Professional Documents
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Monetary policy
Lecture 16
Section D, E and PGP- Fin 03
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RBI’s monetary policy tools
Govt bond
RBI charges banks the repo rate (4.40%) for this liquidity adjustment facility (LAF)
Repo vs Reverse Repo
Repo transactions are used by RBI to inject liquidity
Reverse repo is the opposite of a repo transaction which is
used by RBI to absorb liquidity
Reverse repo rate is currently 3.75% (repo rate – 65 bps)
If banks run out of government bonds to use for repo loans
(but they have to meet SLR) they can borrow at the marginal
standing facility (MSF) charged at ‘bank rate’ – currently
4.65% (repo rate + 25 bps)
Under MSF, SLR can fall below the requirement by 2%
Banks can borrow up to 1% of deposits under repo channel
LAF and the corridor of interest
rates
X+25 bps
X-25 bps
Open market Operations ( secondary market)
This refers to buying and selling of government securities by RBI to regulate
short-term money supply
If RBI wants to induce liquidity or more funds into the system, it will buy
government securities and inject funds,
If it wants to curb the amount of money out there, it will sell these to banks,
thereby reducing the amount of cash that banks have.
RBI uses this tool actively even outside of its monetary policy review to manage
liquidity on a regular basis.
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CRR (3%) vs SLR (18%)
M oney Supply
Interest rate, i
supply as the sum of MS
currency with the
public and demand
deposits with banks
Money Supply (M ) = C + D
The supply of
money
is fixed by the central
bank: Reserve Bank of
India Money
Money demand
Demand for
money:
Interest rate, i
Md = L (i , Y)
- +
Liquidity preference model:
Interest rate is the
opportunity cost of holding
money (paid by bonds or
banks). Negatively sloped Md
money demand curve.
When income is higher, expenditure is higher, so Money, M
people engage in more transactions that require
the use of money. Money demand curve shifts up.
Money Demand, Money Supply,
and the Equilibrium Interest Rate
An increase in
nominal income
leads to an
increase in the
interest rate.
The Effects of an Increase in the Money Supply on the Interest Rate
• Expansionary
monetary policy
results in a higher
quantity of money
and lower interest
rates.
• Contractionary
monetary policy
results in a lower
quantity of money
and higher interest
rates.
Effects of Expansionary Monetary Policy on Interest
Rates, Investment, and Aggregate Demand
(a) Supply and demand (b) Demand for (c) Aggregate demand
Interest rate
Interest rate
for money investment
Price level
MS M’S
LRAS
SRAS
i a i a
P’
b b
i’ i’ P
Md
AD’
I
AD
Y Y’
0 M M’ Money 0 I I’ Real GDP
Investment
This sets off the spending
An increase in the money With the cost of borrowing multiplier process, so output
supply drives the interest lower, the amount invested demanded and GDP at price
rate down to i'. increases from I to I‘. level P increases from Y to Y‘
Bank capital requirements
Regulatory requirement:
minimum amount of capital mandated by regulators
intended to ensure that banks will be able to pay off
depositors
forces shareholders to participate in the risks that depositors
are exposed to
higher for banks that hold more risky assets:
Required capital ratio is 8% of assets (risk weighted) under Basel
norms (9% required by RBI)
out of which at least 4.5% must be equity capital (6% required by
RBI)
Monetary Policy Transmission
Inflation targeting formally adopted in India in 2015 (following Urjit Patel Committee recommendations)
Repo rate decisions taken by a 6-member MPC (monetary policy committee) with 3 RBI and 3 external
members, chaired by RBI governor (with casting vote)