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Instruments of Monetary Policy and the Reserve Bank of India

Instruments of Monetary Policy and the Reserve Bank of India

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If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures. The monetary policy is present to prevent this crisis.
If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures. The monetary policy is present to prevent this crisis.

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Published by: ClassOf1.com on Aug 02, 2013
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Economics
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Sub: Economics Topic: Econometrics
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The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
I
NSTRUMENTS
O
F
M
ONETARY 
P
OLICY 
 A
ND
HE
R
ESERVE
B
 ANK
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F
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NDIA
 
The total amount of money stock in the economy is much greater than the volumeof high powered money. Commercial banks create this extra amount of money by giving out a part of their deposits as loans or investment credits. The total amountof deposits held by all commercial banks in the country is much larger than thetotal size of their reserves. If all the account-holders of all commercial banks in thecountry want their deposits back at the same time, the banks will not have enoughmeans to satisfy the need of every accountholder and there will be bank failures.The Reserve Bank of India plays a crucial role here. In case of a crisis like the aboveit stands by the commercial banks as a guarantor and extends loans to ensure thesolvency of the latter. This system of guarantee assures individual account-holdersthat their banks will be able to pay their money back in case of a crisis and there isno need to panic thus avoiding bank runs. This role of the monetary authority isknown as the lender of last resort. Apart from acting as a banker to the commercial banks, RBI also acts as a bankerto the Government of India, and also, to the state governments. It is commonly 
held that the government, sometimes, ‘prints money’ in case of a budget deficit,
i.e., when it cannot meet its expenses (e.g. salaries to the government employees,purchase of defense equipment from a manufacturer of such goods etc.) from the
 
 
Sub: Economics Topic: Econometrics
*
The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
tax revenue it has earned. The government, however, has no legal authority toissue currency in this fashion. So it borrows money by selling treasury bills orgovernment securities to RBI, which issues currency to the government in return.The government then pays for its expenses with this money. The money thusultimately comes into the hands of the general public (in the form of salary or salesproceeds of defense items etc.) and becomes a part of the money supply. Financingof budget deficits by the governments in this fashion is called Deficit Financingthrough Central Bank Borrowing. However, the most important role of RBI is asthe controller of money supply and credit creation in the economy.RBI is the independent authority for conducting monetary policy in the bestinterests of the economy 
it increases or decreases the supply of high poweredmoney in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors. RBI often intervenes with itsinstruments to prevent such an outcome. RBI will undertake an open market saleof government securities of an amount equal to the amount of foreign exchangeinflow in the economy, thereby keeping the stock of high powered money and totalmoney supply unchanged. Thus it sterilises the economy against adverse externalshocks. This operation of RBI is known as sterilisation. Money supply is, therefore,an important macroeconomic variable. Its overall influence on the values of theequilibrium rate of interest, price level and output of an economy is of greatsignificance.

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