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Banking Awareness: Instruments of Monetary policy in India

Oct 12, 2015 16:28 IST

    Monetary policy is the Macroeconomic Policy laid down by the central bank of the country. It refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit.  It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption and growth.

    In India, monetary policy of the Reserve Bank of India (RBI) is aimed at managing the quantity of money in order to meet the requirements of different sectors of the economy and to increase the pace of economic growth.

    The goals of Monetary Policy:

    • Primarily price stability, while keeping in mind the objective of growth.
    • In India, subsequent to the recommendations of the Dr. Urjit Patel Committee Report, the Reserve Bank has formally announced a “glide path” for disinflation that sets an objective of below 8 per cent CPI inflation by January 2015 and below 6 per cent CPI inflation by January 2016.

    The Reserve Bank’s Monetary Policy Department (MPD) assists the Governor in formulating the monetary policy.

    Instruments of Monetary Policy

    There are several direct and indirect instruments that are used in the implementation of monetary policy.

    • Cash Reserve Ratio (CRR): The share of Net Demand and Time Liabilities (deposits) that banks must maintain as cash balance with the Reserve Bank.
    • Statutory Liquidity Ratio (SLR): The share of Net Demand and Time Liabilities (deposits) that banks must maintain in safe and liquid assets, such as, government securities, cash and gold.
    • Refinance facilities: Sector-specific refinance facilities aim at achieving sector specific objectives through provision of liquidity at a cost linked to the policy repo rate.
    • Liquidity Adjustment Facility (LAF):  LAF is a monetary policy tool which allows banks to borrow money through repurchase agreements. LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF has two components -- repo and reverse repo. Repo or repurchase option is a collaterised lending i.e. banks borrow money from RBI to meet short term needs by selling securities to RBI with an agreement to repurchase the same at predetermined rate and date. The rate charged by RBI for this transaction is called the repo rate.  Repo operations therefore inject liquidity into the system.

    Reverse repo operation is when RBI borrows money from banks by lending securities. The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation therefore absorbs the liquidity in the system.

    • Marginal Standing Facility (MSF): 

    It refers to the penal rate at which banks can borrow money from the central bank over and above what is available to them through the LAF window. MSF, being a penal rate, is always fixed above the repo rate. 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 came into effect from 9th May 2011. MSF scheme is provided by RBI by which the banks can borrow overnight upto 1 per cent of their net demand and time liabilities (NDTL) i.e. 1 per cent of the aggregate deposits and other liabilities of the banks. However, with effect from 17th April 2012 RBI has raised the borrowing limit under the MSF from 1 per cent to 2 per cent of their NDTL outstanding at the end of the second preceding fortnight. The rate of interest for the amount accessed through this facility is fixed at 1 per cent above the repo rate for all scheduled commercial banks.

    • Open Market Operations (OMOs): Buying and selling of government securities is as Open market operations. (For injection/absorption of liquidity in the market)
    • Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. 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.
    • Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills.

    Starting with the first bi-monthly statement of monetary policy in April 2014, the Reserve Bank has changed the normal frequency of monetary policy announcements from eight times in a year (i.e., four quarterly and four mid- quarter) to six times in a year (i.e., bi-monthly).


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