Ask NiyaMonetary policy plays an active role in managing the economy, a fact that is well recognised. Although there is ongoing debate about its core objective, monetary policy typically aims at multiple goals such as sustained real output growth, higher productivity, employment generation, and equitable distribution.
Cross-country evidence suggests that the most fundamental objective of monetary policy should be maintaining low and stable inflation.
In a broader sense, the objectives of monetary policy align with the overall goals of economic policy. In the Indian context, the primary goals have been:
To maintain a reasonable degree of price stability
To ensure adequate credit expansion to support economic growth
The dilemma of selecting a dominant objective arises due to the multiplicity of goals and potential conflicts among them. Jan Tinbergen argued that there must be at least one instrument for every target. Accordingly, some goals are better achieved through specific instruments than others.
The “assignment rule” supports using monetary policy as the most suitable instrument for achieving price stability.
The rationale behind targeting price stability is that price volatility introduces uncertainty in economic decision-making. Rising prices tend to discourage savings and encourage speculative investments, distorting the investment climate.
In India, the Chakravarthy Committee (1985) recommended a 4% inflation rate as an acceptable target, reflecting relative price adjustments needed to channel resources into growth sectors.
Fluctuations in agricultural output significantly impact price trends in India. However, continuous inflation cannot persist without a sustained increase in money supply.
Therefore, controlling money supply is crucial in any effective anti-inflation strategy, thereby facilitating economic growth.
Conclusion: Monetary policy remains a highly effective tool for achieving key macroeconomic objectives, particularly price stability and growth support.
The operating procedure of monetary policy in India has gradually evolved from direct control over credit to a more flexible liquidity management system in a market-oriented framework.
Initially, the Reserve Bank of India (RBI) used direct instruments like fixed deposit and lending rates, selective credit controls, sector-specific refinance, Statutory Liquidity Ratio (SLR), and Cash Reserve Ratio (CRR). The Bank Rate served as the main instrument of interest rate policy.
By the mid-1980s, monetary policy began shifting towards a more market-oriented framework following the Chakravarty Committee (1985) and Vaghul Committee (1987) recommendations, introducing flexible monetary targeting and money market reforms.
The financial sector reforms of the early 1990s accelerated this transition. Key reforms included:
Deregulation of interest rates (mostly completed by October 1997)
Phasing out of selective credit controls by 1994
Withdrawal of most sector-specific refinance facilities by 2002
Shift from CRR-based control to Open Market Operations (OMOs)
The introduction of the Liquidity Adjustment Facility (LAF) in June 2000 became the main instrument for short-term liquidity modulation, using the repo and reverse repo rates for monetary policy signaling. These, along with CRR, OMOs, and the Market Stabilisation Scheme (MSS), formed the key policy tools.
In July 2010, RBI formed a Working Group under Deepak Mohanty to review the operating procedure of monetary policy. The Group defined four distinct phases:
Formative Phase (1935–1950)
Development Phase (1951–1990)
Early Reform Phase (1991–1997)
Liquidity Adjustment Facility Phase (1998 onwards)
The scope of this unit is limited to the LAF Phase (1998 onwards). Key milestones include:
Narasimham Committee II (1998) recommended the LAF, leading to the introduction of Interim LAF (ILAF) in April 1999 to stabilise short-term interest rates.
Under ILAF: The Bank Rate was used for liquidity injection and fixed reverse repo rate for absorption, on a daily basis.
Full LAF implementation began in June 2000 in three stages:
Stage 1 (June 2000): Fixed reverse repo replaced with variable rate auctions
Stage 2 (March 2004): Introduced 7-day fixed rate reverse repo and 14-day variable rate reverse repo; retained overnight repo
Stage 3 (November 2004): LAF operated through overnight fixed rate repo and reverse repo only. The terms "repo" and "reverse repo" were aligned with international usage.
The Public Debt Office (PDO) computerisation and launch of Real Time Gross Settlement (RTGS) enabled electronic operations and intraday repo auctions.
In 2005–06, increased liquidity needs (due to strong credit demand, forex reserve trends, and IMD redemptions) led to the introduction of Second LAF (SLAF) for day-to-day fine-tuning. SLAF is now used periodically depending on market conditions.
For a complete analysis of the earlier monetary policy phases and technical documentation, refer to the RBI’s Report of the Working Group on Operating Procedure of Monetary Policy (2011).
Ask Niya