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Mrunal Explained: Monetary Policy, Rep, SLR, CRR, Qualitative Tools

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- Mrunal - http://mrunal.org -

[Banking] Monetary Policy: Quantitative & Qualitative Tools,


applications & limitations MSF, LAF, Repo, OMO, CRR, SLR,
Revisited before upcoming Urjit Article
Posted By On 30/01/2014 @ 7:13 pm In Economy | 215 Comments
1. Prologue
2. What is monetary policy?
3. Quantitative Tools
1. #1: Reserve Ratios (SLR and CRR)
2. #2: Open Market Operation (OMO)
3. #3: Policy Rate
4. Bank Rate
1. Liquidity Adjustment facility (LAF)
2. LAF Repo Rate
3. Marginal Standing facility (MSF)
4. Reverse repo Rate
5. Repo Rate in recent years:
4. Monetary Policy: limitations
5. Qualitative Tools
1. #1: Margin Requirements/ LTV
2. #2: Consumer credit regulation
3. #3: Selective credit control
4. #4: Moral Suasion
6. Monetary policy tools: Quantiative vs Qualitative
7. Appendix
1. #1: Why High SLR and High CRR are bad?
2. #2: Narsimhan (I) Committee 1991
3. #3: Narsimhan (II) Committee 1998
8. Mock Questions

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.

Why RBI and Why Monetary policy?


Initially people used barter system for trading. But the barter system had many
problems (click me). Therefore, people switched to money system.

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Financial intermediates = middlemen who help in the circular flow of money


between households and business firms.
There are two types of financial intermediaries: banking institution and nonbanking financial institutions.
RBI controls (all) banks and (some) non-banking financial institutions.
RBIs main job is to control Money supply in this game, and thereby fight
inflation and deflation.
Inflation = price rise = bad for economy, you know that by common sense.
But Deflation = price decrease = we can buy things at a lower price. Isnt that good?
Why is deflation bad for economy?
Ans. Every business has fixed cost of production say minimum light bill, phone
bill, office rent, staff salary etc. So, if prices keep falling and falling (say of Nano
car), then car marker will suffer losses. He has no motivation to expand
business. He wants to cut down his production costs, by firing some of the
employees= less new jobs created= unemployment = social unrest.
If prices of everything fall- then custom duty, VAT, excise duty, service tax- their
collection will also decrease. Then government has less money to spend on
education, healthcare, social sector, defense, law and order = poverty, disease,
crime.
by the way
TERM

meaning

DEFLATION

fall in the prices (and fall IN employment.)


Fall in the prices but without causing
DISINFLATION
unemployment.
stagnation + inflation
STAGFLATION

REFLATION

Does RBI want


it?
No.
yes (while
fighting inflation)

prices and wages rise


No
but people cant find jobs, companies cant
find customers.
policy to stop the fall in price levels, but without
causing rise in the price levels (inflation).

yes

What is monetary policy?


Policy made by the central bank.
To control money supply in the economy. (and thereby fight both inflation and
deflation).
RBI implements monetary policy using certain tools. Two types
quantitative tool
qualitative tools
Lets start from here.

Quantitative Tools
#1: Reserve Ratios (SLR and CRR)

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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%

Reserve ratio: SLR, CRR


Suppose economy is showing inflationary trend. Prices of all goods and services
are increasing day by day.
How can RBI stop it using Reserve ratio as a tool?
In this case, RBI should RAISE the reserve ratios.
Observe:
Right now
People deposited total this much money in SBI (net demand &
TIME liabilities NDTL)
CRR (4%) [SBI has to keep this much cash aside for reserve]
SLR (23%) [SBI has to invest this much money in RBI approved
securities]

100 cr.
-4 cr
-23 cr.
100-4-23=73
Cores.

Money left with SBI


Say RBI raises SRL to 40% and CRR to 15% then?
Originally
SLR 40
CRR 15
Money left with SBI

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.

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Solution: RBI raised reserve ratio (CRR, SLR)


Result: SBI is left with less money to lend.
Consequences:
1.
2.
3.
4.

SBI raises its loan interest rate


Businessmen borrow less money from SBI
Businessmen donot start new business. Donot expand existing business
Result=Less jobs. Even existing employees discharged. If anyone remains in
the job, he doesnt get pay raise. He starts cutting down unnecessary
expenditure (e.g. buying two newspapers, getting his shirts ironed, drinking tea
@4PM in office and so on. Thus even paper-wall, dhobi, chai-walla- everyones
income reduced.)
5. Result= Less income (Because of above reasons)
6. Result= Less demand of goods and services (because less income).
7. Ultimately shopkeeper will bring down the prices to attract people into buying
more things.
Thus inflation is reduced.
You may doubt- what about supply side bottlenecks, what about cost push and
demand pull inflation : Im not going into all that details at the moment, else this article
will become longer than five kilometers.
Lets just prepare a summary table:
Policy
dear money
cheap money
Tool
To fight inflation To fight deflation
Reserve Ratio (CRR, SLR) Increase them. Decrease them.
Moving to the next (Quantitative) tool. Under monetary policy

#2: Open Market Operation (OMO)


Open Market Operation= when RBI starts buying/selling government securities
to control money supply.
Government securities= piece of paper. It says something like this give me
Rs.100, Ill give you 8% interest rate for next ten years and after that Ill repay
the principle of Rs.100. This is how government borrows from others.
Situation: Economy has inflationary trend. Prices of goods and services
increasing every day.
Solution: RBI starts selling government securities in open market.
Result: SBI buys them and thus SBIs lending money is reduced. Wait. How?
Imagine Rajan is selling sabzi (vegetables). If SBIs chairman Arundhati Madam
goes to buy vegetables. Obviously madams money will decrease when she buys
vegetables.
Then same as usual:
1. SBI left with less money to lend.
2. SBI raises its loan interest rate (to keep profit margin same)

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3.
4.
5.
6.
7.
8.

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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.

Thus inflation is reduced.


During deflation, RBI will do the reverse. (i.e. RBI buys Sabzi from SBI). How will it
stop deflation? Think in your head.
Lets update our table
Policy
Tool
Reserve Ratio (CRR, SLR)
Open Market Operation (OMO)

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.

Borrowing by scheduled banks from RBI


Lending by commercial banks to industries and trade
Purchase and sale of government securities by the RBI
None of Above

Whenever you face a GS/GK type MCQ, Youve three choices


Skip
Attempt
Mark n
Review.

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.

So, should you put above question in mark n review?


No.
Because its a definition based question. If you dont know the definition of
OMO you might tick a wrong answer and fail. Most of the sincere players fail in
prelims because of this reason. They push their luck in negative marking to
overcome an imaginary cutoff and thus dig up their own grave. (especially
during last 10-15 minutes of the exam.)
Moral of the story: never put fact/definition type MCQs in Mark-n-Review.
Lets solve a bit more complicated MCQ from 2012s CSAT paper.

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Q.Which of the following measures would result in an increase in the money supply in
economy?
1.
2.
3.
4.

Purchase of government securities from public by central bank


Deposit of currency in commercial banks by the public
Borrowing by government from the central bank.
Sale of government securities to the public by central bank.

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

Now the final answer depends on whether statement #3 is right or wrong?


Statement #3 says Borrowing by government from the central bank. (So, will it
increase money supply?)
How does Government borrow from Central bank? Does Mohan just callup
Rajan and demand 1 lakh crores? No. Mohan will have to give Rajan that much
government securities (vegetables) and Rajan will give him cash.
Is money supply increased? Yes Mohan sold veggies to Rajan and got Money.
Whenever Rajan buys veggies and pays the money supply is increased. (this
is similar to Open Market operation)
Besides, Mohan can then use money to pay salaries of government staff, pay
for rail-road-bridges and other infrastructure projects, pay for MNREGA and so
on. Therefore Answer C: 1 and 3 correct.
Counter- argument?

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What if Rajan subsequently sells those (Mohans) securities to bankers. Then


bankers money reduced. Hence #3 is wrong. Therefore final answer A only 1.
So, whats the final answer: is it A or is it C?
Ultimate judge= UPSCs official answer key uploaded on their site.
In 2012s Question paper Test series A, this is Q77: and its official answer is C.
Therefore, both 1 and 3 are correct.
Anyways, what to do in the exam?
Skip
Attempt

Mark n
Review.

If you dont know the concept better skip.


This question is attemptable if you dont drag the logic too much in
statement #3.
Yes, it can be put under mark and review because this is not an
absolute fact/ absolute definition type MCQ. If you apply some concepts,
you can eliminate wrong choices. But still if doubt persists in the mind
(e.g whether Statement 3 is right or not) then its always safe to skip and
avoid negative marking.

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

#3: Policy Rate


Policy rate= in case of India its Repo rate. Before moving further, lets refresh our
concepts of Bank rate, LAF, MSF, Repo and Reverse repo.

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)

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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

Liquidity Adjustment facility (LAF)


Liquidity Adjustment facility
RBI started this in 2000. You can imagine it as a Adda/gambling den/ganghideout where RBIs clients gather, consumer desi liquor, play cards, watch
item songs and borrow money from RBI (or lend Money to RBI).
By the way, who are the clients of RBI?= Central and state governments, Banks
and non-banking financial institutions (NBFI). NBFI further includes:
AIFI (all India finance institutions) NABARD, SIDBI, EXIM Bank and
National Housing Bank.
Primary dealers (Morgan Stanley , Goldman Sachs, JP Morgan Chase,
Standard Chartered Bank, HSBC etc.)
Non-Banking financial companies.
Anyways, Under this LAF adda, RBI has two tools:
Repo

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)

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Reverse
Repo

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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.

LAF Repo Rate


Lets get a bit technically correct now. Observe following image

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.

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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

Marginal Standing facility (MSF)


MSF mechanism is same as repo. But some differences
LAF (Repo)
Rajan says dont come here
unless you want to borrow
minimum Rs.5 crores.
All clients are welcome i.e.
Central and state
governments
Banks be it commercial
bank or RRB or cooperative
bank
Non-banking financial
institutions.
You (bankers) cannot pledge
securities from SLR quota to
borrow from this window.
No limit. You may borrow as
much as you want. (as long as
you have government securities
to pledge to me.)
Rajan decides Repo rate (8%
right now)

MSF
Minimum Rs. 1 crore.

Sorry. Not all clients welcome here.


Only scheduled commercial banks can
borrow under this window. SBI, PNB, BoB,
ICICI etc.
This MSF facility is specially created to
help them solve short-term cash mismatch.

Can use securities from SLR quota.


Maximum 2% of NTDL. To put this in crude
words, if SBI received 100 crores from aamadmi under savings account, current account,
fixed deposit etc. then SBI can borrow only upto
Rs.2 crores from RBI.
MSF = Repo Rate +1% = 8+1=9%. (earlier this
margin of 1% used to be higher. But nowadays
just 1%!)

for those who still have doubt about Repo vs MSF:


for repo borrowing, bank will need to pledge securities to Rajan. But bank cannot use
SLR-reserved securities for this.
so, imagine if a bank is in dire need of cash, but doesnt have spare government
securities- then they can borrow using MSF by pledging those SLR securities. (and
under MSF window, Rajan will demand 1% higher than Repo as one type of
punishment for pledging SLR securities.)

Reverse repo Rate

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Although self-explanatory. But lets check


Repo = clients borrow from Rajan and pay this much interest rate. (short term
loan)
Reverse repo= when Rajan himself borrows from clients, then he has to pay this
much interest rate to clients.
Collateral = yes. What if police raids this gambling-den, and Rajan runs away to
Nepal? Clients can sell Rajans Government securities and recover their money.
Reverse repo = Repo MINUS 1% = 8-1% =7%.
Note: in official parlance, they call percentages in basis points so 1%=100
basis points. So in that official language, Reverse repo = Repo MINUS 100
basis points.
Enough cheap jokes. What have we learned so far?
That Rajan controls money supply using monetary policy.
Under Monetary policy, Rajan has various weapons (or tools)
1. Reserve ratios (SLR, CRR)
2. OMO: Open market operation
3. Rates: Bank rate, LAF (Repo, Reverse repo), MSF.
We already know how to apply SLR, CRR and OMO to fight inflation (and deflation.)
let me paste the table again.
Policy
Tool
Reserve Ratio
(CRR, SLR)
Open Market
Operation (OMO)
Bank Rate
Repo rate
Reverse Repo
Marginal
Standing Facility

dear money
To fight inflation

cheap money
To fight deflation

Increase them.

Decrease them.

RBI sell securities

RBI buy securities

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?

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Just like how things roll in Onion biz.


If prices of Onion rise in Maharashtras wholesale yard (in Lasangaon), then
immediately, retail veggie @Ahmedabad will also raise their onion prices to keep the
profit margin same.
Whatll be the consequences (if repo rate is hiked / increased)?
Consequences:
1.
2.
3.
4.
5.
6.
7.

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.

Thus inflation is reduced.


Policy
Tool
Reserve Ratio (CRR, SLR)
Open Market Operation (OMO)
Policy Rate (Repo Rate)

dear money
To fight inflation
Increase them.
RBI sell securities
Increase it

cheap money
To fight deflation
Decrease them.
RBI buy securities
Decrease it

Repo Rate in recent years:


Lets observe with a graph: how RBI fought inflation/deflation in recent times using
Repo rate as the main-weapon of monetary policy.

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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.

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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.

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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.

Monetary Policy: limitations


In developing countries, Monetary fails to bring quick results because
1. People dont have many investment alternatives. Commercial banks have large
deposits. Rajan is not the main or even prominent money supplier for these
banks. Whatever Rajan does, its effect will be felt only after 6-8 months but by
that time, new factors would cause another rise in inflation and Rajan will have
to start from scratch again.
2. Non-Monetized economy: in rural areas, many transactions are still of barter
nature. (E.g. kiranawalla cum middleman supplies seeds, pesticides, fertilizersin exchange of share in farmers produce.)
3. Lack of financial inclusion. Since most people are not in the banking net. They
rely on Shroffs and moneylenders. Many of them circulate the black money of
cops and politicians, and charge 36% interest rate on loans. Rajan has no
control over them.
4. Monsoon uncertainty, cyclone, flood, draughts and their effect on food
production. Food inflation =>newspaper walla, washerman, barber, car
mechanic everyone will raise their service fees to accommodate their raised
cost of living. Rajan has no control over them.
5. Crude oil and gold import + negative effect when rupee weakens. Rajan can try
to bring 1$=Rs.65 to $1=63 Rs. But he has not enough forex reserves to bring
$1=Rs.50.
6. Fiscal deficit, illogical schemes. e.g MNREGA worker digs a temporary road.
After first rain, t he road is wiped out= physical infrastructure added to
economy no. Wages raised..yes. = this mismatch leads to more inflation.

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7. Subsidy leakage, Black money, underground economy.


8. And most importantly, because Rajan uses Multi-indicator approach, he focuses
on WPI (minus food and fuel). Thats why Urjit Patel recommends him to target
CPI. More on that in next article.
So far, we learned that RBI has two sets of tools/instruments under monetary policy:
Quantitative tool

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.

#2: Consumer credit regulation


Suppose Nano car sells @1 lakh and Rajan has made rule that downpayment
cannot be less than 30%.
It means customer must bring Rs.30,000 from his pocket and bank can only give
him maximum 70000 as loan.
How can Rajan fight inflation with this tool?
Increase downpayment from 30%=>50% (meaning bank can give less loan.
Customer himself has to arrange lot of money from his own pocket)
Rajan can make rule banks cannot accept EMI less than 5000 on car loan.
Observe:
Case #1: 100 EMIs worth 1000 each = 1,00,000. (ignore interest rates)
Case #2: 20 EMIs worth 5000 each=1,00,000. (ignore interest rates)
In case #2: some of the lower-middleclass families may postpone their decision to
purchase nano car (Because they cant afford higher EMIs.)

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Result= less demand=>prices reduced. (indirectly- because car mechanics get


less work, number-plate painters get less orders etc. so they reduce fees to
attract new clients and retain existing clients.)
Thus, Rajan can control money supply by changing downpayment and
installment (EMI) rules.

#3: Selective credit control


Under this, Rajan can specifically instruct bankers not to give loans to traders of
certain commodities e.g. sugar, gur, edible oil etc.
even if the said trader is ready to mortgage his
shares/bonds/factory/machine/vehicle anything.
this prevents speculations/ hoarding of commodities using money borrowed
from banks.

#4: Moral Suasion


Here Rajan tries to persuade the bankers to do xyz thing. Example
1. Please reduce giving automobile loans- instead park your money in government
securities. (above the SLR requirements.)
2. Ive reduced my repo rate, now you also reduce your base rate.
Rajan will try to influence those bankers via- direct meetings, conference, giving
media statements, giving speeches @public seminars, university convocations etc.
(even where bankers are not present.) Hell do so, to build a public opinion, media
opinion and influence those bankers by making them feel guilty.

Rationing
of credit

Direct
action

Found in Planned economies/communist nations.


Here central bank will decide upper limit to loans in each
sector (heavy industries, service, agriculture, small-scale etc.)
So once that quota is over. Additional loans cannot be given to
that borrowers from that sector. This also controls money
supply.
Means RBI gives punishment to erring banks. Punishment can
involve: penal interest, refuses to lend them money from LAF etc.
and in worst case even cancels their banking license.

Lets recap

Monetary policy tools: Quantiative vs Qualitative


Quantitative

1. Reserve ratios (SLR, CRR)


2. Open Market Operation
3. Policy rate (Repo Rate)

Qualitative
1.
2.
3.
4.
5.
6.

Margin requirements / LTV


Consumer credit regulation
Selective credit control
Moral Suasion
Rationing of Credit
Direct Action

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Indirect in nature. (Even if Rajan changes


repo rate, its not necessary SBI will
immediately change its base rate / loan
interest rates.)
General- they affect money supply in entire
economy- be it housing, automobile,
manufacturing- everything.

Page 18 of 24

Direct in nature. (e.g. those margin


requirements)

Selective- can affect money supply


in a specific sector of economy e.g.
automobile.

Lets solve an Official MCQ from UPSC 2012 Question paper


Q. RBI Acts as bankers bank. This would imply which of the following?
1. Other banks retain their deposits with RBI
2. RBI lends funds to commercial banks in the times of need.
3. RBI advises commercial banks on monetary matters.
Correct Statement
1.
2.
3.
4.

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

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Advice they just order the banks- be it SLR, CRR,


PSL. RBI doesnt advice, RBI gives orders and
direction. Therefore statement #3 is wrong.
Even if we accept that RBI advices, still the
questions asks what is implied by RBI as Bankers
bank. So, RBI advices moral suasion that is a
monetary policy tool. RBIs not doing it as a
Banker to those banks. Therefore, Statement #3 is
definitely wrong.
Answer (B)

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)

So, is it B or is it D? Final judge is UPSC.


They had uploaded CSAt-2012 official answer key on their site.
This question is Test Series A, Question #75 and its official answer is D =
meaning all three statements are correct.
If you face such MCQ in exam, what should be your approach?

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:

#1: Why High SLR and High CRR are bad?


From the discussion so far, you might think why Rajan only focuses on Repo rate to
control money supply. Why not simply raise SLR and CRR requirements.
Lets check the de-merits of high SLR and CRR:
Prior to LPG reforms in 90s, RBI used to keep SLR and CRR very high. Lets take an
example
A Bank can two types of deposits
Deposit type
examples
Time Deposit
Fixed deposit (FD) recurring deposit.
Demand Deposit Savings account, current account

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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.

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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.

#2: Narsimhan (I) Committee 1991


Plagued by problems and losses in nationalized banks, Government of India formed
this Committee. Recommendations were:
1. Deregulate interest rates. Let the banks decide their loan interest rates.
Accepted. Gradually, we moved to the Base Rate system.
2. PSL loans should be given at normal interest rates. Accepted (but with
exception=> interest subvention- that we saw under Nachiket articles.)
3. NPA/Loan default matter should be handled by separate body and not civil
courts. Result: Debt recovery tribunal created in 1993. Ultimately SARFAESI Act
in 2002.
4. Reduce CRR, SLR. Accepted. Today weve them @4% and 23% respectively.
5. Allow Private banks and foreign banks. RBI invited applications in 1993. ICICI,
Axis, HDFC and many others got license.
6. Liberate Branch expansion policy. Done (Except that 25% rural branching
mandate we saw under Nachiket articles).
7. Prepare NBFC regulatory framework. Accepted.
8. Government should reduce shareholding (and thereby its official influence) in
the public sector banks. Government agreed. Today governments shareholding
in SBI =~60%.

#3: Narsimhan (II) Committee 1998


Suggested more reforms.
1. allow VRS in the banks so they can get rid of excessive staff.
2. Suggested additional Legal reforms for loan recovery. =>SARFAESI 2002.
3. Computerization, electronic fund transfer, legal framework => Payment and
Settlement Act=>Retail (ECS, NEFT, credit Card) + Wholesale (RTGS)
4. Permit new private /foreign banks. RBI invited license in 2001= Yes Bank and
Kotak Mahindra got licenses. 2013: RBI again invited applications for bank
licenses.
[Note: list of recommendations not exhaustive, Ive only highlighted important topics
that show evolution of banking sector in recent times.]

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

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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

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Q9. Which of the following may cause deflation in the economy?


1. RBI raises policy rate
2. RBI raises cash reserve ratio
3. RBI sells securities
Choices:
a.
b.
c.
d.

only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3

Q10. Money supply in the economy, is affected by


1. Cheap money policy and dear money policy.
2. Open market operation and Moral Suasion.
3. Consumer credit regulation and loan to value ratio.
Choices:
a.
b.
c.
d.

only 1 and 2
only 2 and 3
only 1 and 3
all 1, 2 and 3

Q11. An increase in SLR


1. will restrict the expansion of banks credit
2. will increase banks investment in safe securities
3. will ensure solvency of the banks
choices:
a.
b.
c.
d.

only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3

Mains/interview type questions- after we check Urjit Patels recommendations on


strengthening monetary policy.
Hints
1. can increase by buying, can decrease by selling
2. both [or only B, depending on how UPSC examiner interprets the effect of
taxation on money supply. In one of the reputed book on Banking and finance,
author Narayan Nadar claimed taxation can affect money supply.]
3. dear money policy during deflation =adds insult to the injury of businessman. If
government reduces tax- then its revenue collection will drastically reduce. So
both incorrect. [OR debatable- depending on how UPSC examiner interprets the
effect of taxation during deflation.]
4. directly given in the article.
5. see the last table in the article

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6.
7.
8.
9.
10.
11.

Page 24 of 24

see the last table in the article


observe the table before the topic repo rate in recent years
same as above
same as above
All correct. (Unless you nitpick and drag the logic too much.)
same as above.

Visit Mrunal.org/Economy For more on Money, Banking, Finance, Taxation and


Economy.

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