Monetary Policy is issued by the central bank of the country. In India Reserve Bank of India (RBI) is the central bank.
The monetary policy came into the limelight during the time of Covid-19.
You might have seen a lot of new investors came to the stock markets during the time of Covid-19.
The reason was the fact that everything was closed except the stock markets and covid-19 led to the crash of stock markets to almost 40 percent.
People started to view business channels for investment tips.
This eventually created interest in stock markets and over a period of time, everybody started to have a buzz about stock market expertise.
In between, the business channels started to discuss interest rates, US Fed, RBI monetary policy, inflation, etc.
I have tried to put up all the aspects of monetary policy, the effects of changes in interest rates on the economy, the effects of changes in interest rates on exports and imports, the impacts of changes in interest rates on inflation, etc.
I tried to put up all aspects in one article but the write-up became very much extensive.
So I split them up into two articles. The first one is this article and the second one could be accessed below.
In this article, we would try to inform you about monetary policy and the importance of the US Fed.
The purpose of issuing monetary policy:
The RBI issues a monetary policy for the purposes-
- To regulate the demand and supply of money, to achieve the macroeconomic objectives.
- For maintaining economic growth.
- To create a balance in interest rates.
- For maintaining price stability (.i.e. controlling inflation).
Impact of monetary policy:
Monetary policy influences consumption, exports, and investments which in turn affect demand, output, production, and employment.
Instruments to meet the monetary policy objectives
Cash Reserve Ratio (CRR)
Every scheduled commercial bank in India is required to maintain an average daily balance with RBI.
In simple terms, the banks are required to maintain cash balances with RBI. This cash balance is called the cash reserve ratio or CRR.
When the Reserve Bank of India (RBI) wants to reduce the money flow in the system (.i.e. to reduce inflation) it increases the limit of CRR.
Due to the increase in CRR limit the banks would not be able to give loans. i.e. they have to reduce the speed of giving loans because they have to now maintain a high cash balance with RBI.
When the flow of money in the economy is reduced, inflation would be controlled (Particularly demand-pull inflation).
In times of slowdown, when the economy needs money for expansion, the RBI reduces the CRR Limit.
Due to the reduction of the CRR limit the banks would have more money to give as loans and therefore the flow of money in the economy would increase.
CRR is not applicable to Non-Banking Finance Companies (NBFC).
No interest is paid by RBI to banks for the cash deposited by banks with RBI (.i.e. no interest is paid by RBI to banks for the cash reserve maintained by them with RBI).
But if, banks do not comply with CRR requirements they would be required to pay the penalty to RBI.
Statutory Liquidity Ratio (SLR)
Cash Reserve Ratio (CRR) is the requirement to maintain a cash balance with RBI.
Banks are not only required to maintain CRR but also SLR.
As per the Banking Regulation Act 1949, the scheduled commercial banks are also required to keep the money in the form of cash, gold, government securities, state development loans, etc.
This means banks are required to invest the money in the above-mentioned assets.
The limit at which the banks are required to maintain the balance in such assets is called Statutory Liquidity Ratio (SLR).
When the RBI increases SLR, the banks are required to maintain an increased balance in assets/investments and therefore they are left with less money to give as loans.
If the banks are left with less money to give as loans the flow of money in the economy would reduce and inflation is controlled over time.
In times of slow down the RBI reduces the SLR requirements which leads to the increased flow of money in the economy (in the form of loans) which in turn increases the demand as people have more money.
When the demand is increased, the production would also be increased to meet the demand which in turn would lead to employment generation.
Liquidity Adjustment Facility (LAF)
As the name suggests, a liquidity adjustment facility is the method to adjust the liquidity in the economy.
By LAF, the RBI controls and increases the flow of money in the system (economy).
LAF is the facility by which RBI gives money (.i.e. gives loans) to banks against some collateral security when the banks are in the need of money for short-term.
RBI not only gives money to banks but also receives money from banks and that too against the specified collateral security for the short term.
This means under LAF, RBI gives loans as well as receives loans against specified collateral securities.
Specified collateral securities include government bonds/securities and other eligible securities.
Components of LAF:
The LAF has two components
- Repurchase Option or Repo Rate
- Reverse Repo Rate
Repurchase Option or Repo Rate
The repo rate is also known as the policy rate.
It is the rate at which the RBI lends money to banks and the banks are required to provide collateral securities to RBI for short time.
When the repo rate is increased by RBI, it means the loans taken by banks from RBI would now become costlier.
If the banks are taking costly loans from RBI then the banks would also increase the interest on loans given by them to customers.
If the customers would get loans at higher interest rates it would eventually reduce the demand for loans by the customer because they would need to pay higher interest on loans.
If fewer loans are taken, the flow of money in the economy is controlled which in turn would reduce inflation.
Repo rate is the most important component of monetary policy as it impacts the entire banking and financial system.
If RBI wants to increase the flow of money in the economy, it reduces the repo rate which makes the loans from RBI cheaper for banks.
If the banks are getting cheaper loans they would reduce the interest rate on loans given to customers.
The customer would take more loans and therefore the flow of money in the system would increase.
When the flow of money in the economy increases it would lead to an increase in demand, and an increase in production, and therefore the economy would come out of a slowdown.
Reverse Repo Rate
As we have said earlier, RBI not only gives loans but also receives loans from banks.
RBI takes a loan from banks against specified collateral securities to absorb the liquidity from the system for the short term.
The rate of interest at which RBI pays interest to the banks for loans is called the “Reverse” Repo Rate.
The word “Reverse” in “Reverse Repo Rate” represents that the concept of reverse repo rate is the opposite of repo rate.
The Repo and Reverse repo rate can be changed during monetary policy announcements by RBI.
The repo rate is always lower than the reverse repo rate.
Marginal Standing Facility (MSF)
Marginal Standing Facility is the emergency facility provided by RBI to banks for obtaining liquidity.
Under MSF the banks can get funds from RBI when they are short of funds.
This facility is provided to banks against the collateral of government securities.
The rate at which the banks could get funds from RBI is called the MSF rate.
MSF rate remains higher than the repo rate.
The money could be availed by banks in multiples of 1 crore.
The minimum amount given by RBI under MSF is Rs. 1 crore.
MSF rate is also called the penal rate.
Market Stabilisation Scheme (MSS)
This is an arrangement between the government of India and RBI.
Under this, the government of India issues government securities to RBI for the purpose of absorbing the access liquidity from the system.
Open Market Operations (OMO)
When RBI controls and infuses liquidity in the system (or market or economy) through buying and selling of government securities, these are called open market operations.
When RBI feels there is excess liquidity in the system, it sells government securities and controls the liquidity.
When RBI feels there is a shortage of liquidity in the system, it purchases government securities and increases the flow of liquidity in the system.
US Fed policy
Same as the RBI’s policy rate US Fed has Fed Funds Rate.
The Fed funds rate is the rate at which the US banks borrow funds from the Federal Reserve.
As in India, there are SLR requirements that are to be complied with by Indian banks, the US banks are also required to comply with such statutory requirements as per the US central bank. i.e. Federal Reserve.
As we see in India RBI increases the repo rate/policy rate, which gives an indication of the increase in interest rates across the banking system.
In the US, when the Fed increases the interest rates it gives an indication of an increase in interest rates across the US banking system.
In India, any stand-by RBI affects only Indian markets, but the US being the world’s largest economy and the head office of some of the richest and biggest institutions, the policies of the US fed affect the flow of money across the globe.
As you may have seen the central banks of various countries take the same stand as is taken by the US Fed.
It is almost impossible for RBI to keep the interest rates unchanged or reduced if the US fed is increasing the interest rates.
If RBI would take a contrary stance to US Fed and reduces the interest rates when US Fed is increasing the interest rates, it will lead to the outflow of money from India.
If RBI does not increase the interest rates with the fed, the outflow of money from India might be harmful to the Indian stock markets.
Therefore we can say that the saying “If the US sneezes the world catches a cold” is correct
Now you know the basic structure of the monetary policy issued by RBI. Next time when the Governor announces the policy, read the policy document available on the website of RBI and try to find out the impacts on the economy.
In our next article, we would discuss the impact of monetary policy on various economic indicators.
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