Syllabus
GS Paper 3 – Indian Economy (issues re: planning, mobilisation of resources, growth, development, employment); Inclusive growth and issues therein
Context
Recent rapid changes in global markets are driven by central banks’ efforts to tackle inflation and sluggish economic activity through interest rate adjustments.
Source
The Hindu| Editorial dated 9th August 2024
On monetary policy and financial markets
The global economy is currently navigating a complex landscape marked by volatile financial markets and persistent economic challenges. While there are signs of recovery in financial markets, the broader economic environment remains fragile. Central banks worldwide are grappling with the dual challenges of controlling inflation and stimulating economic growth, all while managing the unpredictable reactions of global financial markets.
Key Terms
- Monetary Policy:
- The process by which a central bank, such as the Federal Reserve in the U.S. or the Bank of Japan, manages the money supply and interest rates to influence economic activity, primarily targeting inflation, employment, and economic growth.
- Interest Rates:
- The cost of borrowing money, typically expressed as a percentage.
- Central banks adjust interest rates to control inflation and stabilize the economy.
- Higher interest rates generally reduce inflation but can slow economic growth.
- Inflation:
- The rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of a currency.
- Central banks aim to control inflation through monetary policy.
- Recession:
- A significant decline in economic activity across the economy, lasting more than a few months. It is typically recognized by a drop in GDP, employment, and other economic indicators.
- Sahm Rule:
- An economic rule used to trigger automatic disbursal of unemployment benefits when the unemployment rate rises by a certain threshold, typically indicating the onset of a recession or economic downturn.
- Carry Trade:
- A financial strategy where investors borrow money at low interest rates in one country (e.g., Japan) and invest it in higher-yielding assets in another country.
- Changes in interest rates can disrupt this trade, affecting global markets.
- Taper Tantrum:
- A period of financial market volatility in 2013, triggered by the U.S. Federal Reserve’s announcement that it would begin tapering its quantitative easing program.
- This led to a sharp rise in interest rates and capital outflows from emerging markets.
Monetary Policy in India
Monetary policy in India is formulated by the Reserve Bank of India (RBI) with the primary objectives of controlling inflation, managing the supply of money, and ensuring financial stability.
- Monetary Policy Framework:
- The RBI operates under a flexible inflation targeting framework, where the target is to maintain inflation at 4% with a tolerance band of ±2%.
- The Monetary Policy Committee (MPC) , established in 2016, is responsible for setting the benchmark interest rates to achieve this target.
- Instruments Used:
- Repo Rate : The rate at which the RBI lends to commercial banks.
- Reverse Repo Rate: The rate at which the RBI borrows from commercial banks.
- Cash Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR): Ratios to regulate the liquidity and lending capacity of banks.
- Open Market Operations (OMO): The buying and selling of government securities to control money supply.
Significance of Monetary Policy
- Inflation Control:
- Monetary policy plays a crucial role in controlling inflation by adjusting interest rates, which influence borrowing and spending in the economy.
- Economic Growth:
- By managing the cost of credit, monetary policy can stimulate or cool down economic activity, thereby influencing GDP growth.
- Employment Generation:
- Through stimulating investment and consumption, an accommodative monetary policy can help generate employment.
- Financial Stability:
- The RBI uses monetary policy tools to ensure stability in the banking sector and financial markets, preventing excessive speculation and asset bubbles.
- External Stability:
- Monetary policy also affects exchange rates and foreign capital flows, influencing the country’s balance of payments and external economic stability.
Issues with Monetary Policy
- Time Lags:
- The effects of monetary policy changes are not immediate; there is often a significant time lag before they influence the economy, making timely interventions challenging.
- Limited Impact on Structural Issues:
- Monetary policy primarily addresses cyclical issues and has limited influence on structural economic problems like unemployment and inequality.
- Transmission Mechanism:
- The effectiveness of monetary policy is dependent on the transmission of rate changes from the RBI to the broader economy, which can be impeded by rigid banking practices and financial market inefficiencies.
- Conflicting Objectives:
- Balancing inflation control with economic growth and employment can be challenging, especially in an economy with diverse sectors and varying levels of development.
- Impact of Global Events:
- Global economic conditions, such as oil price shocks or changes in foreign interest rates, can limit the effectiveness of domestic monetary policy.
Monetary Policy and Global Financial Markets
- Interconnected Economies:
- In an increasingly globalized world, monetary policy decisions in major economies like the U.S. or Eurozone can have significant ripple effects on India’s financial markets and economy.
- Capital Flows and Exchange Rates:
- Changes in interest rates abroad can lead to capital flight or inflows into India, affecting the exchange rate and complicating monetary policy management.
- Global Inflation and Commodity Prices:
- Global inflationary trends, influenced by major central banks’ policies, can affect domestic inflation, particularly in import-reliant sectors.
- Policy Synchronization:
- India’s monetary policy often needs to consider global trends to ensure alignment or appropriate countermeasures, balancing domestic priorities with external pressures.
Way Ahead
- Strengthening Policy Transmission:
- Enhancing the effectiveness of monetary policy requires improving the transmission mechanism, ensuring that changes in RBI rates are quickly reflected in the broader economy.
- Coordination with Fiscal Policy:
- A coordinated approach between monetary and fiscal policies is essential for addressing economic challenges comprehensively and effectively.
- Focus on Financial Inclusion:
- Expanding access to banking and financial services can improve the reach and impact of monetary policy, especially in rural and underserved areas.
- Monitoring Global Developments:
- Vigilance in monitoring global economic trends and preparing for external shocks is crucial for maintaining economic stability.
- Policy Flexibility:
- The RBI should maintain a flexible approach, ready to adjust monetary policy in response to both domestic economic conditions and global financial market dynamics.
Conclusion
The recent fluctuations in global financial markets underscore the difficulties of conducting effective monetary policy in an interconnected world. The rapid reactions of financial markets to economic indicators, driven by expectations rather than actual economic conditions, pose significant challenges for policymakers. These dynamics reveal the need for a nuanced approach to monetary policy that considers the global impact of domestic decisions, as well as the inherent volatility of financial markets.
Related PYQ
Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments.?[ UPSC Civil Services Exam – Mains 2019]
Practice Question
In the context of recent global financial developments, critically examine the challenges faced by central banks in implementing effective monetary policy? [150 words]