Chapter 10 – Introduction to Economic Policies – Part 2

Statutory Liquidity Ratio (SLR)

In the previous chapter, you learnt that banks invest some of the money in liquid assets to ensure they have enough liquidity at their end.

But how much money must be invested in liquid assets?

Well, now that amount is decided by the Statutory Liquidity Ratio (SLR).

Let’s consider the SLR is 22%. That means, out of the total amount the bank holds, i.e., Rs. 1000, it has to invest 22% i.e., Rs. 220 in a liquid asset. The remainder amount i.e., Rs. 730 can be lent as loans to qualified businesses and individuals to earn interest income. Higher the SLR ratio, less amount will be available with the banks, thus reducing market liquidity. When you request your money, the bank would dig into their reserves they’ve set aside for day to day transactions.

Now, what if the bank doesn’t have the money? From where does it get the funds?

Repo rate

All they have to do is ask the RBI for the money. The RBI of course lends them the money against the securities as collateral, but at a specific rate of interest.

Now, this rate of interest given by the RBI to the bank is known as the Repo Rate.

Now that the bank has the money from the RBI, they can give away loans and make sure their daily business requirements are met.

Since the bank needs to ensure they earn profit, they will give individuals or businesses a higher rate than the repo rate.

So, you now understand that if the RBI decides to increase the repo rate, the interest rate on the loans received from the bank will also increase. Similarly, if the RBI decide to decrease the repo rate, the loan interest will also reduce.

But what if the bank has excess money?

Well, they could decide to deposit some of the amount with the RBI at a specific interest rate. Now, this rate at which the RBI pays interest to the bank is known as the Reverse Repo Rate. Here, you need to note that the reverse repo rate will always be lower than the repo rate.

But how does repo rate affect money supply and help manage inflation?

As we know inflation is increase in price levels due to high demand. This would mean there is a high chance of business taking out loans from commercial banks to manage high demand. Now, when the central bank i.e. the RBI increases the repo rate, the bank is forced to increase the loan interest rate for its customers which in turn discourages the customers to take out loan from the bank. And thus, adjusting the repo rate helps manage the money supply and inflation.

Does the change in repo rate affect the investors?

Yes, it does.

As explained earlier, when the repo rate is increased, the bank will have to provide loans at a higher interest rate.

This means:

For equity Investments

  • Cost of capital for capital-intensive industries increases. Many sectors like infrastructure, capital goods and cement require huge capex, and these sectors are likely to be affected the most. 
  • The request for credits or loans to the banks decreases thus affecting the banking sector as well.

So, individuals who have invested their money in these sectors may observe a decrease in their earnings.   

For debt investments

Prices of securities are inversely proportional to interest rate.

An increase in the rate increases the yield, but reduces the prices of securities, leading to a loss for existing investors.

So now we know how the central bank helps during inflation, but where does the government come in?

Additional read: Five Takeaways From RBI Monetary Policy

Fiscal Policy

The Government influences demand in the economy by managing tax rates and government spending through its fiscal policy.

These policies are used to accelerate growth when the economy starts to slow or moderate growth when the economy begins to overheat. In challenging economic times, the government will often lower taxes hoping that businesses and individuals spend money to help grow the economy.

At the same time, the government also spends money on infrastructure and defense to keep the money rolling and increase employment. They also come up with relief programs to help businesses grow. For example, the government has Special Economic Zone (SEZ) to boost up economic activities by providing easier compliance and tax incentives.

The government can also amend tax rates for different sets of people to redistribute wealth and manage incomes.

The common goal of both monetary and fiscal policies is to create a conducive environment for stable growth and controlled inflation.

Let’s sum it up:

Summary

  • Repo rate is the rate at which RBI lends money to the banks, while the rate at which the RBI pays interest to the bank is known as the Reverse Repo Rate.
  • The government influences demand in the economy by managing tax rates and government spending through its fiscal policy.
  • The common goal of both monetary and fiscal policies is to create a conducive environment for stable growth and controlled inflation.

Wasn't this simple to understand? If only Economics was so easy in college! We now move on to the next chapter which covers the basics and the importance of Gross Domestic Product and how it’s calculated.

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