Chanakya IAS Academy Blog


Introduction: The article talks about the Monetary Policy Framework Agreement to target inflation in India and the need of gradual transformation in monetary policy framework.

Topics:General Studies, Paper III

  • In the Budget Session of parliament, the RBI Act, 1934, was amended as part of the finance bill. Inflation targeting has now become law.
  • Successful inflation targeting requires reforms that have not been implemented so far. Such as:
    • A well-functioning bond market,
    • End of financial repression,
    • A competitive banking sector,
    • An independent government debt manager and
    • Full understanding and commitment on part of government to low and stable inflation.
  • Monetary Policy Framework Agreement (MPFA):
    • The Monetary Policy Framework Agreement (MPFA) signed in February 2015, for the first time, put in place an inflation target agreed upon by the RBI and government.
    • As a first step towards making a commitment to low and stable inflation, this was a significant step.
    • Many an expert committee had recommended that India should do what most other countries, including emerging economies, had done, and adopt inflation targeting as the objective of monetary policy.
    • The MPFA made CPI the mutually agreed target. Last week through the amendment to the RBI Act, Parliament made CPI the target.
  • Balancing low and stable inflation with economic growth:
  • The inflation target in the MPFA chosen by government and the RBI was 6 per cent by January 2016 and then 4 per cent for 2016-17 and thereafter (with a band of 2 per cent).
    • This sudden jump down in the inflation rate will be unrealistic and difficult to maintain. There should be a slower and smoother path to achieve long term stability as was seen in case of Chile and other such countries.
  • One of the biggest monetary policy problem in the past one year has been lack of transmission.
    • It appears that given the lack of other reforms in the financial markets such as the creation of a well-functioning bond market, a competitive and market-oriented banking system, and a bond-currency-derivative nexus, monetary policy transmission does not happen easily.
    • In this set-up, it is unlikely that the three-year path to a low and stable inflation envisaged in the MPFA can be achieved in a hurry. We need a gradual transformation through proper targeting of inflation.
  • The independent monetary policy requires government to give clear signals to RBI not to peg the exchange rate.
    • One reason for the high interest rate regime has been the reluctance to ease liquidity after the shock to the rupee following the taper talk in May 2013.
    • The unstated mandate of the RBI seems to be that it has to manage the exchange rate and prevent it from depreciation.
  • Inflation in WPI is determined by global commodity prices and not by domestic monetary policy. So, RBI should not try to target what is beyond its control.
  • From the point of view of the domestic mandate, inflation measures based on CPI i.e ‘core inflation’ are the most common target for inflation-targeting countries.
  • CPI is the measure consumers relate to. WPI does not represent anyone’s basket, and at best, represents the price of inputs and outputs for producers.
  • The choice of CPI is superior to the WPI because it measures the cost of living for consumers. Even though food is volatile, but because it matters to households, it is the rise in cost of living they care about.

Question: High inflation rate has been one of the major obstacle for Indian economy to achieve high growth in past few years. In the light of this statement, analyse the creation of Monetary policy framework agreement. Can this agreement act as the sole panacea for all monetary policy evils.

Suggested Approach:

  1. Start with the need to target inflation and the mandate of RBI.
  2. Highlight positives and negatives of MPFA.
  3. Suggest further measures needed to tackle inflation along with MPFA.


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Source: The Indian Express

Read 472 times Last modified on Monday, 20 June 2016 18:02

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