Here we detail about the three objectives of monetary policy of Reserve Bank of India (RBI).
The three objectives are: (1) Price Stability or Control of Inflation, (2) Economic Growth, and (3) Exchange Rate Stability.
Objective 1# Price Stability or Control of Inflation:
It may be noted that each instrument of economic policy is better suited to achieve a particular objective. Monetary policy is better suited to the achievement of price stability, that is, containing inflation. To quote C. Rangarajan, a former Governor of Reserve Bank of India, “Faced with multiple objectives that are equally relevant and desirable, there is always the problem of assigning to each instrument the most appropriate target or objective of the various objectives, price stability is perhaps the one that can be pursued most effectively by monetary policy. In a developing country like ours, acceleration of investment activity in the context of supply shocks in the agricultural sector tends to be accompanied by pressures on prices and, therefore, monetary policy has much to contribute in the short-run management.”
Thus, achieving price stability has remained the dominant objective of monetary policy of Reserve Bank of India. It may however be noted that price stability does not mean absolutely no change in price at all. In a developing economy like ours where structural changes take place during the process of economic growth some changes in relative prices do occur that generally put upward pressure on prices.
Therefore, some changes in price level or, in other words, a certain rate of inflation is inevitable in a developing economy. Thus, price stability means reasonable rate of inflation. A high degree of inflation has adverse effects on the economy. First, inflation raises the cost of living of the people and hurts the poor most. Therefore, inflation has been described as enemy No. 1 of the poor.
Inflation sends many people below the poverty line. Secondly, inflation makes exports costlier and, therefore, discourages them. On the other hand, due to higher prices at home people are induced to import goods to a large extent. Thus, inflation has an adverse effect on the balance of payments.
Thirdly, when due to a higher rate of inflation value of money is rapidly falling, people do not have much incentives to save. This lowers the rate of saving on which investment and economic growth depend. Fourthly, a high rate of inflation encourages people to invest in the unproductive assets such as gold, jewellery, real estate etc.
An expert committee on monetary reforms headed by Late Prof. S. Chakravarty suggested 4 per cent rate of inflation as a reasonable rate of inflation and recommended that monetary policy by RBI should be so formulated that ensures that rate of inflation does not exceed 4 per cent per annum. Emphasising the importance of price stability from the viewpoint of India’s balance of payments.
Prof. Rangarajan writes, “The increasing openness of the economy, the need to service external debt and the necessity to improve the share of our exports in a highly competitive external environment require that the domestic price level not be allowed to rise unduly, particularly since our major trading partners have had notable success in recent years in achieving price stability.”
Objective 2# Economic Growth:
Promoting economic growth is another important objective of the monetary policy. In the past Reserve Bank has often been criticised that it pursued the objective of controlling inflation and achieving price stability and neglected the objective of promoting economic growth. Monetary policy can promote economic growth through ensuring adequate availability of credit and lower cost of credit.
There are two types of credit requirements of businesses. First, they have to finance their requirements of working capital and for importing needed raw materials and machines from abroad. Secondly, they need credit for financing investment in projects for building fixed capital. Easy availability of credit at low interest rate stimulates investment and thereby quickens economic growth.
However, during the periods of high inflation, Reserve Bank followed a tight monetary policy under which Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) were raised to restrict the availability of credit for private sector. Besides, by raising bank rate and repo rate at which banks borrow from Reserve Bank of India lending rates of interest of banks were kept at high levels which discouraged private investment.
This tight monetary policy worked against promoting growth. However, in the opinion of Prof. Rangarajan, there is no conflict between the objectives of price stability and growth. Price stability, according to him, is a means to ensure economic growth.
To quote him,”It is price stability which provides the appropriate environment under which growth can occur and social justice can be ensured”. However, in our opinion, this may be true in the long run but in the short run there exists trade off between growth and inflation.
To ensure higher economic growth the adequate expansion of money supply and greater availability of credit at a lower rate of interest is needed. But large expansion in money supply and bank credit leads to the increase in aggregate demand which tends to cause a higher rate of inflation. This raises the issue of what is acceptable trade off between growth and inflation, that is, what rate of inflation is acceptable to promote growth through appropriate monetary policy.
Expert Committee on monetary policy headed by Late Prof. Chakravarty suggested a target of 4 per cent as “the acceptable rise in prices”. According to it, the growth of money supply and availability of credit should be so regulated that rate of inflation does not exceed 4 per cent per annum.
However, C. Rangarajan, former Governor of Reserve Bank, fixed a higher target, namely, 5 to 6 per cent rate of inflation in the context of objective of achieving 6 to 7 per cent rate of economic growth. To quote him, “keeping the price and growth objectives in view the money supply growth should be so regulated that inflation rate comes down, eventually to 5 to 6 per cent. That indeed must be the goal of monetary policy.”
It may be noted that in the context of the openness of the economy and floating exchange rate system, as is the case of the Indian economy today, the objective of achieving higher rate of economic growth through monetary measures may also conflict with objective of exchange rate stability, that is, value of rupee in terms of the US dollar and other foreign currencies.
Whereas prevention of the depreciation of rupee requires tightening of monetary policy, that is raising of interest rate, reducing liquidity of the banking system so that banks restrict their credit supply, the promotion of growth objective requires lower lending rates of interest and greater availability of credit for encouraging private investment.
It is this dilemma of conflicting objectives of supporting higher economic growth or achieving price stability through control of inflation by RBI which is being presently faced in India (2012-13 and 2013-14).
Objective 3# Exchange Rate Stability:
Until 1991, India followed fixed exchange rate system and only occasionally devalued the rupee with the permission of IMF. The policies of floating exchange rate and increasing openness and globalisation of the Indian economy, adopted since 1991, have made the exchange rate of rupee quite volatile.
The changes in capital inflows and capital outflows and changes in demand for and supply of foreign exchange, particularly US dollar, arising from the imports and exports cause great fluctuations in the foreign exchange rate of rupee. In order to prevent large depreciation and appreciation of foreign exchange rate Reserve Bank has to take suitable monetary measures to ensure foreign exchange rate stability.
Owing to the fixed exchange rate system prior to 1991 the concern about foreign exchange rate had not played a significant role in the formulation of monetary policy.
Today, the exchange rate of rupee is determined by demand for and supply of foreign exchange (say, US dollar). When there is mismatch between demand for and supply of foreign exchange, external value of rupee changes.
For instance, from August 2011 to December 2011 depreciation of rupee as against US dollar had been caused by the increase in demand for dollars from (1) the corporate sector for financing their imports, (2) Foreign Institutional Investors (FII) who wanted to take out their dollars from India (i.e., capital outflow) to the US risen and (3) increase in demand for US dollar by the Indian banks on the instructions of the public sector undertakings for financing necessary imports from abroad.
Since export earnings and capital inflows which determine the supply of dollars had not risen adequately, mismatch between dollars and supply of dollars had arisen causing the depreciation of rupee as against the US dollar.
Thus when there is large current account deficit (CAD) that exceeds comfortable level (which in Indian situation is estimated at 2.5 per cent of GDP as it can be financed by normal capital inflows), it tends to depreciate the Indian rupee. In 2011-12 there was current account deficit (CAD) of 4.2 per cent and for 2012-13 it is expected that current account deficit (CAD) will be around 5 per cent of GDP.
This is too high current account deficit which is putting downward pressure on the exchange rate of rupee. The depreciation of rupee raises the costs of imports which adds to the inflationary pressures in the Indian economy. Therefore, reducing current account deficit (CAD) to the comfortable level is not only essential for exchange rate stability but also for controlling inflation and achieving price stability.
According to D. Subbarao, the present Governor of RBI, the widening of current account deficit in India during the last two years (2011-12 and 2012-13) has emerged as a major constraint on easing of monetary policy as causing lower lending interest rates and large availability of funds with banks will lead to more imports which will add to the current account deficit.
To arrest the fall in value of rupee Reserve Bank raises the bank rate and repo rate and thus send signals to the banks to raise their lending rates. It also raises cash reserve ratio (CRR) to reduce the liquidity in the banking system and thus reducing lendable resources of the banks.
Thus, through rise in the cost of credit and reduction in the availability of credit, borrowing from the banks are discouraged which is expected to reduce the demand for dollars. The higher interest rates in India would also discourage foreign institutional investors and Indian corporates to invest abroad. This will also work to reduce the demand for dollars which will prevent the fall in the value of the rupee.
Alternatively, to prevent the depreciation of the rupee, Reserve Bank can release more dollars from its foreign exchange reserves. The release of more dollars by Reserve Bank will increase the supply of US dollars in the foreign exchange market and will therefore tend to correct the mismatch between demand for and supply of the US dollars. This will help in stabilising the exchange rate of the rupee. It is clear from above that in the context of flexible exchange rate system, Reserve Bank has to intervene frequently to achieve stability of exchange rate at a reasonable level.