Monetary policy entails measures taken by the Reserve Bank of India to influence aggregate demand in the economy. The monetary policy affects output and prices through its influence on key financial variables such as interest rates, exchange rates, asset prices, credit and monetary aggregates in the future. Monetary policy actions, therefore, are forward looking. The Reserve Bank uses various policy levers, such as repo rate, reverse repo rate, cash reserve ratio, statutory liquidity ratio and bank rate, to influence the amount of money in the market. An increase in any one of these could raise the interest rates.
• How do changes in interest rates affect monetary transmission?
By increasing or decreasing interest rates, thus raising or lowering the cost of holding cash for banks, RBI indicates that banks should increase or decrease rates for their customers. This change affects people's ability to borrow and lend money, thereby affecting overall demand and completing monetary transmission.
• How much time does it take for monetary policy to take effect?
The effect of monetary policy takes place after a lag and is also found to be variable. This depend on the state of the economy, amount of regulation, liberalisation and financial innovation in the economy. Research has shown that in India, monetary policy takes effect after a lag of 8-12 months. Also, experience has shown that tight liquidity conditions lead to faster transmission of monetary policy.
• How has RBI reacted in the recent past?
Inflation has been elevated for over a year and RBI has responded by raising the repo rate, or the rate at which it lends to banks, nine times. It has tried to bring down the aggregate demand. Lower demand acts as a check on rising prices.
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