Monetary system in India
Abstract
Banks and central banks have a great role to play in the development of a country’s economy. In essence, banks provide and create money through credit, a scenario that provide a country with the much needed where withal to implement major policies. Banks have emerged as the new fore front of development across the world with institutions and government agencies turning to banks for support and growth. Yet, the banking sector remains prone to external shocks such as business cycles and political turmoil. Furthermore, banks require a secure and flexible legal structure to offer services to people. The control of Central banks towards the banks acts as an institutional and legal structure for protecting the public and major investment ventures in a country. This paper discusses the issues surrounding the banking industry in India. In addition, the paper looks into the historical context of the monetary system and banking for a better review and comprehension of banking and its purpose.
Introduction
The public presume that central banks perfectly should have a sole overriding goal of price stability in an economy. In truth, nevertheless, central banks are answerable for various objectives besides price stability, such as full employment, monetary stability, and income development. Most countries have defined the principal goals of central banks through official and institutional frameworks. Nonetheless, the objectives of central banks subsist through other structures and may increase through traditions and inherent excess between the governments, the central bank and major institutions in an economy.
Lately, considerations of monetary stability have had increasing implication in financial policy. Most financial downturns across the world appear to have a strong connection with financial instability; thus, policy makers connect to identify the origin and diffusion of diverse types of shocks in the monetary system of a country. Furthermore, the policy makers try to understand the nature and scope of reaction in policy procedures and the efficacy of different policy instruments. Monetary system has both short term and long term effects on a country and ideally affects the real sectors of the economy. Because of the typical lags that influence the real sectors of an economy, it is inherently considerate to understand the transmission mechanism of monetary measures on financial markets, outputs, and prices.
The paper pursues through the transmission cycle of the monetary system in India to offer a comprehensive analysis of the monetary system in the country. The paper also evaluates monetary policies in India in the perspective of interaction between financial structures and external factors. The paper discusses the monetary system in India, the background of the system, and the conceptual framework of the system across the real sectors of the economy.
Evolution of the monetary system in India
Evolution
The monetary system in India dates back in 1542 when the first unit of Indian rupee appeared, though the country used silver as the standard measure of exchange before the appearance of the rupee. However, in 1758, the country used the British rupee predominantly as the standard unit of exchange. In 1882, the British introduced paper money in India, although the money was established as an independent currency in 1935. The country joined the IMF in 1947, at which time the organization fixed the currency by its standards. The first banks in India, the Bank of Hindustan and The General Bank of India established their offices in 1786, although they have become defunct. However, the State Bank of India, which opened its services in 1786, and later changed its name to the Bank of Bengal, still operates today. The bank formed the category of the presidency banks that consisted of the Bank of Bombay and the Bank of Madras. Between the period 1906 and 1911, the country experienced establishment of numerous banks inspired by the Swadeshi association (Strnad & Richards, 2002). The country nationalized the Reserve Bank of India (RBI) in 1948, and later empowered the institution to regulate, control, and inspects banks in the country in 1949 (Basu & Lazaridis, 2002). The country nationalized banks in 1969, and later liberalized the banking sector in 1990s.
Today, the money market in India comprises of two sectors: organized and unorganized markets. The organized market consists of RBI, State Bank of India with its associated banks, national commercial banks, foreign banks, scheduled and no-scheduled banks, development banks, and regional rural banks. On the other hand, the unorganized money market comprises of moneylenders and indigenous bankers. Traditionally, the procedure of monetary system in India had been internal with the government revealing only the results of the policies to the public. Governor Rangarajan initiated the process of openness, which Governor Jalan extended and intensified. Today, the government has made the monetary policy procedure more expressive, consultative and contributive with external direction, while the internal work processes have been re-engineered to point on practical study, organization, and horizontal administration (Scharpf, 2011).
Impact of monetary systems
Although the country lacks an explicit legislation to provide the framework for price stability, the monetary policies in India have managed to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy. The emphasis between the objectives of the monetary policies of price stability, creation of income, economic growth, and full employment depend on the underlying economic conditions. Compared to many other developing economies, the monetary policies of India managed to maintain a modest level of inflation (Basu & Lazaridis, 2002). Over a long period, inflation rates rarely reached double digits unless in times of supply shocks caused by increases in agricultural product prices and international prices of oil.
The government has reduced the legislative preemption on the banking system, which to rise in the level of output, employment and economic growth. Over the years, the RBI has reduced the Cash Reserve Ratio, a principal tool of monetary policy from 15.0 per cent in March 1991 to around 3.5 % by December 2010. The RBI has also managed to trim down the Statutory Liquidity Ratio to its statutory minimum of 25 %. The government has also deregulated and rationalized the interest rate structure to attract foreign firms and individuals to buy bonds and treasuries. The lending rate has reduced over the years to less than 10% to increase borrowing and restrict export credit. Furthermore, the government operationalized the bank rate from 1991to signal the implementation of robust monetary policies.
It has also been possible to deregulate and downsize the structures of lending rates for the public to experience flexibility. The viable lending rates for principal borrowers of banks have decreased from a high of about 16.5 per cent in March 1991 to around 10.0 per cent by December 2004 (Basu & Lazaridis, 2002). The formulation of a robust monetary policy has managed to restrict short-term debts and increase reserves, which have led to increases in the foreign currency assets of the country. Furthermore, the monetary policies have accommodated large capital inflows through OMO, which have helped the country decrease its dependence on credit from the RBI (Hasan, 2006).
Components of the monetary system
The country’s monetary system contains of five major components mainly base of the monetary policy, categories of money, money supply, money demand, external money relations.
Base of the monetary system
This refers to the monetary standard and the financial unit of a country. Today, the country mainly uses one monetary standard based on purchasing power and purchasing power parity (PPP). Price indexes determine the purchasing power of money in India, with the system using a floating exchange rate to reflect the objective level of the currency on the market (Hasan, 2006). The India’s currency rate depreciates or appreciates to offer a consistent PPP level to avoid significant levels of inflation (Scharpf, 2011).
Categories of money
Country’s standard of money comprises of: notes, coins, credit money, and payment cards. In the country the notes are representative a fiat system. In the country credit money is the mostly used category of money and it’s used to represent any future claim against a legal or physical person and can also be used to purchase goods and services. Payment cards are comprised of: debit, credit, smart and store cards. Debit and credit cards are commonly used in India. Whereas debit cards which include: master cards and visa cards are the most common form of payment used in the country.
Money supply and money demand
Money supply refers to flow of a country’s currency at a given time period of time. The R.B.I delineates the monetary aggregates as a sum of M0, M1, M2, M3 and M4 whereby, M0 stands for the money in the circulation, banks deposit with RBI, and additional deposits placed with the RBI.M1 stands for money held by the citizens and other deposits banked with RBI. On the other hand M2 represents the total of M1 and deposit with the post office savings bank and on the other hand M 3 represents the total of M1 in addition with the bank deposits and M4 stands for the aggregate or total of M3 plus all other forms of deposits with the post office savings bank. In India money supply is influenced by required reserved ratio (RRR), the willingness of the citizens to hold deposits as well as cash and the reserves held by the banks. The RRR measures cash ratio against time deposit liabilities and this makes it the greatest tool influencing the supply of money. When the minimum cash reserve ratio reduces, it leads to an increase in supply of money when an increase always results to a decrease in the supply. There is an amount that the banks are required to maintain with the RBI which is a requirement by law and is called Cash reserves or bank reserves
If the law introduces a high bank reserve ratio the consequence is that cash available as credit reduces; hence, decreasing the amount of money in supply. This leads to people predicting the forthcoming prices of goods and services making them to be tempted to hold money. A situation whereby the amount of money in the hands of the citizens is lower than the amount they deposit the existing supply of money increases and this is so because the banks opt to create money in a process of credit creation.
In India people have three motives of holding money. They include: speculative, precautionary and transactional demand for money while the rate of interest and prices are used to measure demand for money in India (Strnad & Richards, 2002)
Organizations and financial institutions
The greatest task of regulating or influencing money supply and demand in a country is left to the financial institutions. In India they include RBI, Commercial banks scheduled and no scheduled banks, rural banks and the state bank of India (Scharpf, 2011). The role played by the commercial banks includes accepting customer deposits, foreign exchange transactions, creation of credit and also a store of wealth. These banks are directly used by RBI to control money supply.
Exchange rate
Exchange rates may be defined as the rate with which an individual country accepts foreign currency in exchange with its currency. In India the currency used is the rupee, which is exchanged with foreign currencies in the following rates. A dollar is exchanged at 62.96, a Euro at 83.99 and a British pound at 100.17. The country adapts a tree market system (Mohanty, 2012) enabling the exchange rate to influence international trade. The decrease in demand of a country’s currency leads to its depreciation while an increase in demand of the currency is termed as appreciation. The reason as to why the rupee depreciates is when India import fewer goods and export more. The government tries to attain equilibrium in the balance of payment and deviations between exports and imports over a period of time (Gaspar & Issing, 2002). This approach represents a relationship between exchange rates and interest rates leading to an influence in the domestic market. If the currency value is low it leads to a decrease in price of domestic goods in relation to foreign goods leading to an increase in exports thereby causing an increase in the aggregate output. Generally the monetary system of the country is affected by exchange rates following the relationship with interest rates, balance of payments and international trade. The following monetary transmission channels are important considerations to policy makers, the exchange rate channel, the asset outlay channel and the quantum aspect (Mohanty, 2012).
Economic, transaction and translation exposure
Monetary deficits in the country has led to excess of monetization and this results to the country lacking a good monetary reserve ratio to solve the problems in the banks. As a result of increased level of imports, unfavorable balance of payment is arrived at and this works to the disadvantage of the country. The development of the financial sector helps the country to improve its monetary policies to offer additional investments for its citizens. There are promising signs of investment chances to the citizens as a result of the fluctuating demand for money and elasticity.
Conclusion
The paper reflects the monetary system in India with emphasis on the situational framework of the system. The paper shows the diverse system and the parameters that affect the country’s monetary market. The paper suggests that the transmission cycle of the monetary system in India offers a comprehensive analysis of the monetary system in the country. The evaluation of the system also suggests that the country has a robust system that offers deliberation on the main impacts of the system to the economy of the country.
References
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Gaspar, V., & Issing, O. (2002). Exchange Rates and Monetary Policy.Australian Economic Papers, 41(4), 342-365.
Hasan, M. S. (2006). The Prices of Silver And Exchange Rates In A Metallic Monetary System—the Cases Of India And Iran. Empirical Economics, 31(1), 195-206.
Mohanty, D. (2012). Evidence on Interest Rate Channel of Monetary Policy Transmission in India. Second International Research Conference at the Reserve Bank of India, February (pp. 1-2).
Scharpf, F. W. (2011). Monetary union, fiscal crisis and the preemption of democracy. LEQS Paper, (36).
Strnad, J., & Richards, J. F. (2002). The Imperial Monetary System Of Mughal India. The Journal of Asian Studies, 61(1), 312.
