Author’s Bio: RP is a regular writer for various finance related Communities. She is a PG degree holder in Marketing and Finance and right now working in a reputed bank as a relationship manager. She is well equipped to write articles on debt consolidation , debt settlement, frugality, savings, economies of states etc.
Monetary policy can be defined as the process by which the financial authority controls the supply of money in a country. Read on to get a brief overview regarding the monetary policies in United States and India, and the functions performed by the Federal Reserve (in US) and the RBI (in India) for the economic growth of the respective countries.
How Federal Reserve controls money supply in US
The Government’s role in US economy is far beyond than just regulating specific industries. It also manages the overall economic activities in order to maintain stable prices along with high levels of employment. To achieve these objectives, the US Government uses two types of tools which are monetary policy and fiscal policy. The former one is the management of money supply and by formulating fiscal policy, the Government determines the levels of taxes as well as spending.
The Federal Reserve (Fed) regulates the monetary policy in United States. The Federal Reserve is the independent central bank as its decisions don’t always require approval from the Congress or President. However, it is very much accountable to Congress. Federal Reserve is responsible for managing money supply along with regulating the use of credit or monetary policy.
In US, the Federal Reserve formulates monetary policy by controlling the amount of loans which are made by the commercial banks. The checkable deposits are a part of money supply and the new loans are mostly in the form of checking account balances. When new loans are made, the money supply increases and vice versa. The banks can give out loans from their excess reserves. So, in order to control the checkable deposits, loans, and in turn, money supply, the Federal Reserve has to influence the excess reserves of the banks.
The Federal Reserve formulates monetary policy and ultimately controls the money supply in 3 ways. Firstly, the Fed allows the banks to borrow from the Federal Reserve, secondly, the Fed changes the required reserve ratio and thirdly, the Fed conducts open market operations by buying and selling bonds.
When the economy faces a recession, the Federal Reserve adjusts above mentioned tools by lowering the interest rates on loans. When the interest rates on loans get reduced, the consumers tend to take out loans and in turn, money flows in the market and it is favorable for the country’s economic growth. Similarly, the interest rates on loans are increased when an economy grows too fast.
How RBI controls money supply in India
In India, the monetary policy is regulated by the Reserve Bank of India (RBI). The monetary policies formulated by the RBI helps regulate the fluctuations in the economy along with supporting the Government. Thus, RBI plays an important role in shaping the economic structure of the country.
The Reserve Bank of India can only issue currency notes and the system through which it is regulated is referred to as Minimum Reserve System. As per the system, the RBI can issue any quantity of money. However, to issue money, there has to be a minimum reserve of gold that is worth of 115 crores of Indian Rupees along with minimum foreign exchange reserve worth of 85 crores of Indian Rupees. Apart from these, there are other factors too, which affect the issue of Indian currency.
Another important role played by the RBI is to regulate the money supply in Indian economy. The RBI has to act as a banker to the commercial banks as well as to the Government. It also controls credit creation and ensures that the foreign exchange reserve is stable.
RBI is responsible for managing the credit that is required for the country’s economic growth. The banks have to keep money reserve, a portion of which is kept as vault and the remaining amount is deposited with the RBI. The commercial banks can borrow funds from RBI at Bank Rate when they fall short of funds. This Bank rate is an effective instrument of the RBI with which it regulates the money supply in the market.
The RBI also uses another instrument, the Cash Reserve Ratio (CRR) that the commercial banks should keep with the Reserve Bank of India so as to regulate the money supply. The banks also have to keep a portion of deposits with RBI in terms of gold or Government Securities. This is referred to as Statutory Liquidity Ratio (SLR). Therefore, modification in the levels of both SLR and CRR affect Indian economy significantly as increase in the SLR and/or CRR results into the decrease in liquidity of commercial banks. So, the RBI can increase or decrease liquidity in the market by formulating suitable monetary policies and modifying them from time to time as per situation.
The RBI can also sell or buy government bonds to regulate the liquidity in the market. This central bank of India also controls the stability of foreign exchange reserve, which affects the economy of the country, significantly. A person selling goods to an investor from US gets USD, which he has to submit to a commercial bank to get equivalent Indian Rupees. In turn, the bank submits the foreign currency to RBI and gets Indian currency in return. So, the foreign exchange reserve of RBI increases and the money flow in the domestic market has already increased. So, in such a condition, RBI sells out Government securities equivalent to foreign exchange inflow and protects the Indian economy from any external shock.
It can be said that the RBI and the Federal Reserve performs somewhat similar regulatory functions that in turn, facilities economic growth of the India and Unites States, respectively.
(editors note: I’ve always been fascinated by the way different countries and cultures handle money. When RP told me a little of her background, I had to have her write a piece about the different places she has lived and their monetary policy.) br>