OVERVIEW

 Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under
its control to achieve the goals specified in the Act.

 The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy. This
responsibility is explicitly mandated under the Reserve Bank of India Act, 1934.

The goal(s) of monetary policy

 The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of
growth. Price stability is a necessary precondition to sustainable growth.

 In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the
implementation of the flexible inflation targeting framework.

 The amended RBI Act also provides for the inflation target to be set by the Government of India, in
consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government has notified in
the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5,
2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent.

 The Central Government notified the following as factors that constitute failure to achieve the inflation target:
(a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive
quarters; or (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.

 Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed
by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India of
February 20, 2015.

The Monetary Policy Framework

 The amended RBI Act explicitly provides the legislative mandate to the Reserve Bank to operate the
monetary policy framework of the country.

 The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving
macroeconomic situation; and modulation of liquidity conditions to anchor money market rates at or around the
repo rate. Repo rate changes transmit through the money market to the entire the financial system, which, in turn,
influences aggregate demand – a key determinant of inflation and growth.

 Once the repo rate is announced, the operating framework designed by the Reserve Bank envisages
liquidity management on a day-to-day basis through appropriate actions, which aim at anchoring the operating
target – the weighted average call rate (WACR) – around the repo rate.

 The operating framework is fine-tuned and revised depending on the evolving financial market and monetary
conditions, while ensuring consistency with the monetary policy stance. The liquidity management framework was
last revised significantly in April 2016.
 Instruments of Monetary Policy
There are several direct and indirect instruments that are used for implementing monetary policy.

 Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against
the collateral of government and other approved securities under the liquidity adjustment facility (LAF).

 Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight
basis, from banks against the collateral of eligible government securities under the LAF.

 Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions.
Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate
repo auctions of range of tenors. The aim of term repo is to help develop the inter-bank term money market, which
in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of
monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated
under the market conditions.

 Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow
additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR)
portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks
to the banking system.

 Corridor: The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted
average call money rate.

 Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other
commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This
rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes
alongside policy repo rate changes.

 Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve
Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify
from time to time in the Gazette of India.

 Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid
assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the
availability of resources in the banking system for lending to the private sector.

 Open Market Operations (OMOs): These include both, outright purchase and sale of government
securities, for injection and absorption of durable liquidity, respectively.

 Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004.
Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-
dated government securities and treasury bills. The cash so mobilised is held in a separate government account
with the Reserve Bank.
The MMA is responsible for the formulation and implementation of monetary policy in the Maldives.
As per the MMA Act 1981, the main objective of the monetary policy is to achieve price stability and
maintain an adequate level of international reserves, while promoting non-inflationary economic
growth.

Framework
Under the current monetary policy framework, the exchange rate peg with the US dollar is used as
the intermediate target to achieve price stability and the liquidity position of the banking system
serves as the operational target, in order to maintain the domestic money supply consistent with
economic activities.

Policy Instruments
The main monetary policy instruments available to the MMA are:

 Minimum Reserve Requirement

 Open Market Operations

 MMA Standing Facilities

 Foreign Exchange Swap Facility

Policy Instruments
The main monetary policy instruments available to the MMA are:

Minimum Reserve Requirement

The Minimum Reserve Requirement (MRR) is one of the main policy instruments used by the MMA
to control money supply and credit expansion. Effective 20th August 2015, the MRR was reduced
from 20% to 10% of the average local and foreign currency deposits, excluding interbank deposits of
other banks in Maldives, and L/C margin deposits. The reserve requirement for local currency is to
be met in the form of rufiyaa deposits, while reserve requirement for foreign currency is to be met in
the form of US dollar deposits. The rufiyaa MRR balances are paid interest at 1% per annum and US
dollar MRR balances are paid 0.01% per annum. Banks that fail to meet the MRR are imposed a
penalty of 18% per annum on the shortfall amount.
Open Market Operations
The MMA commenced Open Market Operations (OMO) on 27th August 2009 with the introduction of
Reverse Repurchase and Repurchase Facility. The main aim of OMO is to manage the Rufiyaa
liquidity in the banking system.
MMA Standing Facilities
The MMA standing facilities aim to provide and absorb overnight liquidity and establish an interest
rate corridor by providing a ceiling and a floor for the market interest rate. The two standing facilities
currently available are:

 Overnight Deposit Facility

 Overnight Lombard Facility

Foreign Exchange Swap Facility

With effect from 3rd July 2011, the MMA introduced foreign exchange swap (FX swap) transactions
with the commercial banks. The FX Swap is a monetary policy instrument that will be used to
manage foreign currency liquidity in the banking system.

Monetary Policy: What Are Its Goals? How Does It Work?

What are the goals of monetary policy?
The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy "so as to
promote effectively the goals of maximum employment, stable prices, and moderate long-term
interest rates."1 Even though the act lists three distinct goals of monetary policy, the Fed's mandate
for monetary policy is commonly known as the dual mandate. The reason is that an economy in
which people who want to work either have a job or are likely to find one fairly quickly and in which
the price level (meaning a broad measure of the price of goods and services purchased by
consumers) is stable creates the conditions needed for interest rates to settle at moderate levels. 2
Decisions about monetary policy are made at meetings of the Federal Open Market Committee
(FOMC). The FOMC comprises the members of the Board of Governors; the president of the
Federal Reserve Bank of New York; and 4 of the remaining 11 Reserve Bank presidents, who serve
one-year terms on a rotating basis. All 12 of the Reserve Bank presidents attend FOMC meetings
and participate in FOMC discussions, but only the presidents who are Committee members at the
time may vote on policy decisions.
Each year, the FOMC explains in a public statement how it interprets its monetary policy goals and
the principles that guide its strategy for achieving them.3 The FOMC judges that low and stable
inflation at the rate of 2 percent per year, as measured by the annual change in the price index for
personal consumption expenditures, is most consistent with achievement of both parts of the dual
mandate.4 To assess the maximum-employmentlevel that can be sustained, the FOMC considers a
broad range of labor market indicators, including how many workers are unemployed,
underemployed, or discouraged and have stopped looking for a job. The Fed also looks at how hard
or easy it is for people to find jobs and for employers to find qualified workers. The FOMC does not
specify a fixed goal for employment because the maximum level of employment is largely
determined by nonmonetary factors that affect the structure and dynamics of the labor market; these
factors may change over time and may not be directly measurable. However, Fed policymakers
release their estimates of the unemployment rate that they expect will prevail once the economy has
recovered from past shocks and if it is not hit by new shocks.
How does monetary policy work?
Figure 1 provides an illustration of the transmission of monetary policy. In the broadest terms,
monetary policy works by spurring or restraining growth of overall demand for goods and
services in the economy. When overall demand slows relative to the economy's capacity to produce
goods and services, unemployment tends to rise and inflation tends to decline. The FOMC can help
stabilize the economy in the face of these developments by stimulating overall demand through
an easing of monetary policy that lowers interest rates. Conversely, when overall demand for goods
and services is too strong, unemployment can fall to unsustainably low levels and inflation can rise.
In such a situation, the Fed can guide economic activity back to more sustainable levels and keep
inflation in check by tightening monetary policy to raise interest rates. The process by which the
FOMC eases and tightens monetary policy to achieve its goals is summarized as follows.
Figure 1: The Transmission of Monetary Policy

The federal funds rate

The FOMC's primary means of adjusting the stance of monetary policy is by changing its target for
the federal funds rate.5 To explain how such changes affect the economy, it is first necessary to
describe the federal funds rate and explain how it helps determine the cost of short-term credit.
On average, each day, U.S. consumers and businesses make noncash payments--including
payments through debit cards, credit cards, electronic transfers, and checks--worth roughly $1/2
trillion.6 To facilitate such payments, banks hold reserve balances at the Fed; payments can be
settled by transferring reserve balances between banks.7 Banks also hold these balances to meet
unexpected liquidity needs and to satisfy a number of regulatory requirements aimed at ensuring
that banks are sound and that their customers' deposits are safe. Banks may borrow and lend
reserves to each other depending on their needs and market conditions; as such, banks can use
reserve balances both as a means of funding and as an investment. The federal funds rate is the
interest rate that banks pay to borrow reserve balances overnight.
The FOMC has the ability to influence the federal funds rate--and thus the cost of short-term
interbank credit--by changing the rate of interest the Fed pays on reserve balances that banks hold
at the Fed.8 A bank is unlikely to lend to another bank (or to any of its customers) at an interest rate
lower than the rate that the bank can earn on reserve balances held at the Fed. And because overall
reserve balances are currently abundant, if a bank wants to borrow reserve balances, it likely will be
able to do so without having to pay a rate much above the rate of interest paid by the Fed. 9 Typically,
changes in the FOMC's target for the federal funds rate are accompanied by commensurate
changes in the rate of interest paid by the Fed on banks' reserve balances, thus providing incentives
for the federal funds rate to adjust to a level consistent with the FOMC's target.
How changes in the federal funds rate affect the broader economy
Changes in the FOMC's target for the federal funds rate affect overall financial conditions through
several channels. For instance, federal funds rate changes are rapidly reflected in the interest
rates that banks and other lenders charge on short-term loans to one another, households,
nonfinancial businesses, and government entities. In particular, the rates of return on commercial
paper and U.S. Treasury bills--which are short-term debt securities issued by private companies and
the federal government, respectively, to raise funds--typically move closely with the federal funds
rate. Similarly, changes in the federal funds rate are rapidly reflected in the rates applied to floating-
rate loans, including floating-rate mortgages as well as many personal and commercial credit lines.
Longer-term interest rates are especially important for economic activity and job creation because
many key economic decisions--such as consumers' purchases of houses, cars, and other big-ticket
items or businesses' investments in structures, machinery, and equipment--involve long planning
horizons. The rates charged on longer-term loans are related to expectations of how monetary policy
and the broader economy will evolve over the duration of the loans, not just to the current level of the
federal funds rate. For this reason, revisions to the expectations of households and
businesses regarding the likely course of short-term interest rates can affect the level of longer-term
interest rates. Fed communications about the likely course of short-term interest rates and the
associated economic outlook, as well as changes in the FOMC's current target for the federal funds
rate, can help guide those expectations, resulting in an easing or a tightening of financial conditions.
In addition to eliciting changes in market interest rates, realized and expected changes in the target
for the federal funds rate can have repercussions for asset prices. Changes in interest rates tend to
affect stock prices by changing the relative attractiveness of equity as an investment and as a way of
holding wealth. Fluctuations in interest rates and stock prices also have implications for household
and corporate balance sheets, which can, in turn, affect the terms on which households and
businesses can borrow.10 Changes in mortgage rates affect the demand for housing and thus
influence house prices. Variations in interest rates in the United States also have a bearing on the
attractiveness of U.S. bonds and related U.S. assets compared with similar investments in other
countries; changes in the relative attractiveness of U.S. assets will move exchange rates and affect
the dollar value of corresponding foreign-currency-denominated assets.
Changes in interest rates, stock prices, household wealth, the terms of credit, and the foreign
exchange value of the dollar will, over time, have implications for a wide range of spending decisions
made by households and businesses. For example, when the FOMC eases monetary policy (that is,
reduces its target for the federal funds rate), the resulting lower interest rates on consumer loans
elicit greater spending on goods and services, particularly on durable goods such as electronics,
appliances, and automobiles. Lower mortgage rates make buying a house more affordable and
encourage existing homeowners to refinance their mortgages to free up some cash for other
purchases. Lower interest rates can make holding equities more attractive, which raises stock prices
and adds to wealth. Higher wealth tends to spur more spending. Investment projects that businesses
previously believed would be marginally unprofitable become attractive because of reduced
financing costs, particularly if businesses expect their sales to rise. And to the extent that an easing
of monetary policy is accompanied by a fall in the exchange value of the dollar, the prices of U.S.
products will fall relative to those of foreign products so that U.S. products will gain market share at
home and abroad.
Monetary policy and the 2007-09 Global Financial Crisis
The crisis in financial markets that began in the summer of 2007 and became particularly severe in
2008 led the FOMC to cut its target for the federal funds rate from 5-1/4 percent in mid-September
2007 to near zero in late December 2008. Even after this large cut, the U.S. economy required
substantial additional support. However, with the federal funds rate near zero, the Fed could no
longer rely on its primary means of easing monetary policy.11
One of the ways in which the FOMC provided further support to the economy was by offering
explicit forward guidance about expected future monetary policy in its communications. The FOMC
conveyed that it likely would keep a highly accommodative stance of monetary policy until a marked
improvement in the labor market had been achieved. Short-term interest rates expected to prevail in
the future and longer-term yields on bonds fell in response to this forward guidance. 12
Another key monetary policy tool deployed in response to the financial crisis was large-scale asset
purchases,which were purchases in securities markets over six years of roughly $3.7 trillion in
longer-term Treasury securities as well as securities issued by government-sponsored enterprises.
By boosting the overall demand for these securities, the Fed put additional downward pressure on
longer-term interest rates. Moreover, as the Fed purchased these securities, private investors looked
for other investment opportunities, and, in doing so, they pushed down other long-term interest rates,
such as those on corporate bonds, and pushed up asset valuations, including equity prices. These
market reactions to the large-scale asset purchases helped ease overall financial market conditions
and thus supported growth in economic activity, job creation, and a return of inflation toward 2
percent.13
In December 2015, the FOMC took a first step toward returning the stance of monetary policy to
more normal levels by increasing its target for the federal funds rate from near zero. A further step
toward normalization occurred in October 2017, when the FOMC began a gradual reduction in its
securities holdings. The FOMC has indicated that, going forward, adjustments in the federal funds
rate will be the primary way of changing the stance of monetary policy.

Principles for the Conduct of Monetary Policy

Three key principles of good monetary policy
Over the past decades, policymakers and academic economists have formulated several key
principles for the conduct of monetary policy; these principles are based on historical experience
with a range of monetary policy frameworks.1
One principle is that monetary policy should be well understood and systematic. The objectives
of monetary policy should be stated clearly and communicated to the public. The Congress has
directed the Federal Reserve to use monetary policy to promote both maximum employment and
price stability; those are the objectives of U.S. monetary policy. Fed policymakers' understanding of
that statutory mandate is summarized in Monetary Policy: What Are Its Goals? How Does It
Work? To be systematic, policymakers should respond consistently and predictably to changes in
economic conditions and the economic outlook; policymakers also should clearly explain their policy
strategy and actions to the public, and they should follow through on past policy announcements and
communications unless circumstances change in ways that warrant adjusting past plans. Following
this principle helps households and firms make economic decisions and plan for the future; it also
promotes economic stability by avoiding policy surprises.
A second principle is that the central bank should provide monetary policy stimulus when
economic activity is below the level associated with full resource utilization and inflation is
below its stated goal.Conversely, the central bank should implement restrictive monetary
policy when the economy is overheated and inflation is above its stated goal. In some
circumstances, the central bank should follow this principle in a preemptive manner. For example,
economic developments such as a large, unanticipated change in financial conditions might not
immediately alter inflation and employment but would do so in the future and thus might call for a
prompt, forward-looking policy response. Conveying how monetary policy would respond to irregular
future events is not easy, but the overarching principle remains the same: Policymakers should strive
to communicate how these events may affect the future evolution of inflation and employment and
set monetary policy accordingly.
A third principle is that the central bank should raise the policy interest rate, over time, by more
than one-for-one in response to a persistent increase in inflation and lower the policy rate
more than one-for-one in response to a persistent decrease in inflation. For example, if the
inflation rate rises from 2 percent to 3 percent and the increase is not caused by temporary factors,
the central bank should raise the policy rate by more than one percentage point. Such an adjustment
to the policy rate translates into an increase in the realpolicy rate--that is, the level of the policy rate
adjusted for inflation--when inflation rises and a decrease in the real policy rate when inflation slows.
As the real policy rate rises, it feeds through to other real interest rates that determine how
expensive it is for households and businesses to borrow money to finance consumption or
investment spending, adjusted for inflation. Raising real interest rates tends to reduce growth of
economic activity, and firms tend to increase prices less rapidly when they see slower growth in their
sales. As a result, inflation is kept in check. A symmetric logic applies to the central bank's response
to persistent decreases in inflation.