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org/)
1. Prologue
2. What is monetary policy?
3. Quantitative Tools
1.
2.
3.
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:
2.
3.
4.
2.
3.
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.
TERM
meaning
Does RBI
want it?
DEFLATION
No.
DISINFLATION
yes (while
fighting
inflation)
stagnation + inflation
prices and wages rise
STAGFLATION
No
REFLATION
yes
quantitative tool
qualitative tools
Quantitative Tools
#1: Reserve Ratios (SLR and CRR)
SLR
A Bank has to set aside this much money into gold or RBI approved
securities.
23%
CRR
A Bank has to set aside this much as reserve. Bank cannot lend it to anyone.
Bank earns no interest rate or profit on this.
4%
100 cr.
CRR (4%) [SBI has to keep this much cash aside for reserve]
-4 cr
SLR (23%) [SBI has to invest this much money in RBI approved
securities]
-23 cr.
100-4-23=73
Cores.
100 cr
SLR 40
-40
CRR 15
-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).
Lets prepare a flow chart.
Situation: Economy has inflationary trend. Prices of goods and services increasing every day.
Solution: RBI raised reserve ratio (CRR, SLR)
Result: SBI is left with less money to lend.
Consequences:
1. SBI raises its loan interest rate
2. Businessmen borrow less money from SBI
3. Businessmen donot start new business. Donot expand existing business
4. Result=Less jobs. Even existing employees discharged. If anyone remains in the job, he
doesnt get pay raise. He starts cutting down unnecessary expenditure (e.g. buying two
newspapers, getting his shirts ironed, drinking tea @4PM in office and so on. Thus even
paper-wall, dhobi, chai-walla- everyones income reduced.)
5. Result= Less income (Because of above reasons)
6. Result= Less demand of goods and services (because less income).
7. Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
Thus inflation is reduced.
You may doubt- what about supply side bottlenecks, what about cost push and demand pull
inflation : Im not going into all that details at the moment, else this article will become longer
than five kilometers.
Lets just prepare a summary table:
Policy
dear money
cheap money
Tool
To fight inflation
To fight deflation
Increase them.
Decrease them.
Policy
dear money
cheap money
Tool
To fight inflation
To fight deflation
Increase them.
Decrease them.
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. Borrowing by scheduled banks from RBI
b. Lending by commercial banks to industries and trade
c. Purchase and sale of government securities by the RBI
d. None of Above
Whenever you face a GS/GK type MCQ, Youve three choices
Skip
If you dont know the answer, Just leave it instead of risking negative mark.
Attempt
Mark n
Review.
It means youve unsure of the answer. 50:50. So you mark the question number
(say 45), at the back of your question paper. At the end of exam, if youre left
with 10-15 free minutes. You look at the question again, and try to solve it.
How does Government borrow from Central bank? Does Mohan just callup Rajan and
demand 1 lakh crores? No. Mohan will have to give Rajan that much government
securities (vegetables) and Rajan will give him cash.
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 railroad-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
Attempt
This question is attemptable if you dont drag the logic too much in statement
#3.
Mark n
Review.
Yes, it can be put under mark and review because this is not an absolute fact/
absolute definition type MCQ. If you apply some concepts, you can eliminate
wrong choices. But still if doubt persists in the mind (e.g whether Statement 3 is
right or not) then its always safe to skip and avoid negative marking.
By the way, What about Statement #2: Deposit of currency in commercial banks by the
public. (Will it increase money supply or not?)
Viewpoint 1: yes. Because bank can used it to expand loanable credit. (as explained in
Money creation topic in Class 12 NCERT Macroeconomics page 39 onwards).
Viewpoint 2: no. (Because Bank will have to put some money aside as CRR- so that much
money is less in the system.)
Either way it doesnt change the answer. Because We know that statement 1 is definitely
correct. And there is no option where (1,2) are given simultaneously.
Anyways, Moving onSo far, RBI has two tools under monetary policy:
1. reserve ratios (SLR, CRR)
2. Open market operation.
Third and the most important quantitative tool is
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
dear money
cheap money
Tool
To fight inflation
To fight deflation
Increase them.
Decrease them.
Bank rate
Increase
decrease
Repo
If client borrows money from RBI (for short term) then client has to pay this
much interest rate to RBI. At present Repo is 8%. (article written on 29th Jan
2014)
Reverse
Repo
If client lends money to RBI (for short term) then RBI has to pay this much
interest rate to client. RBI doesnt like headache. So they made a simple 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.
(http://www.flickr.com/photos/97816112@N02/12220419083/)
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.
LAF (Repo)
Rajan says dont come here
unless you want to borrow
minimum Rs.5 crores.
MSF
Minimum Rs. 1 crore.
governments
Banks be it commercial
bank or RRB or
cooperative bank
Non-banking financial
institutions.
You (bankers) cannot pledge
securities from SLR quota to
borrow from this window.
Policy
dear money
cheap money
Tool
To fight inflation
To fight deflation
Reserve Ratio
(CRR, SLR)
Increase them.
Decrease them.
Open Market
Operation
(OMO)
Bank Rate
increase it
decrease it
Repo rate
increase it
decrease it
Reverse Repo
Marginal
Standing
Facility
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.
4. Less jobs
5. Less income
6. Less demand
7. Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
Policy
dear money
cheap money
Tool
To fight inflation
To fight deflation
Increase them.
Decrease them.
Increase it
Decrease it
(http://www.flickr.com/photos/97816112@N02/12220418853/)
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 given- the
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 monsoon
and black marketeering. Rajan cannot do anything about it.
Agreed that crude oil prices are subject to rupee-Dollar exchange rate, external factors
and governments de-regulation of their prices. Rajan doesnt have much control over
this.
But still even in the non-food, non-fuel type commodities- RBIs monetary policies have failed
to curb inflation. WHY? Observe the following image.
(http://www.flickr.com/photos/97816112@N02/12220829396/)
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
SBI Base rate =10%
Calculation
Result
Car loan
10.75%
18.25%
13.5%
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.
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
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.
#2: Consumer credit regulation
Suppose Nano car sells @1 lakh and Rajan has made rule that downpayment cannot be
less than 30%.
It means customer must bring Rs.30,000 from his pocket and bank can only give him
maximum 70000 as loan.
How can Rajan fight inflation with this tool?
Increase downpayment from 30%=>50% (meaning bank can give less loan. Customer
Here central bank will decide upper limit to loans in each sector
Rationing
of credit
Direct
action
Lets recap
Monetary policy tools: Quantiative vs Qualitative
Quantitative
Qualitative
1. Margin requirements / LTV
General- they affect money supply in entire economybe it housing, automobile, manufacturing- everything.
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 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. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
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
Viewpoint #2
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)
Answer (D)
Skip
Upto you. But if you start skipping all such question (OMO, Money supply,
Bankers bank), because youre completely unaware of those topics=that is
not pardonable.it shows youre underprepared for this exam. You should
either change your study method or change the game- try for some easier
exam.
Attempt
This question is attemptable, if you dont nitpick over the word advises in
third statement.
Mark n
Review
If youve thoroughly prepared the RBIs monetary tools (both qualitative and
quantitative), you can solve it by applying concepts/principles- particularly
the moral suasion thing. But if youre still doubtful over whether #3 is right
or wrong, then better skip. If you skip because youre doubtful = that is
pardonable. But if you skip because youre completely unaware of this
topic= non-bailable offense.
Appendix
These are the topics I wanted to discuss in the article, but they would break the flow of other
topics. Hence writing them @bottom:
examples
Time Deposit
Demand Deposit
Using this money, bank has to count its Net Demand and Time liabilities (NDTL), every
fortnight. Suppose its 100 crores.
Both CRR and SLR are counted on this figure. In the old times, these reserve ratios used
to be as high as 15% and 40% respectively. Observe the effect:
Net Demand and Time Liabilities (NDTL)
+100 cr.
Reserve ratios
CRR (15%)
SLR (40%)
=45 cr.
From 100 crores, barely 45 crores left with the bank. But adding insult to the injury- even
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)
+100 cr.
Reserve ratios
CRR (15%)
SLR (40%)
=45
PSL (40%)
=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.
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 croresso 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.
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
3. increase policy rate
Answer choices
a. only 1 and 2
b. only 2 and 3
c. only 1 and 3
d. 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. only 1 and 2
b. only 2 and 3
c. only 1 and 3
d. 1, 2 and 3
Q9. Which of the following may cause deflation in the economy?
1. RBI raises policy rate
2. RBI raises cash reserve ratio
3. RBI sells securities
Choices:
a. only 1 and 2
b. only 2 and 3
c. only 1 and 3
d. all 1,2 and 3
Q10. Money supply in the economy, is affected by
1. Cheap money policy and dear money policy.
2. Open market operation and Moral Suasion.
3. Consumer credit regulation and loan to value ratio.
Choices:
a. only 1 and 2
b. only 2 and 3
c. only 1 and 3
d. all 1, 2 and 3
Q11. An increase in SLR
1. will restrict the expansion of banks credit
2. will increase banks investment in safe securities
3. will ensure solvency of the banks
choices:
a. only 1 and 2
b. only 2 and 3
c. only 1 and 3
d. all 1,2 and 3
10. All correct. (Unless you nitpick and drag the logic too much.)
11. same as above.
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