Link between Money Market and Monetary Policy in India

The monetary policy represents policies objectives and instruments directed towards regulating money supply and the cost and availability of credit in the economy. In the monetary policy framework broad objectives are prescribed and an operating framework of policy instruments to achieve them is formulated. The monetary policy in India is an adjunct of the economic policy. The objectives of the monetary policy are not different from those of the economic policy. The three major objectives of economic policy in India have been growth price stability and social justice. The emphasis between the first two objectives has changed from year to year, depending upon the conditions prevailing in that year and the pervious year. The objectives of the monetary policy are also price stability and growth. The government of India tries to manipulate its monetary policy through the Reserve Bank, the monetary authority in India. The objectives of the monetary policy are pursued by ensuring credit availability with stability in the external value of the rupee as well as an overall financial stability.

The Reserve Bank seeks to influence monetary conditions through management of liquidity by operating in varied instruments. These instruments can be categorized as direct and indirect market based instruments.

In an administered or controlled regime of money and financial markets, the Reserve bank directly influences the cost, availability and direction of funds through direct instruments. The management of liquidity is essentially through direct instruments such as varying cash reserve requirements, limits, on refinance administered interest rates, and qualitative and quantitative restrictions on credit.

Since 1991, the market environment has been deregulated and liberalized wherein the interest rates are largely determined by market forces. The objective of the monetary policy operations is to make the interest rate regime more flexible and responsive to the economic fundamentals. In such an environment, the Reserve Bank influences monetary conditions through market based, indirect instruments such as open market operations and refinance / discount / repo windows.

The success of market based indirect instruments depends upon the existence of a vibrant liquid and efficient money market that is well integrated with the other segments financial markets such as government securities market an foreign exchange market. The effectiveness of the monetary policy depends on the market and institutional framework available for transmitting monetary policy impulses.

The financial sector in India is still in a state of transition because of ongoing reforms. However, a growing integration among the different segments of the financial markets has been witnessed. Still, the markets do not have adequate depth and liquidity – a major constraint in the conduct of the monetary policy. The Reserve Bank therefore still relies on the cash reserve ratio as an operating instrument. The bank activated the bank rate on 1997 as a reference rate and as a signaling device to reflect the stance of the monetary policy. The interest rates on different types of accommodation from the reserve bank including refinance are linked the banks rate. The announcement impact of bank rate changes has been pronounced in the prime lending rates (PLRs) of commercial banks.

The Reserve bank also set up a framework of interim liquidity (ILAP) which helped in injecting liquidity through collateralized lending facility (CLF) to banks, export credit refinance to banks, and liquidity support to primary dealers. All these facilities were formula based and depended on the bank rate. The ILAF was gradually converted into a full-fledged LAF. The liquidity adjustment facility (LAF) has evolved as an effective mechanism for absorbing and/or injecting liquidity on a day-to-day basis in a more flexible manner.