MONETARY POLICY

MEANING

Regulation of money supply & control of cost &

availability of credit by central bank of country
through the use of deliberate & discretionary action
for achieving the objectives of general economic
policy
 INTRODUCTION
• Designed, formulated & implemented by central bank
through wide network of commercial banks & other
financial institutions

• Includes direct & indirect measures which affect supply of

money, liquidity, cost, direction, availability of credit,
efficiency & development of financial sector

• Finance managers: adjusting financial plans according to

monetary policy stance
 CONSTITUENTS OF MONETARY
ENVIRONMENT

• Money supply & liquidity

• Quantum & direction of credit
• Structure of interest rate
• State of banks & non bank financial institutions
• Competition in financial sector
• Financial risk
• Financial product development
• Foreign exchange rates
OBJECTIVES OF MONETARY POLICY
 Price stability
 High and steady rate of growth
 Fuller employment
 Greater equality in distribution of income and wealth
 Healthy balance in BOP
 ALTERNATIVE DESIGNS OF MONETARY
POLICY

• Restrictive: controlling AD to control inflation

• Expansionary: stimulate AD to boost economy
• Contra cyclical: expand & restrict AD alternatively to
control b/s cycles
 Monetary & credit policy instrument

Quantitative Qualitative (Selective)

Direct instruments Indirect instruments

Bank Rate
LRR
Open market operations

Outright

Repo/ Reverse Repo

 CASH RESERVE RATIO (CRR)
RBI requires every commercial bank to maintain a stated
percentage of their demand & time liabilities as reserves

Purpose of maintaining the minimum cash reserve:

• To ensure the liquidity & solvency of individual commercial
banks
• To influence & restrict commercial banks’ expansion of
credit
• To provide the central bank with the supply of deposits
 CASH RESERVE RATIO

• When RBI raises CRR: banks would be required to hold

more reserves to support the existing amount of demand
deposits. This will reduce the amount of credit which
commercial banks can create i.e. there would be a
reduction in credit (restrictive monetary policy)

• When CRR is revised downwards: expansion of credit

 CASH RESERVE RATIO

Example
If a commercial bank has Rs 1000 cr & the reserve
requirement is 10% So the bank would have to
maintain a reserve of 100 cr & hence can lend only up
to Rs 900 cr.
If the reserve requirement is raised to 20% then it
would have to maintain a reserve of Rs 200 cr & hence
can lend only up to Rs 800 cr.
So the higher the CRR, the smaller the amount
available for banks for loans & advances & investment
STATUTORY LIQUIDITY RATIO (SLR)

Every commercial bank is required to maintain a

prescribed minimum proportion of its daily total
demand & time liabilities in the form of designated
liquid assets (near money)

These liquid assets consists of:

(a) Excess reserves
(b) Unencumbered government & other
approved securities
(c) Current account balances with other banks
 STATUTORY LIQUIDITY RATIO

• When SLR is revised downwards: expansion of credit

• When SLR is revised upwards: contraction of credit

 BANK RATE

It refers to the rate of interest at which the central

bank offers lending facilities to commercial banks

Assumption: market rates of interest respond to changes

in bank rate
 BANK RATE

• RBI raises bank rate (dear/ restrictive money policy):

market rate of interest rise → investment becomes less
attractive & less profitable→ contraction of credit

• When RBI reduces bank rate (cheap money policy):

expansion of credit
 OPEN MARKET OPERATIONS
It refers to purchase & sale of government securities by
Central bank

Types of OMO

Outright Repo/ Reverse Repo

Sale & purchase Sale & purchase of govt securities

of govt securities With an agreement to buyback or resell
 What are government securities?

• https://www.rbi.org.in/scripts/FAQView.aspx?
Id=79
 OUTRIGHT OMO

• RBI sells securities (contractionary monetary

policy): quantity of money falls

• RBI buys securities (expansionary monetary

policy): quantity of money expands
 REPO/ REVERSE REPO

SALE SECURITIES PURCHASES SECURITIES

RECEIVES FUNDS PAYS FUNDS

PARTICIPANT A PARTICIPANT B
BORROWER REPO MARKET
LENDER

REPURCHASE SECURITIES RETURNS SECURITIES

PAYBACK FUNDS GETS BACK FUNDS
REPO/ REVERSE REPO
 REPO/ REVERSE REPO
• In a repo, one party sells an asset (usually fixed-income securities) to
another party at a price at the start of the transaction and commits to
repurchase it later.

• Although assets are sold outright at the start of a repo, the commitment
of the seller to buy back the assets in the future means that the buyer
has only temporary use of those assets, while the seller has only
temporary use of the cash proceeds of the sale. Thus, although repo is
structured legally as a sale and repurchase of securities, it behaves
economically like a secured deposit (and the principal use of repo is in
fact the borrowing and lending of cash). 
The difference between the price paid by the buyer at the start of a repo
and the price he receives at the end is his return on the cash that he is
effectively lending to the seller. In repurchase agreements, this return is
quoted as a percentage per annum rate and is called the repo rate.
Although not legally correct, the return is usually referred to as repo
interest.
 REPO/ REVERSE REPO

The buyer in a repo is often described as doing a reverse repo (ie buying, then selling).
 What is Repo rate

• Rate at which RBI lends short term money to banks against

securities

• Rate at which banks would buy back (repurchase) their

securities that they sold earlier to RBI to raise money
 Why Repo rate is higher than Reverse repo rate
• Repo rate is the rate at which RBI lends money to commercial banks. The higher the repo
rate the lesser the banks will borrow from RBI thereby reducing liquidity in the market and
vice-versa.

Reverse repo rate is the rate at which RBI borrows from the commercial banks. The
higher the reverse repo rate the more commercial banks will park their money in RBI
thereby reducing the liquidity in the market and vice-versa.

Since RBI is a very secure institution, banks will prefer parking their money in RBI rather
than  giving loans to businesses and individuals.
Reverse repo rate is not kept  high in order to avoid this scenario. This will ensure that
the commercial banks will have sufficient funds to invest elsewhere or use as liquidity
thereby increasing the buying capacity of the people.

Reverse repo rate is always lesser than repo rate so that the flow of money should be
there from RBI to commercial banks. RBI doesn't want to keep all the money. The
commercial banks and businesses need the money so that the economy has enough
purchasing power.
 REPO/ REVERSE REPO

• RBI performs REPO (expansionary monetary policy): RBI

is purchasing securities from banks- quantity of money
expands

• RBI performs REVERSE REPO (contractionary monetary

policy): RBI is selling securities- quantity of money falls
 SELECTIVE CREDIT CONTROL
(QUALITATIVE MEASURES)
• Directed towards particular uses of credit

• They can be positive (encourage the flow of credit to

some sectors) as well as negative (restrict the flow of
credit to particular sectors)
• http://economictimes.indiatimes.com/definition/
reverse-repo-rate
 TYPES OF SELECTIVE CREDIT

 Changes in margin requirements

 Differential interest rates

 Regulation of consumer credit

 Direct action: charging penalty interest rates, fixation of

quantitative credit ceiling
 MORAL SUASION

 Combination of persuasion and pressures which RBI uses

on other banks

 Exercised through discussions, letters, speeches & hints

given to banks

 Can be used both for quantitative control of credit &

qualitative control of credit
 DEFICIT FINANCING
• Method to finance budgetary gap

• Developed countries: resorting to loans from banks

• Developing countries: printing currency notes

• http://www.livemint.com/Politics/
gIWJ7pez1uci5bWcxOzCCP/Full-text-of-RBIs-
monetary-policy-minutes.html