Economic reforms mainly depend on Fiscal and Monetary policy. Fiscal policy is regulated by Government of India and Monetary policy is regulated by RBI. In competitive exams, mainly in banking exams many questions come from Monetary policy.
In this section we will discuss "Monetary policy of RBI".
RBI’s Monetary Policy
What is Monetary Policy-
- Policy made by the central bank to control money supply in the economy.
MPC (Monetary policy committee)
- Section 45ZB of the amended RBI Act, 1934 provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government to determine interest rate required to achieve the inflation target.
- The MPC is required to meet at least four times in a year.
- Six member MPC is headed by RBI governor Urjit Patel.
- The Members of the Monetary Policy Committee appointed by the Central Government shall hold office for a period of four years.
Various tools / instruments of monetary policy-
These can be divided into quantitative and qualitative instruments.
Quantitative instruments-
1. Open Market Operations-
- This method refers to the buy and sell of securities, bills and bonds of government by RBI in the open market to expand or contract the amount of money in the banking system.
- When RBI purchases Government securities = liquidity increased (because RBI is paying that party some money to buy that security or RBI is pouring additional money into the system.)
- On reverse when RBI sells Government securities= liquidity is decreased. (because those players are giving their cash to RBI to purchase the securities.)
2. Liquidity Adjustment Facility (Repo and Reverse Repo)-
- Liquidity adjustment facilities (LAF) is also a tool used by RBI to control short-term money supply.
- LAF has two instruments namely repo rate and reverse repo rate.Repo Rate: The interest rate at which the Reserve Bank provides loans to commercial banks by mortgaging their dated government securities and treasury bills.Reverse Repo Rate: The interest rate at which the Reserve Bank borrows from commercial banks by mortgaging its dated government securities and treasury bills.
- While repo rate injects liquidity into the system, the Reverse repo absorbs the liquidity from the system.
3. Marginal Standing Facility-
- It is a loan facility for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely.
- How MSF is different from Repo rate?MSF loan facility was created for commercial banks to borrow from RBI in emergency conditions when inter-bank liquidity dries up and there is a volatility in the overnight interest rates. To curb this volatility, RBI allowed them to deposit government securities and get more liquidity from RBI at a rate higher than the repo rate.
4. Reserve Ratio (SLR, CRR)-
- SLR (Statutory liquidity ratio)- All commercial banks in the country required to keep a given percentage of their demand and time deposits (Net demand and time liabilities or NDTL) as liquid assets in their vault itself.
- It prevents bank from lending all its deposits which is too risky.Note- Net Demand and Time Liabilities (NDTL) mainly consist of Time liabilities and Demand liabilities.Time liabilities includes-(1) Money deposited in Fixed deposits (FD)(2) Cash certificates(3) gold deposits etc.Demand liabilities includes-(1) Money deposited in savings account(2) Money deposited in current account(3) Demand drafts etc.
- Cash Reserve Ration (CRR) - The Cash Reserve Ratio is the amount of funds that the banks are bound to keep with Reserve bank of India as a certain percentage of their Net Demand and Time Liabilities (NDTL). Bank cannot lend it to anyone. Bank earns no interest rate or profit on this.What happens when CRR is reduced?When CRR is reduced, this means banks required to keep less funds with RBI and resource available to banks for lending will go up.
5. Bank Rate-
- The bank rate is the rate which is fixed by RBI at which it rediscounts bills of exchange and government securities held by commercial banks.
- It is also known as discount rate.Note-
- Bill of exchange- is a financial document that assures payment of money by purchaser to seller for goods purchased.
- Differences between Repo rate and Bank rate-Repo Rate is a short-term measure on the other hand Bank Rate is a long-term measure.
Qualitative instruments-
1. Credit rationing-
- In this RBI controlled the maximum amount of credit flow to a certain sector.
- RBI may also make compulsory for the banks to provide certain fractions of their loans to certain sectors such as priority sector lending etc.
2. Selective Credit control-
- Decide Do or Don’t loan to these industries or to speculative businesses.
3. Margin Requirements-
- RBI can prescribe margin against collateral. For instance, lend only 70 Rs. for 100 Rs. value Property, margin requirement being 30%. If RBI raises margin requirement, customers will be able to borrow less.
4. Moral suasion-
Moral Suasion refers to a method of request, method of advice by the RBI to the commercial banks to take certain measures as per the trend of the economy.
5. Direct Action-
RBI issues certain guidelines from time to time based on current situation in the economy. These guidelines should be followed by banks. If any bank violates these guidelines RBI penalize them.
Current Policy Rates-
| Policy Repo Rate | 6.25 % |
| Reverse Repo Rate | 6.00 % |
| Marginal Standing Facility Rate | 6.50 % |
| Bank Rate | 6.50 % |
Reserve Ratios-
| CRR | 4 % |
| SLR | 20.50 % (20 % will be applicable from 24th June) |
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