Objectives of Monetary Policy

The basic objectives of the monetary policy are to influence price level and investments, which determine economic growth. This policy seeks to achieve these objectives by proactive management of:

• Price level
• Money Supply
• Interest rates
• Foreign exchange rate

Relevance of Price Level

A gradual increase in price level has positive influence on sentiments. However, runaway increase in prices or inflation has damaging influence on both investors and savers. Strident increase in prices increases uncertainty and generates a sense of insecurity both among the savers and investors.

Therefore, one of the important objectives of the monetary policy is to limit increase in price level to acceptable levels also known as inflation targeting. What is the acceptable level depends on the situation prevailing in the country. The RBI and the government seem to have accepted an increase of up to 5% in a year in price level as acceptable.

Relevance of Money Supply

One of the factors that influences price level and is under the control of RBI is money supply. The measures of money supply are:

M1: Currency with public and demand deposits with banks and RBI, both available for immediate spending.
M2: M1 plus savings deposits with banks
M3: M2 plus fixed deposits with banks
M4: M3 plus total deposits with post offices

The government influences money supply or liquidity in the following manner:

• Government spending and investments increase money supply
• Collection of taxes and borrowings from the market reduce money supply till it is spent or invested.
• Deficit financing leads to an increase in money supply because deficits exceed expenditure funded by borrowing from RBI

Relevance of Interest Rate

If funds are available at affordable interest rates, it leads to higher investments on personal as well as business front. The increased availability of retail credit at affordable rates leading to growth of automobile, housing and consumer goods industry in India is a good example of relevance of interest rates. Higher investments lead to higher employment and income, which in turn fuels demand and encourages further investments.

Increasing interest rate dampen demand for money for investments from individuals and business. Decline in inventory build up and investments lead to lower employment and lower income. Higher interest may also divert funds from consumption to savings leading to reduction in demand. This further leads to reduction in price level, and in turn dampens business sentiments and fresh investments.

Relevance of Foreign Exchange Rate

If rupee becomes cheaper (more rupees per dollar), then Indian goods will become cheaper abroad which will lead to increase in exports. Investment in export-oriented industries will increase. Conversely, imports will become costlier and import dependent industries will be affected. Other industries, which are consumers of the import dependent industry, will also be impacted negatively. In an import dependent economy like India, which depends on oil imports, trade deficit will increase resulting in further reduction in competitiveness.

India has always had a trade deficit, but the imbalance in trade is being made good by inward remittances from Indians abroad and investment flows such as Foreign Direct Investment [FDI] and Foreign Institutional Investor [FII].

Exchange rates impact prices, interest rates, and economic growth. Therefore, smoothening exchange rate fluctuations and managing its range and direction of movement is an important element of the monetary policy.