RBI and Monetary Policy: Functions, MPC and Credit Control

The Reserve Bank of India is the central bank of the country: it issues currency, acts as banker to the government and to the banks, holds the foreign exchange reserves and, above all, conducts monetary policy, the management of the quantity and the price of money in the economy. Questions on it appear in every banking paper and in the economy section of SSC, Railway and State examinations, and they cluster around three things, the history of the bank, the instruments it uses and the Monetary Policy Committee.

Establishment and ownership

The Reserve Bank was set up on the recommendation of the Hilton Young Commission, formally the Royal Commission on Indian Currency and Finance, which reported in 1926. It was constituted under the Reserve Bank of India Act, 1934 and began work on 1 April 1935 as a shareholders' bank with its central office at Calcutta, which was moved to Bombay in 1937. Sir Osborne Smith was its first Governor and C. D. Deshmukh the first Indian to hold the office. The Bank was nationalised with effect from 1 January 1949 under the Reserve Bank (Transfer to Public Ownership) Act, 1948, and is fully owned by the Government of India. It acted for a time as the central bank of Burma and of Pakistan after partition. It is run by a Central Board of Directors headed by the Governor, who is assisted by Deputy Governors, and the Governor is appointed by the central government.

Functions of the Reserve Bank

The classic functions of a central bank all belong to the Reserve Bank. It has the sole right of note issue in India under Section 22 of its Act, printing notes of two rupees and above; the one rupee note and all coins are issued by the Government of India and the one rupee note carries the signature of the Finance Secretary, not of the Governor. Since 1957 the Bank has followed the minimum reserve system, holding assets of at least two hundred crore rupees, of which gold must be worth at least one hundred and fifteen crore rupees, against the notes it issues. It is banker, agent and adviser to the central and state governments and manages their public debt. It is the bankers' bank, holding the reserves of commercial banks and acting as lender of last resort. It regulates and supervises banks under the Banking Regulation Act, 1949, manages foreign exchange under the Foreign Exchange Management Act, 1999, and is the controller of credit.

The Monetary Policy Committee

Until 2016 the Governor decided the policy rate. The Finance Act, 2016 amended the Reserve Bank of India Act to create a statutory Monetary Policy Committee and a framework of flexible inflation targeting on the lines recommended by the Urjit Patel Committee. The Committee has six members: the Governor as its chairperson, the Deputy Governor in charge of monetary policy, one officer of the Bank nominated by the Central Board, and three members appointed by the central government, who hold office for four years and are not eligible for re-appointment. Decisions are taken by a majority of those present and voting, and in the event of a tie the Governor has a casting vote. The Committee must meet at least four times a year and the vote of each member is published. The inflation target is notified by the central government in consultation with the Bank once every five years; the target first notified in August 2016 was four per cent consumer price inflation with a tolerance band of two percentage points on either side, and it was retained for the five years from April 2021.

Instruments of monetary policy

The quantitative instruments work on the total volume of credit, and the qualitative instruments work on its direction. Under the liquidity adjustment facility the repo rate, the rate at which the Bank lends overnight to banks against government securities, is the policy rate; the marginal standing facility rate stands above it as the ceiling of the corridor and the standing deposit facility rate below it as the floor, so that the operating rate in the money market stays within the corridor.

A rise in the repo rate or in the reserve ratios makes credit dearer and scarcer and is called a dear money or contractionary policy, used when inflation is high. A cut does the opposite and is an easy money or expansionary policy, used to support growth. Selective credit controls, consumer credit regulation, rationing of credit and direct action against a bank are the other qualitative instruments.