Monetary policy is the process by which the monetary authority of a country, typically the central bank (RBI), controls either the cost of very short-term borrowing or the monetary base, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
The methods to control is of 2 types:
- Quantitative Methods (CRR, SLR, OMO, MSF)
- Qualitative Methods
The tools used by RBI to control the quantity of money in economy are bank rate, Open Market Operations, REPO, Reverse REPO, CRR and SLR.
Cash Reserve Ratio (CRR)
Scheduled Commercial Banks are required to maintain CRR as per section 42(1) of RBI Act. Banks are required to maintain certain percentage of Net Demand & Time Liabilities (NDTL) as cash with RBI. There is no minimum or maximum CRR as per RBI Act and RBI will fix CRR. RBI will not pay any interest on the CRR balances. To combat inflation RBI increases CRR and viceversa.
Statutory Liquidity Ratio (SLR)
SLR is maintained as per section 24 of Banking Regulation Act. SLR can be kept in the form of (a) cash, (b) gold valued at a price not exceeding the current market price, (c) unencumbered approved securities valued at a price as specified by the RBI from time to time, (d) cash balance with other banks (e) excess cash balance with RBI.
RBI raises SLR & CRR implies:
- Banks have less money left
- Banks will rise loan interest rates to keep profits => Demand for loans decreases because of high interest rates => people borrow less money => prices fall => inflation controlled.
Open Market Operations (OMO)
OMO refers to sale and purchase of securities, bills and bonds by central bank (RBI).
when inflation is high => OMO sell Govt Bonds => Money flow to RBI => Less money in supply => Inflation is controlled.
Bank rate is the standard rate at which RBI rediscounts Bill of Exchange or other eligible commercial papers from banks. By varying the bank rate RBI controls the credit. It is also the rate of interest which a central bank charges on its loans and advances to a commercial bank. No colleteral is required.
Bank rate is linked with penal rates – if CRR & SLR is not maintained then penalty will be charges on long term funds i.e., bank rate + penalty as imposed by RBI.
Lets Sum Up
- Monetary policy is controlled by central bank (RBI).
- All scheduled commercial banks are required to keep CRR and SLR as percentage of NDTL with RBI. CRR doesn’t carry any interest but SLR carries some interest as prescribed by RBI.
- OMO refers to sale and purchase of securities
- Bank rate is the rate of interest which a central bank charges on its loans. It is a long term loan with no collateral. Penal rates are linked to bank rate.
In my next post I will discuss about non conventional measures such as REPO, RREPO, MSF and MSS.
- “Principles & Practices of Banking”, Tata McGraw-Hill, New Delhi.
- My Virtual Guru – http://www.mrunal.org
- “Indian Economy “, Sankarganesh Karuppiah