INSTRUMENTS OF MONETARY POLICY
Each country has their monetary policy formulated by the central bank of the country. The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
In India, Reserve Bank of India (RBI) holds the right to control the price stability. The monetary policy regulated by RBI governs the various types of rates existing in the banking sector which are flexible as per the economic scenario of the country and are decided from time to time. Such rates are called instruments of monetary policy.
Some important rates in the Indian banking system which are actually quantitative methods of credit control briefly described here:
REPO RATE
The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF). It is one of the main tools of RBI to keep inflation under control.
When the banks fall short of funds, the RBI lends money to the commercial banks at a certain interest rate which is called as repo rate. The banks mortgage their government bonds or sell their securities as collateral to borrow from Reserve Bank of India.
Key Components:
- Inflation control– RBI increases or decreases the Repo rate depending on the inflation. Thus, it aims at controlling the economy by keeping inflation in control. During high inflation, RBI brings down the flow of money in the economy by increasing the repo rate. This makes borrowing costly for businesses and industries, which in turn slows down investment and money supply in the market and ultimately control inflation.
- Short-Term Borrowing– RBI lends money for a short period of time, maximum being an overnight post which the banks buy back their securities deposited at a predetermined price.
- Securities– RBI accepts collateral securities in the form of gold, bonds etc.
- Liquidity– Banks borrows money from RBI to maintain liquidity or cash reserve as a precautionary measure. When the RBI needs to flow funds into the system, it lowers the repo rate. Consequently, businesses and industries borrow money for investment purposes at cheaper rate. This ultimately boosts the growth rate of the economy.
- Current Repo Rate-00%
REVERSE REPO RATE
The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.
During high levels of inflation in the economy, the RBI increases the reverse repo.
When the reverse repo rate is increased, the banks prefer to lend their money to RBI to get substantial rate of interest on that.
Current Reverse Repo Rate-3.35%
BANK RATE
It is also known as discount rate. It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.
Unlike Repo rate, in this case, there is no repurchasing agreement signed, no securities sold or collateral involved. Simply, Banks borrow funds from the central bank and lend the money to their customers at a higher interest rate and makes profits. Here, central bank advances for long term unlike Repo rate where RBI grants for short term.
When Bank Rate is increased by RBI, the borrowing costs of the banks’ increase which, in return, reduce the supply of money in the market and vice-versa.
Current Bank Rate- 4.25%.
CALL RATE
Call rate is the rate at which short-term loan that banks give to brokers who in turn lend the money to investors to fund margin accounts. For both brokers and investors, this type of loan does not have a set repayment schedule and must be repaid on demand. So, call money rate is the rate at which short term (one day) funds are borrowed and lent in the money market.
Current Call Rate-1.95-3.40%
CASH RESERVE RATIO (CRR)
The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India. It started in June 1973.
It supports the RBI in controlling the liquidity in the banking system. RBI uses this tool to drain out excessive money from the system.
Current Cash Reserve Ratio-4.00%
Statutory Liquidity Ratio (SLR)
Under section 24 and 56 of the Banking Regulation Act, 1949 every commercial bank is required to maintain liquid assets in form of gold, RBI approved securities with itself before providing credits to its customers.
The share of NDTL that a bank is required to maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.
The objective of statutory liquidity ratio is to prevent the commercial banks from liquidating their liquid assets during the time when CRR is raised.
A penalty at a rate of 3% per annum above the bank rate is imposed if any commercial bank fails to maintain the statutory liquidity ratio.
Current Statutory Liquidity Ratio-18.00%
MARGINAL STANDING FACILITY (MSF)
A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system
It is always fixed above the repo rate, and when the banks exceed all borrowing options including the liquidity adjustment facility by pledging government securities, MSF is the last substitute rate where the banks can borrow.
The scheme has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system.
MSF rate and Reverse repo rate determine the corridor for the daily movement in weighted average call money rate.
Current Marginal Standing Facility-4.25%.
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