Monetary Policy of India: Part- I

By admin
Feb 28th, 2012
monetary policy

In the last few months, you must have heard a lot about Repo rate and Reverse Repo rate increased by Reserve Bank of India (RBI) to control inflation. And many of you must be wanting to know what exactly are these terms and how can they affect Indian economy.

So, here I try explaining this scenario which will definitely aid you in long run.
But before we do that we must first know what Monetary Policy is?

“A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy.”

Monetary policy, also known as Credit Policy, helps RBI in deciding about the supply of money in an economy, ratio of interest to be charged for some amount of money. It provides measure to control inflation and most important of all it helps in deciding how to achieve the economic growth and development objectives of an economy.
So to attain these objectives various monetary policy instruments are used.

Monetary Policy Instruments

Principal Instruments of monetary policy or credit control are broadly classified as:

  • Quantitative Instruments: These tools are related to the Quantity or Volume of the money. These are the instruments of monetary policy which affect overall supply of money/ credit in the economy. For example, Bank Rate, Cash Reserve Ratio.
  • Qualitative Instruments: These instruments direct or restrict the flow of credit to specified areas of economic activity. These include instruments like Margin Requirement, Direct Auction etc. It may be possible that some qualitative instruments may have shades of quantitative instrument. 
We will limit our scope to various quantitative instruments for this discussion. We will definitely take it forward in the coming posts.

Bank Rate: “The interest rate at which RBI lends money to the commercial banks.”
Managing the bank rate is a preferred method by which central banks can regulate the level of economic activity. In most of the cases, the increase (or decrease) in bank rate is often followed by increase (or decrease) in market rate of interest.
But how is this helping in controlling the credits in an economy. Let’s have a look.
With the increase in the bank rate by RBI, commercial banks reduce their volume of borrowings from RBI as high bank rate increases their cost of borrowing. Thus, they have less availability of credit with them to lend to public or if they have, it is available at high rate. Therefore, with increase in bank rate there is an increase in market rate of interest also and this ultimately results in reduced borrowing by public.

On the other hand, if the RBI reduces the bank rate, borrowings for commercial banks will become cheaper. And banks will also reduce their rates thus resulting in credit expansion.

Open Market Operations (OMO): “The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market.”Let’s see how it helps in credit control.

RBI, especially during inflation, sells government securities in an open market which is purchased by commercial banks and private individuals. When commercial banks purchases securities, money get transferred to RBI from commercial bank. Thus, there is fall in money supply in an economy. Now due to decrease of money supply, purchasing power reduces which helps in controlling inflation. 

While, when RBI buys the securities from commercial banks in the open market, commercial banks sell securities and get back the money. It results in increase in the volume of money in the economy. It is done mostly during depression or recession.

Variable Reserve Rates (VRR): These basically include Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

  • CRR: “Cash reserve ratio is the cash parked by the banks in their specified current account maintained with RBI.”

Commercial banks have to keep a certain percentage of their total deposits in the form of cash reserves with RBI. For example if CRR is 10% and total deposits with a bank are Rs. 100 crore, they will have to keep Rs. 10 crore with RBI as minimum cash reserves.

  • SLR: “Statutory liquidity ratio is in the form of cash (book value), gold (current market value) and balances in unencumbered approved securities.”

Every bank is required to maintain a fixed percentage of its assets in the form of cash and other liquid assets with RBI.
“Other liquid assets include cash, balances with RBI, balances in current accounts with banks, money at call and short notice, inter-bank placements due within 30 days and securities under “held for trading” and “available for sale” categories excluding securities that do not have ready market.”
All said and done but how does it helps in controlling money supply?

By varying VRR commercial banks lending capacity can be affected. Suppose, commercial banks have total deposits of 100 crore with them. Now if VRR increases from 20% to 30%, than the reserves to be held by banks would increase from 20 crore to 30 crore. 

Thus, the availability of money with commercial bank which can be used for credit creation will reduce by 10 crore. On the contrary any decrease in VRR will make more money available with banks for credit creation.

Liquidity Adjustment Facility: “A tool used in monetary policy that allows banks to borrow money through repurchase agreements.” 

But what is repurchase agreement or Repo?

“Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.”
Thus, in Repo transaction banks borrow funds from RBI by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price. If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
“The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.”
The RBI uses this tool when it feels there is too much money floating in the banking system. With the increase in reverse repo rate, RBI gives bank a lucrative rate for depositing money. Thus, banks prefer to deposit money with RBI rather than lending it. It results in reduction of money circulation in an economy and thus purchasing power.

LAF enables liquidity management on a day to day basis. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets. 

Marginal Standing Facility Rate: “Banks will be able to borrow up to 1% of their respective Net Demand and Time Liabilities”. The rate of interest on the amount accessed from this facility is 100 basis points (i.e. 1%) above the repo rate.

This scheme will reduce volatility in the overnight rates and improve monetary transmission. This measure has been introduced by RBI to regulate short-term asset liability mismatches more effectively.
This was brief about the quantitative instruments of monetary policy. We will discuss about qualitative instruments in the coming posts.

Posted by our guest author Priyanka

Priyanka Maheshwari
About Priyanka :

Priyanka Maheshwari, a student of The Institute of Company Secretary enjoys reading novels.

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