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Group Project on Managerial Economics
[Sub: Find out the meaning of the following terms: bank rate, repo rate, reverse repo rate, CRR, SLR, PLR, basis points, open market operations. Trace their current values. In what purpose are these values used? Find the objectives and implications of monetary policy.] BANK RATE: Bank rate, also referred to as the discount rate, is the rate of interest which a central bank [Reserve Bank of India (RBI) in case of India] charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Bank rate is a long-term measure and is governed by the long-term monetary policies of the governing banks concerned. Purpose of using bank rate: Changes in the bank rate are often used by central banks to control the money supply. At the time of inflation, the central bank may increase bank rate while providing financial assistance to commercial banks. As a result, commercial banks also charge high rates from the borrowers. As interest on loan increases, people will prefer to borrow smaller amounts from the commercial banks. Smaller amount of loan reduces purchasing power of people, which in turn contracts aggregate demand and reduces inflationary pressure. REPO RATE: Whenever the banks have any shortage of funds they can borrow it either from RBI or from other banks. The repo rate is the rate at which the banks borrow these excess funds. The borrowing bank mortgages its government securities to carry out this loan transaction. Repo is a short-term measure, i.e. applicable to short-term loans and comes from the repurchasing agreement. Purpose of using repo rate: The main purpose of repos is to finance the purchase of Securities by government bond dealers until they can be sold to customers. These are private traders for which there are no public quotes. Since most dealers can sell most of their inventory quickly, they only need 2 borrow money for a day or a few days at most, which is why the terms of most repos is very short. REVERSE REPO RATE: Reverse Repo rate is the rate at which the central bank borrows money from banks. Banks are always happy to lend money to the central bank since their money are in safe hand with good interest.
This kind of deposit is known as SLR. CASH RESERVE RATIO (CRR): Cash Reserve Ratio (CRR) is the fraction of total demand and time deposits that a bank has to keep with the central bank of a country. i. If SLR is increased. central bank may increase CRR to reduce lending capacity of commercial banks anticipating that reduced lending capacity reduces aggregate demand which in turn will help in curbing inflationary pressure. At the time of inflation. compulsory cash balance etc. Purpose of using CRR: Increase in the value of CRR reduces the amount of money available with the commercial banks which again reduces the amount of money to be given as loans. some part has the reverse repo. depending on the condition of the economy. PRIME LENDING RATE (PLR): Prime Lending Rate is a term applied in many countries to a reference interest rate used by banks. It can cause the money to be drawn out of the banking system. An increase in reverse repo rate can cause the banks to transfer more funds to the central bank due to the attractive interest rates. though this is no longer always the case. In India. but also contracts banks’ ability to provide loans because of banks. The term originally indicated the rate of interest at which banks lend to favoured customers. inflationary pressure may be reduced as it reduces lending capacity of banks leading to fall in private purchasing power. Some variable interest rates may be expressed as a percentage above or below prime rate. STATUTORY LIQUIDITY RATIO (SLR): Banks are bound to set aside a part of their demand and time deposits either in form of cash or in the form of central and state government securities. CRR generally lies between 3% to 15%.Purpose of using reverse repo rate: The bank that makes the loan for a repo. usually reverse repo position.e. It is used in the calculation of some private student loans. which is simply the opposite side of a repo. Many credit cards and home equity lines of credit with variable interest rates have their rate specified as the prime rate (index) plus a fixed value commonly called the spread or margin. Purpose of using SLR: SLR not only increases solvency of banks. augmented investment in government securities. . those with high credibility. The value of CRR is not fixed. Hence for every repo. central bank can announce any value of CRR. Purpose of using PLR: PLR is often used as an index in calculating rate changes to adjustable rate mortgages (ARM) and other variable rate short term loans.
e. But in the broad sense the term implies purchase and sale of not only government securities but also other eligible papers by the central bank in the open market. interest on loans.75% . i. For example. or the difference (spread) between two interest rates. reduce. High interest on loans discourages people to take loans.BASIS POINT: Basis point (bp) is a unit that is equal to 1/100th of a percentage point. In the narrow sense open market operations mean purchase and sale of government securities by the central bank in the open market. total expenditure of the economy falls causing decline in inflation. The basis point is also used to calculate changes in equity indexes and the yield of a fixed-income security. Purpose of using basis point: It is common practice in the financial industry to use basis points to denote a rate change in a financial instrument. CURRENT VALUES AS SPECIFIED BY RBI Terms Bank rate Repo rate Reverse repo rate Cash Reserve Ratio Statutory Liquidity Ratio Prime lending rate Current Values 6% 9% 6% 9% 25% 12. Reduced cash available to commercial banks makes credit scarce. OPEN MARKET OPERATIONS: The term open market operations is used in two senses. a “1% increase” from a 10% interest rate could refer to an increase either from 10% to 10. It avoids the ambiguity between relative and absolute discussions about rates.1% (relative). specially the commercial banks. This is partially due to the large effect of small changes to financial instruments. Purpose of open market operations: At the time of inflation. and this leads to increase in price of credit. As a result. central bank sells government securities and consequently the cash reserves of all the buyers. It is frequently used to express percentage point changes of less than 1%. or from 10% to 11% (absolute).
a decrease in real interest rates lowers the cost of borrowing. and this increase in wealth makes them willing to spend more. Changes in real interest rates affect the public's demand for goods and services mainly by altering borrowing costs. Households with stocks in their portfolios find that the value of their holdings is higher. • For the most part. Instead. employment.OBJECTIVES OF MONETARY POLICY Monetary policy refers to the policy adopted by the central bank of the country. known as nominal rates. the availability of bank loans. and it leads households to buy durable goods. • In addition. common stock prices tend to rise. such as autos and new homes. as a result. Lower real rates also make common stocks and other such investments more attractive than bonds and other debt instruments. This may increase spending. The objectives of monetary policy are as follows:• • • • To regulate monetary growth so as to maintain a reasonable degree of price stability To ensure adequate expansion in credit to assist economic growth To encourage the flow of credit into certain desired channels including priority and the hitherto neglected sectors. and inflation. the wealth of households. especially by smaller borrowers who have few sources of credit other than banks. lower real rates and a healthy economy may increase banks' willingness to lend to businesses and households. IMPLICATIONS OF MONETARY POLICY • The point of implementing policy through raising or lowering interest rates is to affect people's and firms' demand for goods and services. Monetary policy actions affect real interest rates. and. the demand for goods and services is not related to the market interest rates quoted in the financial pages of newspapers. • For example. To introduce measures for strengthening the banking system and creating institutions for filling credit gaps. • . that leads businesses to increase investment spending. and foreign exchange rates. which in turn affect demand and ultimately output. nominal interest rates minus the expected rate of inflation. it is related to real interest rates—that is.
. which in turn increases business spending on capital goods even further by making greater demands on existing factory capacity. the trade-off disappears in the long run. • Policy also affects inflation directly through people's expectations about future inflation. If consumers and business people figure that will mean higher inflation in the future. In other words. they'll ask for bigger increases in wages and prices. As noted earlier. That in itself will raise inflation without big changes in employment and output. • The increase in aggregate demand for the economy's output through these different channels leads firms to raise production and employment. It also boosts consumption further because of the income gains that result from the higher level of economic output. output and employment cannot be set by monetary policy. In fact. • Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities. with no permanent increases in the growth of output or decreases in unemployment. in the long run. For example.Higher stock prices also make it more attractive for businesses to invest in plant and equipment by issuing stock. These are some of the implications of monetary policy. while there is a trade-off between higher inflation and lower unemployment in the short run. suppose the RBI eases monetary policy. a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates.