provided their accounts were classified as standard as on March
1, 2020
 ● The National Automated Clearing House was made available on all days of the week
to enable timely transfer of government subsidies during the COVID-19 pandemic.

C. Decisions in respect of Financial Markets:

● RBI allowed offshore units of Indian banks to participate in the offshore rupee
derivative market to reduce currency market volatility due to the COVID-19
pandemic.
● Non-cash digital payment options (like NEFT, IMPS, UPI, and BBPS) were made
available round the clock to facilitate fund transfers, purchase of goods/services,
payment of bills, etc., during the pandemic and to avoid social contact and visiting
public places.
● RBI conducted a number of USD/INR Sell Buy Swaps to support the Indian rupee as
financial markets worldwide were facing intense selling pressures due to the spread
of COVID-19 infections, compounded by the slump in international crude prices and
a decline in bond yields in advanced economies in search of safe haven.
● RBI announced certain measures to support the foreign trade sector, including
increasing the export credit limit, providing a liquidity facility for Exim Bank of India,
and extending the time for payment for imports

Fiscal policy

● Fiscal policy refers to changes in government expenditures and taxes aimed at

achieving macroeconomic objectives.
● Fiscal policy is based on two fundamental instruments: taxation and government
expenditure.
● Taxes have a direct impact on people's income, savings, consumption, and standard
of living. Taxes also affect investment and the prices of goods and services.
● Government expenditures can be on goods and services, such as infrastructure, or
on income support for the poor, unemployed, and elderly.
● The primary objectives of fiscal policy in India are to promote economic growth and
maintain price stability, while additional objectives include mobilizing resources,
promoting allocative efficiency, reducing inequality in income and wealth, and
promoting private sector investment.
● Fiscal policy can be used to promote economic growth, maintain price stability,
mobilize resources, promote allocative efficiency, reduce inequality, and promote
private sector investment.

FRBM ACT:

● Fiscal policy refers to changes in government expenditures and taxes to achieve

macroeconomic objectives.
● Fiscal policy is based on taxation and government expenditure, which affect people's
income, savings, consumption, investment, and prices of goods and services.
● The primary objectives of fiscal policy in India are economic growth and maintaining
price stability, with additional objectives of mobilizing resources, promoting allocative
efficiency, reducing inequality, and promoting private sector investment.
 ● The Fiscal Responsibility and Budget Management (FRBM) Act requires the
government to present three statements to Parliament each year, with specific
content and format.
● The FRBM Act lays down fiscal management principles for reducing the fiscal deficit
(with no target mentioned in the Act but 3% of GDP prescribed in the Rules),
eliminating revenue deficit, setting a ceiling on guarantees (0.5% of GDP), prohibiting
borrowing from the Reserve Bank of India, and requiring the finance minister to keep
Parliament informed through quarterly reviews and take corrective measures if
deviations occur.
● The FRBM Act aims to reduce the government's dependence on borrowing and
reduce the fiscal deficit gradually.
● The implementation of the FRBM Act improved the fiscal performance of both the
central and state governments, but the global financial crisis of 2008 caused a
breach of the Act's targets, leading to amendments.
● Amendments were made in 2012 to add the Medium-Term Expenditure Framework
Statement (MTEF) and the concept of Effective Revenue Deficit (ERD), with targets
for reducing fiscal deficit, revenue deficit, and ERD.
● The government further amended the FRBM Act in 2015, extending the deadlines for
eliminating ERD and reducing the fiscal deficit, and the budget deficit target of 3%
was pushed back to the end of 2017-2018.
● The 2018-2019 budget introduced a new FRBM structure, where the revenue deficit
is no longer a targeted fiscal indicator, and effective revenue deficit is the gap
between revenue deficit and grants for creation of capital assets.1

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Jaiib Exam Notes By Ahsan Malik