Monetary Policy

• it is the process by which
  • monetary authority of a country controls the supply of money
  • by targeting a rate of interest for the purpose of promoting economic growth and stability
• goals
  • stabilise the prices
  • reduce the unemployment levels
• types
  • Expansionary
  • Contractionary

Role of Central Bank

• Functions
  • Custody and management of Foreign Exchange Reserves
  • Acting as a bank to the banker
  • Acting as a bank to the government
  • Leader of the last resort
  • Controller of credit
    • exercises discretionary control over the monetary system of the country
    • commands an imp. position in the monetary and banking structure of country
• Monetary policy
  • Announced six times a year
  • Determines the supply of money in the economy
  • Determines the rate of interest charged by bank
  • Contains an economic overview and presents future forecasts
• Instruments
  • Quantitative
    • bank rate
    • statutory liquidity ratio
    • cash reserve ratio
    • repo rate
    • reverse repo rate
    • open market operations
  • Qualitative
    • Margin requirements
    • Consumer credit regulation and guidelines
    • moral suasion
      • moral request by bank to control it or not
    • direct action

Bank Rate

• Refers to the official interest rate at which RBI provides loans to the banking system
• It includes
  • commercial/cooperative banks
  • development banks etc.
• such loans are given out by
  • direct lending
  • rediscounting (buying back) the bills of commercial banks and treasury bills
• Bank rate is also known as discount rate
• Objective
  • When RBI increases the bank rate, the cost of borrowing for banks rises
  • this credit volume gets reduced leading to decline in supply of money
  • thus, increase in bank rate reflects tightening of RBI monetary policy

Repo Rate

• Repurchase rate
• Rate at which RBI lends to banks for short periods
• Done by RBI buying government bonds from banks with an agreement to sell them back at a fixed rate
• Objective
  • inject liquidity in the system
  • increased repo rate -> expensive for banks to borrow
  • decreased repo rate -> cheaper for banks to borrow

Bank Rate vs Repo Rate

• Repo rate is a short term measure and it refers to short-term lonas and used for controlling amount of money in market
• Bank rate is a long term measure and is governed by the long-term monetary policy of RBI

Reverse Repo Rate

• Rate of interest at which the RBI borrows funds from other banks in the short term
• Done by RBI selling government bonds or securities to banks with commitment to buy them back at a future date
• Bank use reverse repo facility to deposit their short term excess funds with RBI and earn interest for it
• RBI can reduce liquidity in banking system by increasing the rate at which it borrows from banks
• Procedure
  • When RBI increases the reverse repo, it means that now RBI will provide extra interest on the money which it borrows from the banks.
  • An increase in reverse repo rate means that banks earn higher returns by lending to RBI
  • This indicates a hike in deposit rates
  • pushes up interest rates

Open Market Operations

• Purchase and Sale of the Government Securities by RBI from/to market
• When there is excess of liquidity RBI resorts to sale of G-secs to suck out rupee from system
• When there is liquidity crunch, RBI buys securities from the market in order to release liquidity
• Objective
  • carried out to adjust liquidity condition of rupee in the economy
  • when RBI sells g-secs to banks
  • as soon as banks purchase g-secs, they have reduced money to lend to the industrial houses or other commercial sectors
  • this reduces surplus cash, contracts the rupee liquidity
  • contracts credit creation / credit supply

Cash Reserve Ratio

• It is the amount of funds that the banks are bound to keep with RBI as a percentage of their Net Demand and Time Liabilities (NDTL)
• CRR = Cash Deposited with RBI / NDTL
• CRR has to be maintained on a daily basis with RBI by every bank
• Objective
  • Ensure adequate liquidity in financial system
  • enough solvency for banks
  • CRR is maintained fortnightly average basis
• CRR is altered by RBI
• RBI does not pay any interest on the CRR balances
• Reduction of CRR
  • excess funds are available with banks for deploying in other businesses because they are required to keep lesser amounts with RBI
  • banks would have more money to lend
  • this leads to reduction of interest rates on loans provided by banks
  • example
    • SBI has balance of 100 crores
    • CRR @5%
    • SBI has to maintain atleast 5cr with RBI
    • Only has 95cr to its disposal
    • If CRR @4.5%
    • SBI can lend more now outside as it has 95.5cr to its disposal
  • Impact on inflation
    • Reduction in CRR leaves more money in the hands of commercial banks and this leads to increase in money supply in system
    • When money supply rises, too much money chases too few goods and this leads to rise in inflation
• Increase in CRR
  • banks will have less money
  • since banks don't earn any interest, banks are left with no option but to increase the interest rates
  • hike in CRR sucks money out of system causing inflation to come down
• From 2006, RBI is empowered to fix the CRR on its discretion without any ceiling

Statutory Liquidity Ratio

• All banks have to keep a fraction of their total net time and demand liabilites in form of liquid assets such as
  • G-secs
  • precious metals
  • approved securities amongst others
• Maintained with banks themselves
• SLR = Liquid Assets / NDTL
• Ratio was prescribed by Section 24(2A) of Banking Regulation Act 1949
• Original ratio mandated for a 23% SLR
• Presently 21% (August 2016)
• SLR deposits include
  • Cash
  • Gold reserves kept in bank
  • Balances with RBI
  • Net balance in current account
  • Investment in G-secs(if any)
• SLR has to be maintained on a daily basis by every bank
• SLR is inversely proportional to money in market

CRR vs SLR

Liquidity Adjustment Facility

• This is the primary instrument of RBI for modulating liquidity and sending interest rate signals to the market
• It refers to the difference b/w the two key rates
  • repo rate
  • reverse repo rate
• Also known as Liquidity Corridor
• While repo infuses liquidity into the system, reverse repo absorbs liquidity from system
• RBI just announces Repo Rate
• Reverse repo rate is linked to repo rate and is 100 basis points (1%) below repo rate

Marginal Standing Facility

• Created by RBI in its credit policy of may 2011
• MSF is the rate at which banks are able to borrow overnight funds from RBI against apporved government securities
• MSF is always 1% higher than Repo rate

Qualitative Tools

• Those tools thru which the central bank not only controls the value of loans but also the purpose for which these loans are assigned by the commercial banks
  • Moral suasion
  • Rationing of credit
  • Direct Action
  • Margin requirements

Moral Suasion

• Suasion means request or persuasion
• To arrest inflationary situation central bank persuades and requests the commercial banks to refrain from giving loans for speculative and non-essential purposes
• To counter deflation, central bank persuades the commercial banks to extend credit for different purposes
• Periodic discussions are held with authorities of commercial banks in this respect from 1949

Rationing of Credit

• Method by which the RBI seeks to limit the maximum amount of loans and advances
• Also in certain cases, fix ceiling for specific categories of loans and advances
• Priority Sector Landing - making credit flow to certain priority or weaker sectorsnby charging concessional rates of interest