Monetary policy, Objective, Instruments

Monetary policy:

Monetary policy consists the actions of a central bank that determine the size and rate of growth of
money supply, which in turn affects interest rates. Monetary policy is maintained through actions such
as modifying the interest rate, buying or selling government bonds, and changing the amount of money
banks are required to keep in the vault.

Monetary policy is the macroeconomic policy laid down by the RBI in India. It involves management of
money supply and interest rate and is used by government of a country to achieve macroeconomic
objectives like inflation, consumption, growth and liquidity.
The RBI implements the monetary policy through open market operations, bank rate policy, reserve
system, credit control policy, moral persuasion.

Monetary policy can be expansionary and contractionary in nature. Increasing money supply and
reducing interest rates indicate expansionary policy. The reserve of this is a contractionary monetary
policy.

Central banks use a number of tools to shape monetary policy. Open market operations directly affect
the money supply through buying short-term government bonds (to expand money supply) or selling
them (to contract it). Benchmark interest rates, Repo rates affect the demand for money by raising or
lowering the cost to borrow- in essence, money’s price. When borrowing is cheap, firms will take on
more debt to invest in hiring and expansion; consumers will maker larger, long-term purchases with
cheap credit; savers will have more incentive to invest their money in stocks or other assets, rather than
earn very little. Policy makers also manage risk in the banking system by mandating the reserves that
banks must keep in hand i.e. CRR and SLR [Cash reserve ratio (CRR) is the compulsory reserve that must
be maintained with the central bank whereas Statutory liquidity ratio shortly called as SLR is also
obligatory reserve to be kept by the banks, as prescribed securities, based on a certain percentage of net
demand and time liabilities. CRR is in the form of cash and SLR can be cash and other assts like gold and
government securities.]

CRR
CRR is the percentage of money which the banks
have to keep with the RBI in the form of cash.
It has to be kept in the form of cash only with the
central bank.
It controls excess money flow in the economy of
the country.
It has to be maintained with the RBI.
It regulates the liquidity in the economy.
Current CRR- 4%
SLR
The banks have to keep a certain percentage of
their net time and demand liabilities in the form
of liquid assets as specified by RBI.
It should be kept in the form of cash and other
assets like gold and government securities viz.
central or state government securities.
It helps in meeting out the unexpected demand
of any depositor by selling the bonds.
It has to be maintained with the bank itself.
It regulates the credit growth in the economy.
Current SLR-19.5%
CRR:

CRR is the percentage of total deposits, which a commercial bank has to keep as reserves in the form of
cash with the RBI. The banks are not allowed to use that money, kept with RBI, for economic and
commercial purposes. It is a tool used by the RBI to regulate the liquidity in the economy and control the
flow of the money in the country.

If the RBI wants to increase the money supply in the economy, it will reduce the rate of CRR while, if RBI
seeks to decrease the money supply in the market then it will increase the rate of CRR.
 Liquidity Adjustment Facility (LAF)

Liquidity adjustment facility may be defined as a monetary policy tool, which helps banks to borrow
money through repurchase agreements. Banks use LAF to adjust the day to day mismatches in liquidity.
LAF consists of repo and reverse repo operations. In LAF, money transaction is done through RTGS. Repo
rate and reverse repo rate are the two major components of LAF. The minimum bidding amount is Rs. 5
crores.

Repo Rate (Policy Rate)

Repo rate is the rate at which the RBI lends money to commercial banks. Repo rate stands for
repurchase rate. Repo rate is usually offered for loans of short durations (up to 2 weeks). Repo rate is
used by monetary authorities to control inflation. Commercial banks borrow money from RBI by selling
securities or bonds with an agreement to repurchase the security on a certain date at a predetermined
price. The rate of interest charged by the central bank on the cash borrowed by commercial bank in such
way is called “repo rate”.

Repo rate decides the liquidity rate in the banking system. If RBI wants to increase the liquidity rate, it
will reduce the repo rate and encourage the banks to sell their securities. However, if the RBI wants to
control liquidity, it will increase the interest rate, discouraging the banks to borrow easily. An increased
Repo rate means that the central bank will earn a higher interest rate from the commercial banks.

Current repo rate is 6.50%

Bank Rate:

The rate of interest charged by the central bank on the loans they have extended to commercial banks
and other financial institutions is called “Bank rate”. In this case, there is no repurchasing agreement
signed, no securities sold, or collateral involved. Banks borrow funds from the central bank and lend the
money to their customers at a higher interest rate, thus, making profits. Bank rate is usually higher than
Repo rate as it is an important tool to control liquidity. Also known as “Discount Rate”, Bank rate is often
confused with overnight rate. While the bank rate refers to the interest rate charged by the central bank
on the loans granted to commercial banks, overnight rate is the interest charged when banks borrow
funds among themselves. When bank rate is increased by RBI, the borrowing costs of the banks increase
which, in return, reduce the supply of money in the market.

Current bank rate is 6.75%

Key differences between repo rate and bank rate:

1. Bank rate is charged against loans offered by central bank to commercial banks, whereas, repo
rate is charged for repurchasing the securities sold by the commercial banks to the central bank.
2. Repo rate is always lower than bank rate.
3. Increase in bank rate directly affects the lending rates offered to the customer, restricting
people to avail loans and damages the overall economic growth, whereas increase in repo rate
is usually handled by the banks and doesn’t affect customers directly.
 4. No collateral is required while charging the bank rate, but securities, bonds, agreements and
collateral is involved when repo rate is charged.
5. Comparatively, bank rate caters to long term financial requirements of commercial banks
whereas repo rate focuses on short term financial needs.

Reverse Repo Rate:

Reverse repo rate is the rate at which the central bank of the country borrows money from commercial
bank within the country. It is a monetary policy instrument which can be used to control the money
supply in the country.
An increase in the reverse repo rate will decrease the money supply and vice-versa, other things
remaining constant. An increase in reverse repo rate means that commercial banks will get more
incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.

Current reverse repo rate is 6.25%

Marginal Standing Facility (MSF):

Marginal standing facility is the rate at which scheduled banks could borrow funds overnight from the
RBI against approved government securities. Banks often face liquidity shortfalls due to mismatch in
their deposit and loan portfolios. These are usually very short term and banks can borrow from RBI for
one day period by offering dated government securities.
MSF had been introduced by RBI to reduce volatility in the overnight lending rates in the inter-bank
market and to enable smooth monetary transmission in the financial system. RBI had introduced the
MSF in its monetary policy (2011-12). Banks used the facility for the first time in June 2011 and
borrowed Rs. 1 billion via the MSF.
Under MSF, banks can borrow funds overnight up to 1% of their net demand and time liabilities. NDTL
liabilities represent a bank’s deposits and borrowings from others.

Hiking MSF rate makes borrowing expensive for a bank which means loans become expensive for
individual and corporate borrowers and this in turn translates to lesser availability of the rupee. RBI uses
MSF and other measures to control money supply in the financial system. MSF rate hike is being done to
control excess availability of the rupee and to control its depreciation with respect to the dollar.
The minimum account which can be accessed through MSF is Rs. 1 crore and in multiples of Rs. 1 crore.

The question is- banks are already able to borrow from RBI via Repo rate, then why MSF is needed? We
note here that this window was created for commercial banks to borrow from RBI in certain emergency
conditions when inter-bank liquidity dried up completely and there is a volatility in the overnight
interest rates. To curb this volatility, RBI allowed them to pledge G-secs and get more funds from RBI at
a rate higher than the repo rate. Thus, overall idea behind the MSF is to curb volatility in the overnight
inter-bank rates.

Current MSF is 6.75%

Open Market Operations

The open market operations refer to the sale/purchase of short-term and long-term securities by the
RBI in open market. This is very effective and popular instrument of the monetary policy. The OMO is
used to wipe out shortage of money in the money market, to influence the term and structure of the
interest rate and to stabilize the market for government securities, etc. If the RBI sells the securities in
the open market, commercial banks and private individuals buy it. This reduces the existing money
supply as money gets transferred from commercial banks to the RBI. Contrary to this when the RBI buys
the securities from commercial banks in the open market, commercial banks sell it and get back the
money they had invested in them resulting in the increase of the stock of money in economy. This way
when the RBI enters in the OMO transactions, the actual stock of money gets changed. Normally during
the inflation period in order to reduce the purchasing power, the RBI sells securities and during the
recession or depression phase it buys securities and makes more money available in the economy
through the banking system. Thus, under OMO there is continuous buying and selling of securities taking
place leading to changes in the availability of credit in an economy.
However there are certain limitations that affect OMO viz; underdeveloped securities market, excess
reserves with commercial banks, indebtedness of commercial banks, etc.

A. Quantitative Instruments
The quantitative instruments are also known as the general tools of monetary policy. These
tools are related to the quantity or volume of money. The quantitative tools of credit control are
designed to regulate or control the total volume of bank credit in the economy. These tools are
indirect in nature and are employed for influencing the quality of credit in the country. The
general tools of credit control are following:

1. Bank rate policy

2. Open market operations
3. Variation in the Reserve Ratios (CRR and SLR)

B. Qualitative Instruments or Selective Tools

The qualitative instruments are also known as selective tools of monetary policy. These tools are
not directed towards the quality of credit or the use of the credit. They are used for
discriminating between different uses of credit. These methods can have influence over the
lender and borrower of the credit. The selective tools of credit control comprise of following
instruments:

1. Fixing margin requirements: The margin refers to the proportion of the loan amount
which is not financed by the bank or in other words, it is that part of a loan which a
borrower has to raise in order to get finance. A change in margin implies a change in the
loan size. This method is used to encourage credit supply for the needy sector and
discourage it for other non-necessary sectors. This can be done by increasing margin for the
non-necessary sectors and by reducing it for other needy sectors.
2. Consumer credit regulation: Under this method, consumer credit supply is regulated
through hire-purchase and instalment sale of consumer goods. Under this method the down
payment, instalment amount, loan duration, etc is fixed in advance. This can help in
checking the credit use and then inflation in a country.
3. Publicity: This is yet another method of selective credit control. Through it RBI publishes
various reports stating what is good and what is bad in the system. This published
information can help commercial banks to direct credit supply in the desired sectors.
Through its weekly and monthly bulletins, the information is made public and banks can use
it for attaining goals of monetary policy.
4. Credit Rationing: RBI fixes the credit amount to be granted. Credit is rationed by limiting
the amount available for each commercial bank. This method controls even bill
rediscounting. For certain purposes, upper limit of credit can be fixed, and banks are told to
stick to this limit. This can help in lowering banks credit exposure to unwanted sectors.
5. Moral Suasion: it implies to pressure exerted by the RBI on the Indian banking system
without any strict action for compliance of the rules. It is a suggestion to banks. It helps in
restraining credit during inflationary periods. Commercial banks are informed about the
expectations of the central bank through a monetary policy. Under moral suasion central
bank can issue directives, guidelines and suggestions for commercial banks regarding
reducing credit supply for speculative purposes.
6. Control through directives: Under this method the central bank issue frequent directives
to commercial banks. These directives guide commercial banks in framing their lending
policy. Through a directive the central bank can influence credit structures, supply of credit
to certain limit for a specific purpose. The RBI issues directives to commercial banks for not
lending loans to speculative sector such as securities, etc beyond a certain limit.
7. Direct action: Under this method the RBI can impose an action against a bank. If certain
banks are not adhering to the RBI’s directives, the RBI may refuse to rediscount their bills
and securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are
in excess to their capital. Central bank can penalize a bank by changing some rates. At last it
can even put a ban on a particular bank if it does not follow its directives and work against
the objectives of monetary policies.