Simplified explanation of quantitative tools of monetary policy

1. MONETARY
POLICY
QUANTITATIVE TOOLS

2. MONETARY POLICY
– Monetary policy is the process by which the monetary authority
of a country, typically the central bank or currency board, controls
either the cost of very short-term borrowing or the money supply,
often targeting inflation or the interest rate to ensure price
stability and general trust in the currency.
– According to G. K. Shaw, refers to any deliberate and conscious
action undertaken by the central monetary authority “to change
the quantity, availability or cost (interest rate) of money.

3. RBI AND MONETARY POLICY
– The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to
provide for a statutory and institutionalised framework for a Monetary Policy Committee,
for maintaining price stability, while keeping in mind the objective of growth.
– The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy
rate (repo rate) required to contain inflation within the specified target level.
– As per the provisions of the RBI Act, three of the six Members of the Monetary Policy
Committee will be from the RBI and the other three Members will be appointed by the
Central Government.
– The Government of India, in consultation with RBI, notified the 'Inflation Target' in the
Gazette of India Extraordinary dated 5th August 2016 for the period beginning from the
date of publication of the notification and ending on the March 31, 2021 as 4%. At the
same time, lower and upper tolerance levels were notified to be 2% and 6% respectively.

4. OBJECTIVES
• RAPID ECONOMIC GROWTH
An important objective of monetary policy is to make available necessary supply of money and
credit for the economic growth of the country. Those sectors which are quite significant for the
economic growth are provided with adequate availability of credit.
• PRICE STABILITY
Price Stability implies promoting economic development with considerable emphasis on price
stability. The centre of focus is to facilitate the environment which is favourable to the architecture
that enables the developmental projects to run swiftly while also maintaining reasonable price
stability.
• EXCHANGE RATE STABILITY
Exchange Rate is the value of one currency against any other foreign currency. High volatility in the
exchange rate will affect our currency so the central bank of a country takes measures to control the
exchange rate.

5. • FULL EMPLOYMENT
It is a situation where all those who are able and willing to work are provided with jobs. In a way it can be
termed as the absence of involuntary employment. During times of high unemployment, RBI follows
expansionary monetary policy to increase aggregate demand and thereby more production and more
employment.
• PROMOTION OF FIXED INVESTMENT
The aim here is to increase the productivity of investment by restraining non essential fixed investment.
• RESTRICTION OF INVENTORIES AND STOCKS
Overfilling of stocks and products becoming outdated due to excess of stock often results in sickness of the unit.
To avoid this problem, the central monetary authority carries out this essential function of restricting the
inventories. The main objective of this policy is to avoid over-stocking and idle money in the organisation.

10. • Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of
customers(NDTL), which commercial banks have to hold as reserves either in cash or as deposits
with the central bank. CRR is set according to the guidelines of the central bank of a country.
• The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or
parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of
cash to meet the payment demands of their depositors.
• CRR specifications give greater control to the central bank over money supply. Commercial
banks have to hold only some specified part of the total deposits as reserves. This is called
fractional reserve banking.

11. INCREASE IN
CRR
USED DURING
INFLATION
BRINGS DOWN
MONEY SUPPLY
LENDING RATE
INCREASES

12. DECREASE IN
CRR
USED DURING
DEFLATION
INCREASES THE
MONEY SUPPLY
LENDING RATE
DECREASES

13. • Statutory liquidity ratio (SLR) is the Indian government term for the reserve requirement that
the commercial banks in India are required to maintain in the form of cash, gold reserves, RBI
approved securities before providing credit to the customers.
• The SLR is determined by a percentage of total demand and time liabilities. Time liabilities refer
to the liabilities which the commercial banks are liable to pay to the customers after a certain
period mutually agreed upon, and demand liabilities are such deposits of the customers which
are payable on demand.
• The maximum limit of SLR is 40% and minimum limit of SLR is 0 In India, Reserve Bank of India
always determines the percentage of SLR.
• If any Indian bank fails to maintain the required level of the statutory liquidity ratio, then it
becomes liable to pay penalty to Reserve Bank of India. The defaulter bank pays penal interest at
the rate of 3% per annum above the bank rate, on the shortfall amount for that particular day.

14. INCREASE IN
SLR
USED DURING
INFLATION
Tighten the
measure to
safeguard the
customers'
money.
LIQUIDITY IN
THE MARKET
DECREASES.

15. DECREASE IN
CRR
USED DURING
DEFLATION
To encourage
growth.
LIQUIDITY IN
THE MARKET
INCREASES.

16. • Repo rate also known as the benchmark interest rate is the rate at which the RBI lends
money to the banks for a short term.
• When the repo rate increases, borrowing from RBI becomes more expensive.
• If the repo rate is increased, banks can't carry out their business at a profit whereas the very
opposite happens when the repo rate is cut down. Generally, repo rates are cut down
whenever the country needs to progress in banking and economy.
• If banks want to borrow money (for short term, usually overnight) from RBI then banks have
to charge this interest rate. Banks have to pledge government securities as collateral. This
kind of deal happens through a re-purchase agreement.
• If a bank wants to borrow Rs. 100 crores, it has to provide government securities at least
worth Rs. 100 crore (could be more because of margin requirement which is 5%–10% of loan
amount) and agree to repurchase them at Rs. 106.5 crore at the end of borrowing period. So
the bank has paid Rs. 6.5 crore as interest. This is the reason it is called repo rate.

17. REPO RATE
INCREASES
COST OF
BORROWINGS
INCREASES
Fewer people will apply for loan and aggregate demand will get reduced. This will
result in inflation coming down. RBI does the opposite to fight deflation. Although
when RBI reduce Repo rate, banks are not legally required to reduce their base
rate.

18. • As the name suggest, reverse repo rate is just the opposite of repo rate. Reverse Repo rate is the
short term borrowing rate at which RBI borrows money from banks.
• The reserve bank uses this tool when it feels there is too much money floating in the banking
system.
• An increase in the reverse repo rate means that the banks will get a higher rate of interest from
RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending it
to others (people, companies, etc.) which is always risky.
• Repo Rate signifies the rate at which liquidity is injected into the banking system by RBI, whereas
Reverse Repo rate signifies the rate at which the central bank absorbs liquidity from the banks.
Currently, Reverse Repo Rate is pegged to be 0.25% below Repo Rate.

19. • It is defined in Sec 49 of RBI Act of 1934 as the ‘standard rate at which RBI is prepared to buy or
rediscount bills of exchange or other commercial papers eligible for purchase‘
• When banks want to borrow long term funds from RBI, it is the interest rate which RBI charges
to them.
• The bank rate is not used to control money supply these days. Although penal rates are linked to
bank rate. If a bank fails to keep SLR or CRR then RBI will impose penalty & it will be 300 basis
points above bank rate.
• This rate is linked with MSF rate and it changes whenever MSF rate changes.

20. • This scheme was introduced in May 2011 and all the scheduled commercial bank can participate in this
scheme. Banks can borrow up to 2% percent of their respective Net Demand and Time Liabilities.
• RBI receive application under this facility for a minimum amount of Rs. One crore and in multiples of Rs.
One crore thereafter. The important difference with repo rate is that bank can pledge government
securities from SLR quota (up to one percent). So even if SLR goes below 20.5%(RBI/2014-15/445
DBR.Ret.BC.70/12.02.001/2014-15, dt. 16 October 2016) by pledging SLR quota securities under MSF,
bank will not have to pay any penalty.
• MSF would be the last resort for the banks if they exhaust all the borrowing options including LAF.
• Higher the MSF rate, more expensive is borrowing for banks, as well as corporate borrowers and
individuals. It is used by RBI to control the money supply in the country’s financial system.

21. Key Differences between Repo Rate and MSF
Both repo rate and MSF are rates at which RBI lends money to various other banks. However, there are
some differences between the two, they are:
•The repo rate is applied to loans given to banks that are looking to meet their short-term financial needs.
While, the MSF is meant for lending overnight to banks.
•Repo rate is the rate at which money is lent by RBI to commercial banks, while MSF is a rate at which RBI
lends money to scheduled banks.
•Lending at repo rates involve selling of bank’s securities as collateral to RBI along with a repurchase
agreement. Loans given at MSF rates involve providing government securities as collateral.
•Another major difference between the MSF and repo rate is that as MSF banks are allowed to use the
securities that come under Statutory Liquidity Ratio (SLR) in the process of availing loans from RBI.

22. • Open market operation is the activity of buying and selling of government securities in open
market to control the supply of money in banking system.
• When there is excess supply of money, central bank sells government securities thereby sucking
out excess liquidity.
• Similarly, when liquidity is tight, RBI will buy government securities and thereby inject money
supply into the economy.
• Classical economic theory postulates a distinctive relationship between the supply of central bank
money and short-term interest rates: like for a commodity, a higher demand for central bank
money would increase its price, the interest rate.
• When there is an increased demand for base money, the central bank must act if it wishes to
maintain the short-term interest rate. It does this by increasing the supply of base money: it goes
to the open market to buy a financial asset, such as government bonds.

23. • To pay for these assets, new central bank money is generated in the seller's loro account, increasing
the total amount of base money in the economy. Conversely, if the central bank sells these assets in
the open market, the base money is reduced.
• Technically, the process works because the central bank has the authority to bring money in and out
of existence. It is the only point in the whole system with the unlimited ability to produce money.
Another organization may be able to influence the open market for a period of time, but the central
bank will always be able to overpower their influence with an infinite supply of money.
https://youtu.be/deRl_13W8gM VISIT THIS LINK TO SEE RBI’S MONETARY POLICY.

24. Repo rate reduced by 25 bps to 5.75 per cent for third time in a row
* Reverse repo rate now stands at 5.50 per cent, marginal standing facility (MSF) rate 6 per cent
* RBI changes policy stance to accommodative from neutral
* Cuts GDP growth forecast to 7 per cent from 7.2 per cent for FY20
* Raises retail inflation forecast for April-September to 3-3.1 per cent and 3.4-3.7 per cent in
October-March
* Projects upward bias in food inflation in near term due to rising prices of food items
* Forecast risks to inflation trajectory from monsoon uncertainties, unseasonal spike in
vegetable prices, crude oil prices, financial market volatility and fiscal scenario
* Waives RTGS and NEFT charges to promote digital transactions
* Sets up a panel to review ATM charges, fees levied by banks
* To issue draft guidelines for ‘on tap’ licensing of small finance banks by August
* Flags sharp slowdown in investments, moderation in private consumption growth as concern
* All six MPC members voted in favour of 0.25 per cent policy rate cut
* Average daily surplus liquidity in the system at ₹ 66,000 crore in early June
* Foreign Exchange Reserves stood at USD 421.9 billion on May 31, 2019
* Next monetary policy statement on August 7.