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- Mrunal - http://mrunal.org -
1. Prologue
2. What is monetary policy?
3. Quantitative Tools
1. #1: Reserve Ratios (SLR and CRR)
2. #2: Open Market Operation (OMO)
3. #3: Policy Rate
4. Bank Rate
1. Liquidity Adjustment facility (LAF)
2. LAF Repo Rate
3. Marginal Standing facility (MSF)
4. Reverse repo Rate
5. Repo Rate in recent years:
4. Monetary Policy: limitations
5. Qualitative Tools
1. #1: Margin Requirements/ LTV
2. #2: Consumer credit regulation
3. #3: Selective credit control
4. #4: Moral Suasion
6. Monetary policy tools: Quantiative vs Qualitative
7. Appendix
1. #1: Why High SLR and High CRR are bad?
2. #2: Narsimhan (I) Committee 1991
3. #3: Narsimhan (II) Committee 1998
8. Mock Questions
Prologue
Next article is about RBI appointed Urjit Patel Committee on Monetary policy
framework.
But before dwelling into that, we must recap the basic concepts of what is
monetary policy: its tools and limitations. Otherwise Urjit wont make much sense.
Hence in a way, this whole article is a prologue to next article.
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meaning
DEFLATION
DISINFLATION
Does RBI
want it?
No.
yes (while
fighting
inflation)
stagnation + inflation
STAGFLATION
REFLATION
No
yes
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Quantitative Tools
#1: Reserve Ratios (SLR and CRR)
A Bank has to set aside this much money into gold or RBI approved
securities.
A Bank has to set aside this much as reserve. Bank cannot lend it to
CRR
anyone. Bank earns no interest rate or profit on this.
SLR
23%
4%
100 cr
-40
-15
45 cr.
You can see, when Rajan has raised reserve ratio, money with SBI is reduced (from 73
crores to just 45 crores.)
What will be its implication?
Imagine youre a money lender. Youve 100 crore rupees and you must make Rs.1
crore profit in a year.
Obviously, you should lend it @1% interest rate. (because 1% of 100 crore = 1
crore.)
But what if youve only 2 crore rupees, and you still want to make Rs.1 croer profit
in a year?
Now you must lend it @50% interest rate. (because 50% of 2 cores = 1 crore.)
Observe that as money decreased (from 100 to 2), loan interest rate increased
(from 1% to 50%).
Same happens when SBI is left with less money (after RBI increases reserve ratio).
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dear money
To fight inflation
Increase them.
RBI sell securities
cheap money
To fight deflation
Decrease them.
RBI buy securities
Mock Question
In 2013, UPSC walla asked a very chillar question from this topic.
In context of Indian Economy, Open Market Operation refers to
a.
b.
c.
d.
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imaginary cutoff and thus dig up their own grave. (especially during last 10-15
minutes of the exam.)
Moral of the story: never put fact/definition type MCQs in Mark-n-Review.
Lets solve a bit more complicated MCQ from 2012s CSAT paper.
Q.Which of the following measures would result in an increase in the money supply in
economy?
1.
2.
3.
4.
Answer choice
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
2, 3 and 4
Whenever you face such multiple statement type MCQs, always use elimination
method. First find a statement that is definitely right or definitely wrong and eliminate
choices accordingly.
Focus on first statement Purchase of government securities from public by
central bank: will it increase money supply in the system?
Imagine Rajan puts an ad in newspaper: bring your Sabzi (vegetables), Ill buy it.
Junta gives him their own veggies, Rajan gives them money. (a classic buy and
sell).
Ultimate result: money supply increased in the system- because junta got the
money. Meaning #1 definitely correct.
If you think it on technical terms. Central bank purchases government
securities=OMO (Open market operation), where money shifts hands from RBI to
people.
Hence money supply increased. (In reality, money doesnt go to aam admi
directly, but those bankers and non-banking institutions who participate in OMO).
Anyways, #1 is right, Eliminate choices that do not have #1
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
2, 3 and 4
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Is money supply increased? Yes Mohan sold veggies to Rajan and got Money.
Whenever Rajan buys veggies and pays the money supply is increased. (this is
similar to Open Market operation)
Besides, Mohan can then use money to pay salaries of government staff, pay for
rail-road-bridges and other infrastructure projects, pay for MNREGA and so on.
Therefore Answer C: 1 and 3 correct.
Counter- argument?
What if Rajan subsequently sells those (Mohans) securities to bankers. Then
bankers money reduced. Hence #3 is wrong. Therefore final answer A only 1.
So, whats the final answer: is it A or is it C?
Ultimate judge= UPSCs official answer key uploaded on their site.
In 2012s Question paper Test series A, this is Q77: and its official answer is C.
Therefore, both 1 and 3 are correct.
Anyways, what to do in the exam?
Skip
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Policy rate= in case of India its Repo rate. Before moving further, lets refresh our
concepts of Bank rate, LAF, MSF, Repo and Reverse repo.
Bank Rate
When banks borrow long term funds from RBI. Theyve to pay this much interest
rate to RBI. [Note: different books give different explanation of Bank Rate. I've used
NDTV's definition]
At present, Bank rate= 9%
Collateral: nothing. (Bank can borrow money without pledging government
securities to RBI)
Bank rate is not the main tool to control money supply these days.
Nowadays, RBI uses LAF Repo rate as the main tool, to control money supply.
Ok then Whats the use of Bank rate?
Penal rates are linked with Bank rate. For example, If a bank doesnt maintain
CRR, SLR as per the prescribed limit.
Then RBI can impose penalty interest on such notorious bank.
At present, Penalty rate = Bank rate + 3% (or 5% in some cases)
Meaning if Bank rate = 9% then penalty rate=9+3=12%
Anyways, what if RBI wants to fight inflation using bank rate as a tool?
Obviously they should increase bank rate. That way it becomes harder (more expensive)
for banks to borrow from RBI.=> SBI increases its loan rates (to keep the profit margin
same). Result?
Less people get home loan, bike loan, business loans.
Less business expansion
Less jobs
Less incomes
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
Thus inflation is reduced.
Lets update our (stupid) table
Policy
Tool
Reserve Ratio (CRR, SLR)
Open Market Operation (OMO)
Bank rate
dear money
To fight inflation
Increase them.
RBI sell securities
Increase
cheap money
To fight deflation
Decrease them.
RBI buy securities
decrease
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hideout where RBIs clients gather, consumer desi liquor, play cards, watch item
songs and borrow money from RBI (or lend Money to RBI).
By the way, who are the clients of RBI?= Central and state governments, Banks
and non-banking financial institutions (NBFI). NBFI further includes:
AIFI (all India finance institutions) NABARD, SIDBI, EXIM Bank and National
Housing Bank.
Primary dealers (Morgan Stanley , Goldman Sachs, JP Morgan Chase,
Standard Chartered Bank, HSBC etc.)
Non-Banking financial companies.
Anyways, Under this LAF adda, RBI has two tools:
If client borrows money from RBI (for short term) then client has to pay this
Repo
much interest rate to RBI. At present Repo is 8%. (article written on 29th Jan
2014)
If client lends money to RBI (for short term) then RBI has to pay this much
Reverse
interest rate to client. RBI doesnt like headache. So they made a simple
Repo
formula: Reverse repo rate= Repo MINUS 1%=8-1=7%.
Collateral:
Problem with running a adda/gambling-den = sometimes client drinks too much
desi liquor and passes out on floor. Sometimes he even dies because of hooch.
Sometimes police raids the den, and clients run away with cash and register.
If such things happen, Rajan will be at loss. So, he demands government
securities as collataral. So even if client doesnt repay money on time, Rajan can
sell those securities (in open market operations) and recover money.
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Scenario
SBI chairman Arundhati mam wants to borrow Rs.100 crore (for short term).
She gives her stash of government securities to Rajan.
Rajan gives her Rs.100 crore.
Madam Also signs an agreement
I, Arundhati Bhattacharya, agree to buy same securities from Rajan, at 108
crores after 14 days.
Notice that she has agreed to re-purchase same securities from Rajan.
Therefore its called Repo.
And how much interest rate did she pay on this loan? [108-100]/100=8%. Thats
our repo rate.
Important:
Recall that SBI also has to keep part of her money in RBI approved securities
(under SLR).
So Madam cannot USE those government securities to borrow under Repo Rate
from Rajan.
That leads to a new topic
MSF
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dear money
To fight inflation
cheap money
To fight deflation
Increase them.
Decrease them.
increase it
decrease it
increase it
decrease it
its value is linked with Repo, hence cannot be increased/decreased
Reverse Repo
independently.
Marginal
its value is linked with Repo, hence cannot be increased/decreased
Standing
independently. Besides MSF= temporary firefighting, cash
Facility
mismanagement.
We learned that Rajan doesnt use Bank rate much, to control money supply.
We learned that Rajan doesnt decide Reverse repo and MSF. (theyre
automatically -1% and +1% of Repo rate).
Thus the only thing Rajan has to decide under monetary policy= Repo rate.
Therefore, Repo rate is called the policy rate
Lets revisit out flow chart:
Situation: Economy has inflationary trend. Prices of goods and services
increasing every day.
Solution: Rajan increases Repo rate. (say from 7.75% to 8%).
Result: it becomes expensive for SBI to borrow from Rajan. Theyll increase their
own rates as well.
Wait. How?
Just like how things roll in Onion biz.
If prices of Onion rise in Maharashtras wholesale yard (in Lasangaon), then
immediately, retail veggie @Ahmedabad will also raise their onion prices to keep the
profit margin same.
Whatll be the consequences (if repo rate is hiked / increased)?
Consequences:
1. SBI raises its loan interest rate (to keep profit margin same)
2. Businessmen borrow less money from SBI.
3. Businessmen donot start new business. Donot expand existing business.
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4.
5.
6.
7.
Less jobs
Less income
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
dear money
To fight inflation
Increase them.
RBI sell securities
Increase it
cheap money
To fight deflation
Decrease them.
RBI buy securities
Decrease it
From above above graph, you can see RBI has frequently changed its repo rate to
combat both inflationary and deflationary trend. But Youd agree that inflation has not
been contained. No matter what number juggling or statistical interpretations are giventhe hardship of common man has not stopped- be it milk, petrol, onion, LPG anything.
Agreed that prices of onion, sugar, pulses and food are subject to vagaries of
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Suppose Vijay Mallay got 100 crore loan from State Bank of India. If you trace the
source of that money, itll turnout 60-70 crores came from banks savings account,
fixed deposit etc. Rajan lends money in repo rate yes, but that doesnt mean banks
depend only on Rajan to arrange the cash for its clients.
Suppose Rajan reduces repo rate from 8% to 5%. Banks are not legally required to
reduce their loan interest rates.
The current system is following:
Banks are free to decide their base rate. E.g. SBIs base rate is 10%.
It means SBI wont loan money to anyone at an interest rate lower than 10%
(except those farmers under Interest subvention scheme.)
SBI will link all of its loan products with Base rate. For example
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Calculation
Result
0.75% above Base rate 10.75%
8.25% above base rate 18.25%
3.5% above base rate 13.5%
0.10% above base rate 10.10%
Meaning if SBI changes her Base rate then all of above loan interest rates will change
automatically.
If Rajan changes his repo rate, will SBI change her base rate?
Not always.
Because those common men are the main suppliers of money to SBI.
RBI is not the main supplier of money to SBI.
SBI will only change its base rate, when she feels necessary for its own profit /
loss compared to its competitors.
Does it mean Repo rate system is bogus and ineffective?
Not always.
In developing countries like India, most people park their money in only four
things: savings account, fixed deposit (FD), provident fund and LIC. Weve mutual
funds, weve NPS, weve ULIPs, weve Rajiv Gandhi equity savings scheme
but most people (particularly the older generation) feels insecure in into such new
things. Therefore lot of money flows into Savings accounts and fixed deposits=
SBIs main source of money.
But, In advanced economies, like USA, people dont invest large portion their
income in savings account or FD. Theyve variety of investment options. So, for
those American banks, their own Central bank (US Feds) is a significant money
supplier.
Hence US Feds monetary policy shows faster impact on their American Banks,
THAN Rajans monetary policy on Desi banks.
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4.
5.
6.
7.
8.
and politicians, and charge 36% interest rate on loans. Rajan has no control over
them.
Monsoon uncertainty, cyclone, flood, draughts and their effect on food production.
Food inflation =>newspaper walla, washerman, barber, car mechanic everyone will
raise their service fees to accommodate their raised cost of living. Rajan has no
control over them.
Crude oil and gold import + negative effect when rupee weakens. Rajan can try to
bring 1$=Rs.65 to $1=63 Rs. But he has not enough forex reserves to bring
$1=Rs.50.
Fiscal deficit, illogical schemes. e.g MNREGA worker digs a temporary road. After
first rain, t he road is wiped out= physical infrastructure added to economy no.
Wages raised..yes. = this mismatch leads to more inflation.
Subsidy leakage, Black money, underground economy.
And most importantly, because Rajan uses Multi-indicator approach, he focuses
on WPI (minus food and fuel). Thats why Urjit Patel recommends him to target
CPI. More on that in next article.
So far, we learned that RBI has two sets of tools/instruments under monetary policy:
Quantitative tool
Qualitative tools
1. Reserve ratios
2. OMO
Well see them in a moment
3. Policy rate (Repo Rate)
Qualitative Tools
#1: Margin Requirements/ LTV
Mallya wants to borrow from SBI. He pledges his companys shares worth Rs.100
crores as collateral.
For such loans, Rajan can prescribe margin, say 65%.
In that case even if Mallya pledges 100 crores worth shares, SBI can give him
100-65=only 35 Crore rupees as loan.
Using this tool, Rajan can control money supply. e.g. during inflation, he should
increase margin requirement, so Mallya can borrow less=> less job=>less
income=>less demand=>prices reduced.
If Rajan changes repo rate, it is not compulsory for SBI to change her loan interest
rates. (we saw how Alok Nath keeps giving money to SBI, so they are not entirely
dependent on Rajan.)
But if Rajan changes margin requirements, then SBI and all other banks must obey
it. In other words, this tool has direct impact on money supply.
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Rationing
of credit
Direct
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action
Lets recap
Qualitative
1.
2.
3.
4.
5.
6.
Only 2 and 3
Only 1 and 2
Only 1 and 3
1, 2 and 3
Approach:
Whenever you face such 3 statement MCQ or 4 statement MCQ, Always use
elimination method. First you find out a statement that is definitely right or definitely
wrong. In above case, we can see #2 is definitely right. RBI lends funds to banks in the
times of need (Repo, MSF)
So lets eliminate choices that dont involve statement #2
1.
2.
3.
4.
Only 2 and 3
Only 1 and 2
Only 1 and 3
1, 2 and 3
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This did not help much. We still have three choices left. Observe statement #1:
Other banks retain their deposits with RBI. That is correct with respect to cash
reserve ratio. CRR is one type of deposit that banks make to RBI. (RBI doesnt
pay interest on it- thats a different story).
Meaning #1 is also correct eliminate choices that donot have #1
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
Only two choices left and the ultimate solution = is statement #3 is correct or not?
Viewpoint #1
The statement says RBI advises commercial banks on
monetary matters.The word advises makes this
statement incorrect. Because RBI doesnt Advice they
just order the banks- be it SLR, CRR, PSL. RBI doesnt
advice, RBI gives orders and direction. Therefore
statement #3 is wrong.
Even if we accept that RBI advices, still the questions
asks what is implied by RBI as Bankers bank. So, RBI
advices moral suasion that is a monetary policy tool.
RBIs not doing it as a Banker to those banks.
Therefore, Statement #3 is definitely wrong.
Answer (B)
Viewpoint #2
RBI does advice those
banks. We saw it under
Moral Suasion.
Therefore, Statement #3 is
right.
Money Banking and
finance, E Narayan Nadar
(PHI publication). He has
specifically listed this
Advice function under
Bankers bank topic.
Answer (D)
Appendix
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These are the topics I wanted to discuss in the article, but they would break the flow of
other topics. Hence writing them @bottom:
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45 cr.
From 100 crores, barely 45 crores left with the bank. But adding insult to the injuryeven here RBI mandates Priority sector lending (PSL). Meaning, at least 40% of the
loans has to be given to farmers, small businessmen, students etc. groups.
Lets update the table:
Net Demand and Time Liabilities (NDTL)
Reserve ratios
CRR (15%)
SLR (40%)
Money left with bank
PSL (40%)
Money left for big borrowers (i.e. big businessmen, upper
middleclass)
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45
=45 x 0.4 =18
crore.
=45-18=27 crores.
By the way, PSL is counted on annual basis while SLR, CRR counted on fortnight
basis so above table is technically incorrect but Ive plugged in those numbers only
for the sake of explanation.
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before the 90s- Government would even interfere and order public sector banks to
give PSL-loans @cheap interest rates. The local politicians would coerce the
branch manager to give PSL-loans to ineligible people. They default on loans,
Branch manager cannot recover money (because defaulter will goto civil court
then taarikh pe taarikh.) So, bank would have to forget about most of those 18
crores given in PSL loans.
Anyways you can see people deposited 100 crores in the bank yet bank is left with
barely 27 crores (over which, bank has Freedom to decide whom they should
give the loan.)
What are the consequences for businessmen?
1. High cost of credit (because bank will try to make maximum profit from those 27
crores- so bank will charge very high interest rate on the business loans- to pay off
for the staff salaries, branch office rents and everything.)
2. Businessman cannot expand his business.
3. Less exports.
4. Less tax income for the government.
So in a way- that was also one of the factors leading to Balance of Payment crisis (and
subsequently LPG reforms.) You can read more about that in NCERT Class 11- chapter
2 and 3.
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Mock Questions
1. With open market operations, RBI can
a. increase liquidity in the economy, but cannot decrease it
b. decrease liquidity in the economy, but cannot increase it
c. Can increase or decrease liquidity in the economy to control money supply.
d. None of above.
2. By which of the following methods, government can reduce money supply in the
economy?
a. taxation
b. sale of securities to public
c. both A and B
d. neither A nor B
3. During the period of deflation
a. RBI should use dear money policy to combat it
b. Government should reduce its tax rates.
c. both A and B
d. Neither A nor B.
4. IF prices are lowered without causing unemployment, we call it:
a. stagflation
b. reflation
c. disflaction
d. Disinflation.
5. Which of the following contains correct set of quantitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. open market operations, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
6. Which of the following contains correct set of qualitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. credit rationing, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
Q7. To counter the effect of deflation, which of the following steps should RBI
initiate?
1. decrease reserve ratios
2. buy government securities through open market operation
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only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
Q8. To counter inflation, which of the following steps should RBI initiate?
1. Increase reserve ratios
2. sell government securities through open market operation
3. Increase policy rate
Answer choices
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1, 2 and 3
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only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3
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