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Monetary Policy in India - Explained

Monetary Policy is a Policy made by the central bank(RBI) to control money supply in the economy and thereby fight both inflation and deflation. It helps maintain price stability and achieve high economic growth. To Combat Inflation RBI reduces Money Supply (Tight/Dear Money Policy). To Combat Deflation RBI increases Money Supply (Easy/Cheap Money Policy).

RBI implements monetary policy using certain tools. These are Quantitative Tools and Qualitative Tools. Quantitative Tools are Reserve Ratios(CRR,SLR) , OMO(Open Market Operations) and Rates(Repo , Reverse Repo , Bank Rate , MSF).

Must also readMonetary policy tools in hands of RBI

Cash Reserve Ratio

  • Cash Reserve Ratio is a certain percentage of bank deposits (Net Time and Demand Liabilities) which banks are required to keep with RBI in the form of reserves or balances .
  • Higher the CRR with the RBI lower will be the liquidity in the system and vice-versa. 
  • It’s a dead Money as Banks don’t receive any Interest from RBI for reserves kept. RBI can charge Penalty(3% above Bank Rate) for not keeping the reserves. CRR is defined under Sec 42(1) of RBI Act , 1934. 
  • Its Minimum and Maximum value is the discretion of RBI. It is maintained on Fortnightly Average Basis. At Present The CRR is 4%. By Increasing CRR the Money Supply can be Reduced in Market thereby Controlling Inflation(Dear Money Policy) and by Decreasing it Money Supply can be Increased thereby promoting Growth(Cheap Money Policy)

Statutory Liquidity Ratio

  • Every financial institution has to maintain a certain quantity of liquid assets with themselves at any point of time of their total time and demand liabilities. These assets can be cash, precious metals, RBI approved securities like bonds, Shares etc. The ratio of the liquid assets to time and demand liabilities is termed as the Statutory liquidity ratio.
  • Some profits are earned through SLR by banks depending upon the asset. It is defined under Sec 24 of Banking Regulation Act 1949. It is maintained on daily basis by Banks.
  • Penalty for Not Maintaining SLR can be 3% above Bank Rate. 
  • Its Minimum and Maximum value(can be 40%) is the discretion of RBI. It is maintained on Daily Basis. At Present The SLR is 22%. By Increasing SLR the Money Supply can be Reduced in Market thereby Controlling Inflation(Dear Money Policy) and by Decreasing it Money Supply can be Increased thereby promoting Growth(Cheap Money Policy)

Repo (Repurchase) rate

  • It is the rate at which RBI lends money to commercial banks against securities in case commercial banks fall short of funds for Short Term. But Remember The banks cannot get money by mortgaging SLR quota securities to get money from RBI. It has to have securities above the SLR quota to Buy Money. This rate is also known as “Policy Rate” under LAF(Liquidity Adjustment Facility).
  • There is No Limit on how much the Client can Buy from RBI but Minimum has to Rs 5 crores. Banks use this Facility only when they have less Deposits from Public but have more Loan Demand. Currently the Repo Rate is 7.75%. 
  • By Increasing Repo Rate the Money Supply can be Reduced in Market as Money becomes Costly(Dearer) thereby Controlling Inflation(Dear Money Policy) and by Decreasing it Money Supply can be Increased as Money becomes Cheap thereby promoting Growth(Cheap Money Policy). Indirectly This helps in GDP growth of India as less Repo Rates most probably leads to Less Lending Rates by Banks. So Business can buy More Loans and invest that Money in Production.

Reverse Repo (Repurchase) Rate

  • Rate at which RBI borrows money from commercial banks. When Banks have collected More Money from Public but Demand for Loans is Less then Banks mostly park their Money with RBI and Receives Interest(Reverse Repo Rate). Reverse Repo Rate is Dependent on Repo Rates as Reverse Repo Rate is set to Repo Rate -1%. RBI gives Government Securities as Collateral to Banks. Current rate is 6.75%
  • Officially Repo and Reverse Repo Rates Percentages are in Basis Points. So 1% means 100 Basis Points.

Marginal Standing Funding

  • By this mechanism commercial banks can get loans from RBI for their emergency needs. Under the Marginal Standing Facility (MSF), currently banks avail funds from the RBI on overnight basis against their excess SLR holdings
  • Additionally, they can also avail funds on overnight basis below the stipulated SLR up to two per cent of their respective Net Demand and Time Liabilities (NDTL) outstanding at the end of second preceding fortnight. 
  • With a view to enabling banks to meet the liquidity requirements of mutual funds under the RBI’s Special Repo Window announced on July 17, 2013, it has been decided to raise the borrowing limit below the stipulated SLR requirement under the MSF from 2 per cent of NDTL to 2.5 per cent of NDTL. This Facility is only Available to Scheduled Commercial Banks. Under This Facility Banks can use securities from SLR quota. MSF Rate = Repo Rate +1%. Current is 8.75%

Bank rate

  • It is a rate at which RBI lends money to commercial banks without any security. It is used for Long Term Borrowing . Bank rate is not the main tool to control money supply. Repo Rate is the main tool to Control Money Supply. Penal rates are linked with Bank rate. At present, Penalty rate = Bank rate + 3% (or 5% in some cases) 

Impact

  • When bank rate is increased interest rate also increases which have negative impact on demand thus prices increases. 

Qualitative Tools

  1. LTV (Loan to Value Ratio) : Suppose I have Land Worth Rs 1 Crore and I want to get Loan from Bank by Mortgaging that Land. Then I will Not get Rs 1 Crore Loan . If LTV=60% then I can Get Maximum Loan of Rs 60 Lakh. 
  2. Moral Suasion : Moral Suasion is just as a request by the RBI to the commercial banks to take so and so action and measures in so and so trend of the economy. RBI may request commercial banks not to give loans for unproductive purpose which does not add to economic growth but increases inflation. Rajan will try to influence those bankers through direct meetings, conference, giving media statements, giving speeches etc 
  3. Credit Ceiling: In this operation RBI issues prior information or direction that loans to the commercial banks will be given up to a certain limit. In this case commercial bank will be tight in advancing loans to the public. They will allocate loans to limited sectors. Few example of ceiling are agriculture sector advances, priority sector lending. 
  4. Credit Authorization Scheme: Under this instrument of credit regulation RBI as per the guideline authorizes the banks to advance loans to desired sectors 
  5. Direct action : Means RBI gives punishment to notorious banks for not abiding by its guidelines. Punishment can involve: penal interest, refuses to lend them money and in worst case even cancels their banking license.

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