The working of the Indian monetary system and the Chakravarty Committee Report

1. The Indian monetary system

Currency. India’s monetary unit is the rupee. Bank notes are issued by the RBI under section 22 of the RBI Act and backed under the minimum reserve system; coins and the one-rupee note are issued by the Government of India (Coinage Act, 2011). The currency is a managed paper currency: its value rests on legal tender status and confidence, not on gold.

Measures of money supply. The RBI publishes:

M3 is the main measure used for policy. A Working Group under Y.V. Reddy (1998) added new monetary aggregates (NM1, NM2, NM3) and liquidity aggregates (L1, L2, L3).

Institutions. The organised sector has the RBI at its head; scheduled commercial banks (public, private, foreign, regional rural, small finance and payments banks); co-operative banks; NBFCs; and development finance institutions (NABARD, SIDBI, EXIM Bank, NHB). The unorganised sector has moneylenders and indigenous bankers. The money market (call money, treasury bills, commercial paper, certificates of deposit, repo) deals in short-term funds and is regulated by the RBI; the capital market deals in long-term funds and is regulated by SEBI (statutory since 1992).

How it works. The RBI sets the policy repo rate through the Monetary Policy Committee and manages liquidity with LAF, OMOs and CRR. Changes pass to money-market rates, then to bank deposit and lending rates (now linked to external benchmarks), and so to spending and prices. Fiscal policy interacts with it: government borrowing affects interest rates and liquidity.

2. The Chakravarty Committee: background

The Committee to Review the Working of the Monetary System was appointed by the RBI in December 1982 under the chairmanship of Prof. Sukhamoy Chakravarty, and reported in 1985. In the 1970s and early 1980s money supply had grown fast, mostly because the government financed deficits by selling ad hoc treasury bills to the RBI (automatic monetisation). Inflation was high, interest rates were administered at many different levels, and the RBI relied on raising CRR and SLR, which squeezed banks and left government securities with low coupon rates.

3. Recommendations

1. Objectives. Monetary policy should aim at price stability, growth and social justice, with price stability given importance because inflation hurts the poor most. An acceptable rate of inflation was put at about 4 per cent.
2. Monetary targeting with feedback. The RBI should set a target range for the growth of broad money (M3), consistent with the expected growth of real output and the acceptable inflation rate, and review it in the light of results. This was the “monetary targeting” approach followed until 1998.
3. Control of reserve money. Since reserve money drives M3, the main source of its growth, RBI credit to the government, must be controlled.
4. Limit on deficit financing. RBI credit to the government should be limited and agreed in advance; the government should restrain its budget deficits. Fiscal and monetary policy must be co-ordinated.
5. Interest-rate reform. Rationalise the complex administered structure; reduce the number of rates; make deposit rates positive in real terms to encourage saving.
6. Market-related yields on government securities. Raise coupon rates on government securities to make them attractive to investors other than captive banks, so that open market operations can become an effective tool.
7. Treasury bills and the money market. Develop the treasury bill market with market-determined rates and widen the money market (182-day treasury bills followed in 1986, and the Vaghul Committee on the money market in 1987).
8. Reduce reliance on CRR and SLR, which pre-empt bank resources, in favour of indirect instruments.
9. Revive the bank rate as the central signalling rate of monetary policy.
10. Credit allocation. Priority-sector lending should continue, but concessional interest rates should be kept to a minimum and confined to the needy; refinance facilities should be rationalised.

4. Evaluation and follow-up

The report gave Indian monetary policy a theoretical framework and moved it from direct controls towards indirect, market-based instruments. Its ideas were carried forward by later steps:

• the agreements of 1994 and 1997 that ended ad hoc treasury bills from 1 April 1997, replacing them with ways and means advances;
• auction of government securities at market rates from 1992;
• interest-rate deregulation in the 1990s and reductions in CRR and SLR after the Narasimham Committee;
• the Fiscal Responsibility and Budget Management Act, 2003, which barred the RBI from subscribing to primary issues of government securities except in specified cases;
• the shift to a multiple-indicator approach (1998) and then to flexible inflation targeting (Urjit Patel Committee, 2014; statutory in 2016) with a 4 per cent target, the same figure the Chakravarty Committee had called acceptable.

Criticism: the money-demand relation on which M3 targeting rested became unstable after financial liberalisation, and supply shocks (monsoon, oil) made inflation hard to control through money supply alone.

How this is examined

June/July 2025 (100 marks): “What are the recommendations made by Chakrabarthy Committee?” (16). June/July 2025 (80 marks): the same (10). January/February 2025: “Explain the recommendations of Chakravarty Committee Report on monetary policy” (10). Open with section 2 (four lines), list the ten recommendations, and close with two lines on how they were implemented.