Académique Documents
Professionnel Documents
Culture Documents
Page 1 of 24
- Mrunal - http://mrunal.org -
Prologue
Next article is about RBI appointed Urjit Patel Committee on Monetary policy
framework.
But before dwelling into that, we must recap the basic concepts of what is
monetary policy: its tools and limitations. Otherwise Urjit wont make much
sense.
Hence in a way, this whole article is a prologue to next article.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 2 of 24
meaning
DEFLATION
REFLATION
yes
Quantitative Tools
#1: Reserve Ratios (SLR and CRR)
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 3 of 24
SLR A Bank has to set aside this much money into gold or RBI approved
securities.
A Bank has to set aside this much as reserve. Bank cannot lend it to
CRR
anyone. Bank earns no interest rate or profit on this.
23%
4%
100 cr.
-4 cr
-23 cr.
100-4-23=73
Cores.
100 cr
-40
-15
45 cr.
You can see, when Rajan has raised reserve ratio, money with SBI is reduced (from
73 crores to just 45 crores.)
What will be its implication?
Imagine youre a money lender. Youve 100 crore rupees and you must make
Rs.1 crore profit in a year.
Obviously, you should lend it @1% interest rate. (because 1% of 100 crore = 1
crore.)
But what if youve only 2 crore rupees, and you still want to make Rs.1 croer
profit in a year?
Now you must lend it @50% interest rate. (because 50% of 2 cores = 1 crore.)
Observe that as money decreased (from 100 to 2), loan interest rate increased
(from 1% to 50%).
Same happens when SBI is left with less money (after RBI increases reserve ratio).
Lets prepare a flow chart.
Situation: Economy has inflationary trend. Prices of goods and services increasing
every day.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 4 of 24
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
3.
4.
5.
6.
7.
8.
Page 5 of 24
dear money
To fight inflation
Increase them.
RBI sell securities
cheap money
To fight deflation
Decrease them.
RBI buy securities
Mock Question
In 2013, UPSC walla asked a very chillar question from this topic.
In context of Indian Economy, Open Market Operation refers to
a.
b.
c.
d.
If you dont know the answer, Just leave it instead of risking negative
mark.
Correct answer is Opt C.
It means youve unsure of the answer. 50:50. So you mark the question
number (say 45), at the back of your question paper. At the end of
exam, if youre left with 10-15 free minutes. You look at the question
again, and try to solve it.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 6 of 24
Q.Which of the following measures would result in an increase in the money supply in
economy?
1.
2.
3.
4.
Answer choice
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
2, 3 and 4
Whenever you face such multiple statement type MCQs, always use elimination
method. First find a statement that is definitely right or definitely wrong and eliminate
choices accordingly.
Focus on first statement Purchase of government securities from public by
central bank: will it increase money supply in the system?
Imagine Rajan puts an ad in newspaper: bring your Sabzi (vegetables), Ill buy
it. Junta gives him their own veggies, Rajan gives them money. (a classic buy
and sell).
Ultimate result: money supply increased in the system- because junta got the
money. Meaning #1 definitely correct.
If you think it on technical terms. Central bank purchases government
securities=OMO (Open market operation), where money shifts hands from RBI
to people.
Hence money supply increased. (In reality, money doesnt go to aam admi
directly, but those bankers and non-banking institutions who participate in
OMO). Anyways, #1 is right, Eliminate choices that do not have #1
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
2, 3 and 4
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 7 of 24
Mark n
Review.
By the way, What about Statement #2: Deposit of currency in commercial banks by
the public. (Will it increase money supply or not?)
Viewpoint 1: yes. Because bank can used it to expand loanable credit. (as
explained in Money creation topic in Class 12 NCERT Macroeconomics page 39
onwards).
Viewpoint 2: no. (Because Bank will have to put some money aside as CRR- so
that much money is less in the system.)
Either way it doesnt change the answer. Because We know that statement 1 is
definitely correct. And there is no option where (1,2) are given simultaneously.
Anyways, Moving onSo far, RBI has two tools under monetary policy:
1. reserve ratios (SLR, CRR)
2. Open market operation.
Third and the most important quantitative tool is
Bank Rate
When banks borrow long term funds from RBI. Theyve to pay this much interest
rate to RBI. [Note: different books give different explanation of Bank Rate. Ive
used NDTV s definition]
At present, Bank rate= 9%
Collateral: nothing. (Bank can borrow money without pledging government
securities to RBI)
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 8 of 24
Bank rate is not the main tool to control money supply these days.
Nowadays, RBI uses LAF Repo rate as the main tool, to control money supply.
Ok then Whats the use of Bank rate?
Penal rates are linked with Bank rate. For example, If a bank doesnt maintain
CRR, SLR as per the prescribed limit.
Then RBI can impose penalty interest on such notorious bank.
At present, Penalty rate = Bank rate + 3% (or 5% in some cases)
Meaning if Bank rate = 9% then penalty rate=9+3=12%
Anyways, what if RBI wants to fight inflation using bank rate as a tool?
Obviously they should increase bank rate. That way it becomes harder (more
expensive) for banks to borrow from RBI.=> SBI increases its loan rates (to keep the
profit margin same). Result?
Less people get home loan, bike loan, business loans.
Less business expansion
Less jobs
Less incomes
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying
more things.
Thus inflation is reduced.
Lets update our (stupid) table
Policy
Tool
Reserve Ratio (CRR, SLR)
Open Market Operation (OMO)
Bank rate
dear money
To fight inflation
Increase them.
RBI sell securities
Increase
cheap money
To fight deflation
Decrease them.
RBI buy securities
decrease
If client borrows money from RBI (for short term) then client has to pay
this much interest rate to RBI. At present Repo is 8%. (article written on
29th Jan 2014)
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Reverse
Repo
Page 9 of 24
If client lends money to RBI (for short term) then RBI has to pay this
much interest rate to client. RBI doesnt like headache. So they made a
simple formula: Reverse repo rate= Repo MINUS 1%=8-1=7%.
Collateral:
Problem with running a adda/gambling-den = sometimes client drinks too
much desi liquor and passes out on floor. Sometimes he even dies because of
hooch. Sometimes police raids the den, and clients run away with cash and
register.
If such things happen, Rajan will be at loss. So, he demands government
securities as collataral. So even if client doesnt repay money on time, Rajan
can sell those securities (in open market operations) and recover money.
Scenario
SBI chairman Arundhati mam wants to borrow Rs.100 crore (for short term).
She gives her stash of government securities to Rajan.
Rajan gives her Rs.100 crore.
Madam Also signs an agreement
I, Arundhati Bhattacharya, agree to buy same securities from Rajan, at 108
crores after 14 days.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 10 of 24
Notice that she has agreed to re-purchase same securities from Rajan.
Therefore its called Repo.
And how much interest rate did she pay on this loan? [108-100]/100=8%.
Thats our repo rate.
Important:
Recall that SBI also has to keep part of her money in RBI approved securities
(under SLR).
So Madam cannot USE those government securities to borrow under Repo Rate
from Rajan.
That leads to a new topic
MSF
Minimum Rs. 1 crore.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 11 of 24
dear money
To fight inflation
cheap money
To fight deflation
Increase them.
Decrease them.
increase it
decrease it
increase it
decrease it
its value is linked with Repo, hence cannot be
increased/decreased independently.
its value is linked with Repo, hence cannot be
increased/decreased independently. Besides MSF= temporary
firefighting, cash mismanagement.
We learned that Rajan doesnt use Bank rate much, to control money supply.
We learned that Rajan doesnt decide Reverse repo and MSF. (theyre
automatically -1% and +1% of Repo rate).
Thus the only thing Rajan has to decide under monetary policy= Repo rate.
Therefore, Repo rate is called the policy rate
Lets revisit out flow chart:
Situation: Economy has inflationary trend. Prices of goods and services
increasing every day.
Solution: Rajan increases Repo rate. (say from 7.75% to 8%).
Result: it becomes expensive for SBI to borrow from Rajan. Theyll increase
their own rates as well.
Wait. How?
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 12 of 24
SBI raises its loan interest rate (to keep profit margin same)
Businessmen borrow less money from SBI.
Businessmen donot start new business. Donot expand existing business.
Less jobs
Less income
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying
more things.
dear money
To fight inflation
Increase them.
RBI sell securities
Increase it
cheap money
To fight deflation
Decrease them.
RBI buy securities
Decrease it
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 13 of 24
From above above graph, you can see RBI has frequently changed its repo rate to
combat both inflationary and deflationary trend. But Youd agree that inflation has not
been contained. No matter what number juggling or statistical interpretations are
given- the hardship of common man has not stopped- be it milk, petrol, onion, LPG
anything.
Agreed that prices of onion, sugar, pulses and food are subject to vagaries of
monsoon and black marketeering. Rajan cannot do anything about it.
Agreed that crude oil prices are subject to rupee-Dollar exchange rate, external
factors and governments de-regulation of their prices. Rajan doesnt have much
control over this.
But still even in the non-food, non-fuel type commodities- RBIs monetary policies
have failed to curb inflation. WHY? Observe the following image.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 14 of 24
Suppose Vijay Mallay got 100 crore loan from State Bank of India. If you trace the
source of that money, itll turnout 60-70 crores came from banks savings account,
fixed deposit etc. Rajan lends money in repo rate yes, but that doesnt mean banks
depend only on Rajan to arrange the cash for its clients.
Suppose Rajan reduces repo rate from 8% to 5%. Banks are not legally required to
reduce their loan interest rates.
The current system is following:
Banks are free to decide their base rate. E.g. SBIs base rate is 10%.
It means SBI wont loan money to anyone at an interest rate lower than 10%
(except those farmers under Interest subvention scheme.)
SBI will link all of its loan products with Base rate. For example
SBI Base rate =10%
Car loan
Two wheeler loan
Education loan (upto 4 lakh)
Home loan for women (upto 75 lakh)
Calculation
0.75% above Base rate
8.25% above base rate
3.5% above base rate
0.10% above base rate
Result
10.75%
18.25%
13.5%
10.10%
Meaning if SBI changes her Base rate then all of above loan interest rates will change
automatically.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 15 of 24
If Rajan changes his repo rate, will SBI change her base rate?
Not always.
Because those common men are the main suppliers of money to SBI.
RBI is not the main supplier of money to SBI.
SBI will only change its base rate, when she feels necessary for its own profit /
loss compared to its competitors.
Does it mean Repo rate system is bogus and ineffective?
Not always.
In developing countries like India, most people park their money in only four
things: savings account, fixed deposit (FD), provident fund and LIC. Weve
mutual funds, weve NPS, weve ULIPs, weve Rajiv Gandhi equity savings
scheme
but most people (particularly the older generation) feels insecure in into such
new things. Therefore lot of money flows into Savings accounts and fixed
deposits= SBIs main source of money.
But, In advanced economies, like USA, people dont invest large portion their
income in savings account or FD. Theyve variety of investment options. So, for
those American banks, their own Central bank (US Feds) is a significant money
supplier.
Hence US Feds monetary policy shows faster impact on their American Banks,
THAN Rajans monetary policy on Desi banks.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 16 of 24
Qualitative tools
1. Reserve ratios
2. OMO
Well see them in a moment
3. Policy rate (Repo Rate)
Qualitative Tools
#1: Margin Requirements/ LTV
Mallya wants to borrow from SBI. He pledges his companys shares worth
Rs.100 crores as collateral.
For such loans, Rajan can prescribe margin, say 65%.
In that case even if Mallya pledges 100 crores worth shares, SBI can give him
100-65=only 35 Crore rupees as loan.
Using this tool, Rajan can control money supply. e.g. during inflation, he should
increase margin requirement, so Mallya can borrow less=> less job=>less
income=>less demand=>prices reduced.
If Rajan changes repo rate, it is not compulsory for SBI to change her loan
interest rates. (we saw how Alok Nath keeps giving money to SBI, so they are
not entirely dependent on Rajan.)
But if Rajan changes margin requirements, then SBI and all other banks must
obey it. In other words, this tool has direct impact on money supply.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 17 of 24
Rationing
of credit
Direct
action
Lets recap
Qualitative
1.
2.
3.
4.
5.
6.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 18 of 24
Only 2 and 3
Only 1 and 2
Only 1 and 3
1, 2 and 3
Approach:
Whenever you face such 3 statement MCQ or 4 statement MCQ, Always use
elimination method. First you find out a statement that is definitely right or definitely
wrong. In above case, we can see #2 is definitely right. RBI lends funds to banks in
the times of need (Repo, MSF)
So lets eliminate choices that dont involve statement #2
1.
2.
3.
4.
Only 2 and 3
Only 1 and 2
Only 1 and 3
1, 2 and 3
This did not help much. We still have three choices left. Observe statement #1:
Other banks retain their deposits with RBI. That is correct with respect to cash
reserve ratio. CRR is one type of deposit that banks make to RBI. (RBI doesnt
pay interest on it- thats a different story).
Meaning #1 is also correct eliminate choices that donot have #1
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
Only two choices left and the ultimate solution = is statement #3 is correct or not?
Viewpoint #1
Viewpoint #2
The statement says RBI advises commercial banks RBI does advice those banks.
on monetary matters.The word advises makes
We saw it under Moral
this statement incorrect. Because RBI doesnt
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 19 of 24
Suasion. Therefore,
Statement #3 is right.
Money Banking and finance,
E Narayan Nadar (PHI
publication). He has
specifically listed this Advice
function under Bankers bank
topic.
Answer (D)
Skip
Attempt
Mark n
Review
Upto you. But if you start skipping all such question (OMO, Money
supply, Bankers bank), because youre completely unaware of those
topics=that is not pardonable.it shows youre underprepared for this
exam. You should either change your study method or change the
game- try for some easier exam.
This question is attemptable, if you dont nitpick over the word advises
in third statement.
If youve thoroughly prepared the RBIs monetary tools (both qualitative
and quantitative), you can solve it by applying concepts/principlesparticularly the moral suasion thing. But if youre still doubtful over
whether #3 is right or wrong, then better skip. If you skip because youre
doubtful = that is pardonable. But if you skip because youre completely
unaware of this topic= non-bailable offense.
Appendix
These are the topics I wanted to discuss in the article, but they would break the flow
of other topics. Hence writing them @bottom:
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 20 of 24
Using this money, bank has to count its Net Demand and Time liabilities
(NDTL), every fortnight. Suppose its 100 crores.
Both CRR and SLR are counted on this figure. In the old times, these reserve
ratios used to be as high as 15% and 40% respectively. Observe the effect:
Net Demand and Time Liabilities (NDTL)
Reserve ratios
CRR (15%)
SLR (40%)
Money left with bank
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45 cr.
From 100 crores, barely 45 crores left with the bank. But adding insult to the injuryeven here RBI mandates Priority sector lending (PSL). Meaning, at least 40% of the
loans has to be given to farmers, small businessmen, students etc. groups.
Lets update the table:
Net Demand and Time Liabilities (NDTL)
Reserve ratios
CRR (15%)
SLR (40%)
Money left with bank
PSL (40%)
Money left for big borrowers (i.e. big businessmen, upper
middleclass)
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45
=45 x 0.4 =18
crore.
=45-18=27 crores.
By the way, PSL is counted on annual basis while SLR, CRR counted on
fortnight basis so above table is technically incorrect but Ive plugged in those
numbers only for the sake of explanation.
before the 90s- Government would even interfere and order public sector banks
to give PSL-loans @cheap interest rates. The local politicians would coerce the
branch manager to give PSL-loans to ineligible people. They default on loans,
Branch manager cannot recover money (because defaulter will goto civil court
then taarikh pe taarikh.) So, bank would have to forget about most of those 18
crores given in PSL loans.
Anyways you can see people deposited 100 crores in the bank yet bank is left
with barely 27 crores (over which, bank has Freedom to decide whom they
should give the loan.)
What are the consequences for businessmen?
1. High cost of credit (because bank will try to make maximum profit from those 27
crores- so bank will charge very high interest rate on the business loans- to pay
off for the staff salaries, branch office rents and everything.)
2. Businessman cannot expand his business.
3. Less exports.
4. Less tax income for the government.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 21 of 24
So in a way- that was also one of the factors leading to Balance of Payment crisis
(and subsequently LPG reforms.) You can read more about that in NCERT Class 11chapter 2 and 3.
Mock Questions
1. With open market operations, RBI can
a. increase liquidity in the economy, but cannot decrease it
b. decrease liquidity in the economy, but cannot increase it
c. Can increase or decrease liquidity in the economy to control money supply.
d. None of above.
2. By which of the following methods, government can reduce money supply in the
economy?
a. taxation
b. sale of securities to public
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
3.
4.
5.
6.
Page 22 of 24
c. both A and B
d. neither A nor B
During the period of deflation
a. RBI should use dear money policy to combat it
b. Government should reduce its tax rates.
c. both A and B
d. Neither A nor B.
IF prices are lowered without causing unemployment, we call it:
a. stagflation
b. reflation
c. disflaction
d. Disinflation.
Which of the following contains correct set of quantitative instruments of
monetary policy?
a. reserve ratio, bank rate, margin requirements
b. open market operations, margin requirements, regulation of consumer
credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
Which of the following contains correct set of qualitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. credit rationing, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
Q7. To counter the effect of deflation, which of the following steps should RBI
initiate?
1. decrease reserve ratios
2. buy government securities through open market operation
3. increase policy rate
Answer choices
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
Q8. To counter inflation, which of the following steps should RBI initiate?
1. Increase reserve ratios
2. sell government securities through open market operation
3. Increase policy rate
Answer choices
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
Page 23 of 24
only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1, 2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015
6.
7.
8.
9.
10.
11.
Page 24 of 24
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applicati... 1/21/2015