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Monetary Policy Tools

Monetary Policy Tools

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Published by Sudhir Shankla
This pdf file covers the measures/tools of monetary policy used by RBI and i hope it to be useful for banking job aspirants or other public service examinations.
This pdf file covers the measures/tools of monetary policy used by RBI and i hope it to be useful for banking job aspirants or other public service examinations.

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Published by: Sudhir Shankla on Jun 16, 2010
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Measures which aim to control the quantity of money supply directly such as CashReserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open Market Operations (OMO)
 Cash Reserve Ratio:
It is a quantitative tool of monetary and credit policy to regulate the money supply in the economy.Cash reserve ratio (CRR) is that slice of a bank's deposits, which the bank has to compulsorily deposit with RBI. A CRR of six per cent means that out of every Rs 100, bank has to deposit Rs. 6 with RBI. Interestingly, RBI does not pay any interest on this money to banks. When RBI wants to reduce liquidity from the system, like in times of high inflation, it increasesthe CRR.RBI by varying the CRR regulates the lendable funds of commercial banks. An increase in CRR would also mean that money is being sucked out of the system. This would mean that funds are hard tocome by and hence banks will have to pay more to depositors in order to induce them to keep their funds with banks. This willpush up cost of funds for banks. The banks therefore will also have to raise lending rates in or
der to meet the increased cost while maintaining their margins. For exampleRBI has increased the CRR of scheduled banks by 6% of their Net Demand and Time Liabilities (NDTL). As a result of thisincrease in the CRR, about 12,500 crore of excess liquidity will be absorbed from the system.
Statutory Liquidity Ratio:
It is a quantitative tool of monetary and credit policy to regulate the money supply in theeconomy. Under the provision of Banking Regulation Act governing the banking operations, banks are required to hold liquidassets such as government securities, or other unencumbered approved securities, cash or gold, against their demand and timeliabilities as on the last Friday of second preceding fortnight in India. This is known as supplementary reserve requirement orsecondary reserve requirement. The main objective of this monetary policy instrument is to ensure solvency of commercial banks by compelling them to hold low risk assets up to a stipulated extent. It also helps to regulate the pace of credit expansionto commercial sector. SLR refers to the ratio of holdings of the prescribed liquid assets to total time and demand liabilities. Atpresent, SLR is 25%, means 25 out of 100 are invested in prescribed liquid assets.The objectives of SLR are:1.
To restrict the expansion of bank credit.2.
To augment the investment of the banks in Government securities.3.
To ensure solvency of banks. A reduction of SLR rates looks eminent to support the credit growth in India.
Open Market Operations:
 A monetary policy instrument which is used by the Reserve Bank mainly with a view to affectthe reserve base of the banks and thereby the extent of monetary expansion. It also, in the process, helps to create and maintaina desired pattern of yield on government securities (G-Sec) and to assist the government in raising resources from the capitalmarket. Under the RBI Act, the RBI is authorized to purchase and sell the securities of the Union Government and StateGovernments of any maturity and the security specified by the Central Government on the recommendation of Bank's CentralBoard. Presently the RBI deals only in the securities issued by the Union Government. Open market operations are by way outright sale and purchase of securities through the Securities Department and repo and reverse repo transactions. When RBI buys the securities in the open market, It increases the liquidity and reserves of commercial banks, making itpossible for banks to expand their loans and investments. If RBI sells the securities, the effects are reversed.
They aim to control the quantity of money supply indirectly through cost of credit. Thesemeasures are Bank Rate, Repo & Reverse Repo Rates, and Interest Rates etc.
Bank Rate:
 An instrument of general credit control and represents the standard rate at which the RBI is prepared to buy orrediscount bills of exchange or other commercial paper eligible for purchase under the provisions of the Act. In short, Bank rateis the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate.Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect thelending rates through altering the cost of credit. At present Bank rate is 6%.
Repo Rate:
Repo and Reverse Repo Rates are Liquidity adjustment Facility (LAF) tools used by RBI. Repo is an instrumentmeant for injecting the funds required and Reverse Repo for absorbing the excess liquidity out of system.In bond markets, interest rates are the most important factor, and the RBI controls interest rates. RBI uses various rates likerepo, reverse repo and CRR to give direction to interest rates in the country. Take an exampleRepo refers to '
 bligation'. In case of tight liquidity conditions (as you saw in 2008), when banks need funding forthe short term, they approach the RBI and ask for a temporary loan. RBI gives them a loan only after taking some collateral.

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