Model Answer

• Long-Term Impact: A higher savings rate leads to greater capital accumulation, which increases deposits in banks. These deposits are then lent out to businesses, enabling investments in infrastructure, technology, and equipment. This investment drives long-term economic growth, higher incomes, and better living standards. Additionally, a high savings rate helps make the economy more resilient to downturns and reduces dependence on foreign borrowings, thereby shielding the economy from external shocks.
• Short-Term Impact: However, in the short term, an increase in savings reduces consumption expenditure. Lower consumption results in reduced demand for goods and services, which can lead to slower economic growth.

Factors Behind Decline in Savings Rate in India

• Increase in Household Debt: Rising consumption, particularly among younger populations, has led to higher private consumption. This, in turn, has increased financial liabilities, with a surge in credit card spending observed in 2023. As a result, households are saving less.
• Falling or Stagnant Income Levels: Many households, particularly the poorest, are facing declining or stagnant incomes. A study by PRICE revealed that from 2015-16 to 2020-21, the income of the poorest 20% of households dropped by 53%, while the wealthiest 20% saw a 39% increase. This growing income disparity impacts the ability of households to save.
• High Inflation: Persistent inflation has eroded real wages, making it difficult for households to save. The combination of stagnant incomes and rising inflation has put additional strain on savings.
• Exit of High Net-Worth Individuals (HNIs): Between 2017-2022, around 30,000 to 35,000 HNIs left India, taking their savings with them, which further exacerbated the decline in domestic savings.
• Shift to Physical Savings: Low-interest rates have prompted a shift away from financial savings toward physical assets like real estate, as households seek higher returns, contributing to the decline in financial savings.

The decline in domestic savings may necessitate increased reliance on foreign savings, which introduces risks. Restoring high savings, investment, and growth cycles is essential for sustainable long-term growth

Model Answer

Instruments Used by the RBI for Regulating Money Supply

The Reserve Bank of India (RBI) employs various tools to regulate the money supply in the economy, aiming to balance inflation control with economic growth. These tools can be broadly classified into Quantitative and Qualitative measures.

Quantitative Measures

1. Open Market Operations (OMO)
   The RBI conducts buying and selling of government securities in the open market. By selling securities, it absorbs liquidity from the banking system, thereby reducing the money supply. Conversely, buying securities injects money into the economy, increasing the money supply.
2. Cash Reserve Ratio (CRR)
   CRR is the minimum percentage of a bank’s total deposits that must be kept in reserve, either as cash or with the RBI. Increasing the CRR reduces the liquidity available for lending by commercial banks, thereby controlling credit creation.
3. Statutory Liquidity Ratio (SLR)
   The SLR is the portion of a bank’s net demand and time liabilities (NDTL) that must be invested in government-approved securities. By altering the SLR, the RBI can influence the amount of credit banks can extend.
4. Liquidity Adjustment Facility (LAF)
   The LAF consists of two key rates:
   • Repo Rate: The rate at which the RBI lends money to commercial banks in times of short-term liquidity shortages. A higher repo rate discourages borrowing and helps reduce money supply.
   • Reverse Repo Rate: The rate at which commercial banks park their surplus funds with the RBI. An increase in this rate encourages banks to keep funds with the RBI, thereby reducing liquidity in the economy.

Qualitative Measures

1. Margin Requirements
   The RBI sets margin requirements, which are the differences between the value of securities pledged by borrowers and the loan amount. This helps control speculative lending and ensures prudent lending practices.
2. Rationing of Credit
   The RBI can ration credit, guiding banks to extend credit to priority sectors like agriculture and education, while restricting loans to less critical sectors.
3. Moral Suasion
   The RBI uses moral suasion by advising commercial banks to adjust their lending policies. This may involve persuading banks to restrict loans for speculative purposes or to focus on sectors in need of credit support.

By combining both Quantitative and Qualitative measures, the RBI effectively manages money supply and promotes economic stability.

Model Answer

Monetary Policy Framework in India

India’s monetary policy framework, established through the Monetary Policy Framework Agreement (MPFA) signed in February 2015, emphasizes flexible inflation targeting (FIT). This framework mandates the Reserve Bank of India (RBI) to achieve an inflation target set by the government in consultation with the central bank. The inflation target is set at 4%, with a ±2% tolerance band, determined every five years (Source: Author’s content).

A key feature of the monetary policy framework is the establishment of the Monetary Policy Committee (MPC), which consists of six members, including the RBI Governor. The MPC is tasked with setting the policy rate to align inflation with the target. It uses various instruments such as open market operations, reserve requirements, and the policy rate to achieve operational targets like short-term money market interest rates and reserve money (Source: Author’s content).

The overarching goals of India’s monetary policy are price stability, economic growth, financial stability, and exchange rate stability. These goals aim to ensure a stable economic environment conducive to growth while controlling inflation and maintaining currency stability (Source: Author’s content).

Challenges in Monetary Management

Despite a well-defined framework, India faces several dilemmas in monetary management:

1. Trade-off Between Growth and Inflation
   • In developing economies like India, there is a constant trade-off between controlling inflation and supporting economic growth. Tight monetary policy to reduce inflation could reduce liquidity in the economy, potentially hampering growth (Source: Author’s content).
2. Balance of Internal and External Sectors
   • India’s open economy faces the challenge of maintaining a balance between internal inflation and external pressures. If domestic inflation is higher than that of trading partners, it can weaken the exchange rate, impacting the economy’s external balance (Source: Author’s content).
3. Public Debt and Monetary Authority Dilemma
   • The government’s fiscal deficit impacts the monetary policy, especially when large-scale market borrowing increases government debt. The central bank faces a dilemma in keeping interest rates low to stimulate growth, while also managing the cost of government borrowing (Source: Author’s content).
4. Conflict Between Regulator and Monetary Policy
   • Another challenge arises from the conflict between the central bank’s regulatory role and its monetary policy conduct. For instance, raising interest rates to control inflation may harm weak banks by increasing their borrowing costs, creating tensions between regulatory needs and monetary policy objectives (Source: Author’s content).

Conclusion

The monetary policy framework in India is well-structured, focusing on inflation control, economic growth, and stability. However, the central bank faces multiple challenges such as balancing growth with inflation, managing fiscal and monetary tensions, and addressing external sector pressures. To address these dilemmas effectively, coordination between the RBI and the government is crucial, especially in the context of global economic integration (Source: Author’s content).