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A Beginner’s Guide to Monetary Policy Tools

The Reserve Bank of India has the incredibly crucial responsibility to formulate the monetary policy. The main objective of monetary policy is to control inflation and provide a conducive environment for the country's economic growth. RBI has various tools like Repo Rate, CRR, SLR etc., to manage inflation, and in this article, we will look at a few of them.

Let’s start by understanding why the monetary policy is so crucial. Inflation is the outcome of the mismatch in demand and supply. If the demand becomes too high, inflation will exceed the optimum levels; you will see the price of goods soar and it becomes difficult for people to purchase the goods. Conversely, if the demand is too low, industries and firms won’t sustain, leading to a recession.

Both of these situations can be disastrous for the country and its citizens.

The main objective of the monetary policy is to promote economic growth while maintaining prices in control.  As per the economic definition of inflation, the leading cause of inflation is the excess money supply. So effectively, inflation can be controlled by regulating the money supply in the market.

RBI makes use of various tools to regulate the money supply.

Let’s take a look at a few of these tools in RBI’s arsenal using which it controls the supply of money in our economy.

Firstly, let’s understand what Repo rate and Reverse repo rate are

Repo rate is defined as the rate at which the RBI lends money to commercial banks if they face a shortage of funds. The repo rate as of Jul, 2021 is 4%.

The reverse repo rate is the exact opposite of repo rate. It is the rate at which commercial banks deposit their excess money with the RBI and receive interest from this deposit.,. The reverse repo rate as of Jul 2021 is 3.35%.

Now let’s understand the significance and impact of repo rate and reverse repo rate on the economy

The RBI uses repo rate and reverse repo rate as tools to regulate money supply a.k.a liquidity in the market and control inflation levels. By varying the repo rate and the reverse repo rate, RBI directly impacts the borrowing patterns of banks and consequently those of the general public. These 2 rates generally move together, with the reverse repo rate being 50-100 basis points lower than the repo rate.

RBI usually increases the repo rate in order to control high inflation levels. This increase makes it expensive for commercial banks to borrow money from the RBI, which pushes commercial banks to increase their lending rates as well. This move discourages businesses and individuals from taking loans which reduces the money available in the hands of public and slows down the overall money supply in the economy, thereby controlling the rising inflation levels.

Similarly, RBI may increase the reverse repo rate to absorb excess liquidity from the economy, because now banks can earn a higher interest rate if they deposit their additional funds with the RBI instead of lending it to borrowers, which brings about a reduction in the overall flow of money, or in other words, reducing the liquidity in the economy.

RBI may then decrease the repo rate and reverse repo rate to inject liquidity into the economy to boost growth. Reduction in repo rate allows banks to borrow money from the RBI at lower interest rates which then may lead to banks lowering their own lending rates to businesses and individuals, prompting them to avail such loans at cheaper rates and start spending the money, thereby increasing the overall supply of money in the economy which eventually leads to economic growth. A reduction in the reverse repo rate also has similar effect as banks now find it more advantageous to infuse surplus funds into the market instead of depositing the surplus with the RBI due to the reduced rate of interest.

Let’s now move on to CRR and SLR, which stand for Cash Reserve Ratio and Statutory Liquidity Ratio respectively.

CRR, or Cash Reserve Ratio is the minimum percentage of cash deposits which need to be maintained by commercial banks with RBI. The CRR as of Jul, 2021 is 4%, which basically means that for every Rs.100 deposited with the bank, the bank needs to deposit Rs.4 with the RBI.

Commercial banks do not earn any interest on keeping this cash deposited with the RBI and cannot use it for any investment or lending purposes. The purpose of CRR is to ensure that commercial banks maintain a minimum level of liquidity.

SLR, or Statutory Liquidity Ratio is the minimum percentage of deposits which need to be maintained by commercial banks in the form of gold or other RBI-approved securities, as per the guidelines set by the RBI. The SLR as of Jul, 2021 is 18%.

CRR and SLR are important monetary policy tools employed by the RBI to control inflation levels, let’s take a look at how they exactly work.

RBI may increase the CRR and SLR levels in order to control rising inflation levels. By increasing the CRR and SLR, commercial banks have to maintain more cash and liquid assets reserved with the RBI respectively. This in turn reduces the funds available with commercial banks to lend out in the form of loans. This then decreases the overall supply of money in the economy thereby bringing inflation levels under control.

Conversely, RBI may decrease the levels of CRR and SLR to increase the liquidity in the economy. This increase in the CRR and SLR means that commercial banks have to maintain lesser amounts of cash and liquid assets with the RBI, which means that they now have more money to lend to businesses and individuals. This move increases the overall supply of money in the economy, potentially increasing the growth rate of the economy.

Let’s now deal with Open Market Operations

Open Market Operations, or OMOs are acts of selling or buying securities by the RBI in the money market.

They are used by the RBI to stabilize the liquidity in the market.

When RBI sells securities in the market, many market participants buy them which reduces the supply of money in the market due to the transfer of money from market participants to the RBI. The opposite happens when RBI buys securities.

The main goal of doing all this is to regulate the supply of money in the economy and promote stability while controlling inflation.

To conclude, let’s summarize everything we discussed:

  1. The Reserve Bank of India formulates the monetary policy, according to which it controls inflation and helps create an environment for the economy's growth.
  2. Repo rate is the rate at which RBI lends money to commercial banks and reverse repo rate is the rate of interest which commercial banks get upon depositing surplus funds with the RBI. Repo rate can be increased in order to control high inflation levels or decrease liquidity in the economy.
  3. Cash Reserve Ratio is the minimum percentage of cash deposits which need to be maintained by commercial banks. Statutory Liquidity Ratio is the minimum percentage of deposits which need to be maintained by commercial banks in the form of gold or other RBI-approved securities, as per the guidelines set by the RBI. CRR and SLR can be increased to control high inflation levels or decrease liquidity in the economy.
  4. In Open Market Operations, the RBI buys and sells government securities with the goal of regulating the money supply in the economy.

Also Read: Why is knowledge essential before starting on your equity investment journey

Disclaimer:

ICICI Securities Ltd. ( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.

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