Instruments Of Monetary Policy

8/12/2019 Instruments Of Monetary Policy

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Unlike other central banks, RBI has two policyratesthe repo rate, at which it injects moneyinto the financial system or lends money tobanks, and the reverse repo rate, at which itsucks out excess money or borrows moneyfrom banks.

If liquidity is abundant in the system, thenreverse repo becomes the key policy rate, butwhen money is scarceas is the case nowand banks borrow from RBI, the repo rate is

the key policy rate.


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RBI uses Repo Rate to control the supply of

money in the banking system.

By reducing the Repo rate RBI can reduce thecost of borrowing and there by the interest

rate in the system

RBI uses Reverse Repo Rate tocontrolliquidityin the system.

If RBI increases the Reverse Repo rate, it

indicates its readiness to accept money at ahigher rate.

Cash rich banks will use this facility to park

their surplus money with RBI.


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A reduction in the repo rate will help

banks to get money at a cheaper rate.

When the repo rate increases, borrowing

from RBI becomes more expensive.

The repo rate RBIs main short-term

lending ratehas now been cut by 25

basis points to 7.75% from the earlier level

of 8%.

100 basis points is equal to 1%.


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The SLR is the amount a commercial bankneeds to maintain in the form of cash, or goldor government approved securities (Bonds)

before providing credit to its customers. SLR rate is determined and maintained by the

RBI in order to control the expansion of bankcredit.

Higher reserve requirements such as SLR makebanks relatively safe but at the same timerestrict their capacity to lend.


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By changing the SLR rates, RBI can increase ordecrease bank credit expansion.

Also through SLR, RBI compels the commercialbanks to invest in government securities likeGovernment bonds.

If any Indian Bank fails to maintain therequired level of Statutory Liquidity Ratio,then it becomes liable to pay a penalty to the

RBI.


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The SLR has been unchanged since July 2012and is at 23%.

Banks will be required to invest 23% of theirdeposits in government bonds.

Banks will have more cash in hand to lend to

industry. The unchanged SLR is aimed atensuring free flow of credit growth throughenough liquidity in the system.


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It is a bank regulation that sets the minimumreserves each bank must hold by way ofcustomer deposits and notes

These deposits are designed to satisfy cashwithdrawal demands of customers

Deposits are normally in the form of currency

stored in a bank vault or with the central banklike the RBI

CRR is also called the Liquidity Ratio as it seeksto control money supply in the economy


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For e.g. saythe CRR is pegged by RBI at 10%.

if a bank receives Rs. 100 as deposit, then they

can lend Rs. 90 as a loan and will have to keep

the balance Rs. 10 in customers account

Now, the borrower who has received Rs. 90 as

a loan will deposit the same in his bank

The borrowers bank will now lend out Rs. 81

(Rs. 90 X 90%) and keep Rs. 9 in his account

As this process continues, the banking system

can expand the initial deposit of Rs.100 into a

maximum of Rs. 1000(Rs. 100 + Rs. 90 + Rs.

81.=Rs. 1000)


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CRR is increased to bring down inflation which

happens due to excessive spending power Spending power is augmented by loans - if

money that goes out as loans is controlled,inflation can be tamed to some extent

Conversely, if the government wants tostimulate higher economic activity andencourage higher spending to achieve

economic growth, they will lower CRR A lower CRR allows the bank to lend more

money and will fuel consumption andspending


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Instruments Of Monetary Policy

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