Study Notes for Various tools/instruments of Monetary Policy || Commerce || Management || Economics

By Tanuj Bansal|Updated : September 9th, 2020


Various tools/instruments of Monetary Policy

These can be divided into quantitative and qualitative instruments.

Quantitative instruments

1. Open Market Operations (OMO)

  • This method refers to the buy and sells of securities, bills and bonds of government by RBI in the open market to expand or contract the amount of money in the banking system.
  • When RBI purchases Government securities, liquidity increases (because RBI is paying that party some money to buy that security or RBI is pouring additional money into the system).
  • On the reverse, when RBI sells Government securities, liquidity decreases (because those players are giving their cash to RBI to purchase the securities.)

2. Liquidity Adjustment Facility (LAF)

  • Liquidity adjustment facilities (LAF) is also a tool used by RBI to control the short-term money supply.
  • Liquidity adjustment facilities (LAF) has two instruments namely Repo rate and Reverse Repo Rate.
    Repo Rate: The interest rate at which the Reserve Bank provides loans to commercial banks by mortgaging their dated government securities and treasury bills.
    Reverse Repo Rate: The interest rate at which the Reserve Bank borrows from commercial banks by mortgaging its dated government securities and treasury bills.
  • While repo rate injects liquidity into the system, the Reverse repo absorbs the liquidity from the system.

3. Marginal Standing Facility (MSF)

  • It is a loan facility for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely.
  • How is MSF different from Repo rate?
    MSF loan facility was created for commercial banks to borrow from RBI in emergency conditions when inter-bank liquidity dries up and there is a volatility in the overnight interest rates. To curb this volatility, RBI allowed them to deposit government securities and get more liquidity from RBI at a rate higher than the Repo rate.

4. Reserve Ratio (SLR, CRR)

  • SLR (Statutory liquidity ratio): All commercial banks in the country required to keep a given percentage of their demand and time deposits (Net demand and time liabilities or NDTL) as liquid assets in their vault itself.
  • It prevents the bank from lending all its deposits which is too risky.
    Note: Net Demand and Time Liabilities (NDTL) mainly consist of Time liabilities and Demand liabilities.
    Time liabilities include:
    (1) Money deposited in Fixed deposits (FD)
    (2) Cash certificates
    (3) gold deposits etc.
    Demand liabilities include:        
    (1) Money deposited in the savings account
    (2) Money deposited in the current account
    (3) Demand drafts etc.
  • Cash Reserve Ratio (CRR): The Cash Reserve Ratio is the amount of funds that the banks are bound to keep with Reserve bank of India as a certain percentage of their Net Demand and Time Liabilities (NDTL). Bank cannot lend it to anyone. Bank earns no interest rate or profit on this.
    What happens when CRR is reduced?
    When CRR is reduced, this means banks required to keep fewer funds with RBI and resource available to banks for lending will go up.

5. Bank Rate

  • The bank rate is the rate which is fixed by RBI at which it re-discounts bills of exchange and government securities held by commercial banks.
  • It is also known as the discount rate.
  • Bill of exchange- is a financial document that assures payment of money by the purchaser to the seller for goods purchased.
  • Differences between Repo rate and Bank rate: Repo Rate is a short-term measure on the other hand Bank Rate is a long-term measure.

Qualitative instruments

1. Credit rationing

  • In this, RBI controlled the maximum amount of credit flow to a certain sector.
  • RBI may also make compulsory for the banks to provide certain fractions of their loans to certain sectors such as priority sector lending etc.

2. Selective Credit control

  • Selective credit control is a tool in the hands of Reserve Bank of India to restrict bank finance against sensitive commodities.

3. Margin Requirements

  • RBI can prescribe margin against collateral. For instance, lend only 70 Rs. for 100 Rs. value Property, margin requirement being 30%. If RBI raises margin requirement, customers will be able to borrow less.

4. Moral suasion

  • Moral Suasion refers to a method of request, a method of advice by the RBI to the commercial banks to take certain measures as per the trend of the economy.

5. Direct Action

  • RBI issues certain guidelines from time to time based on the current situation in the economy. These guidelines should be followed by banks. If any bank violates these guidelines RBI penalizes them.

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