A Beginners Guide To Monetary Policy Tools

Personal Finance

Needless to say, the RBI holds the power to create and control the monetary policy tools of our Nation. So, instruments like monetary policy are vital. It deals with the central bank’s matters relating to the interest rate, money supply, and credit availability. 

The RBI formulate these monetary policies to control inflation in our country. They use financial instruments like Reverse REPO Rate, REPO Rate, SLR, and CRR. We will discuss them further in the later part of this piece.

But first, you must know that monetary policies are of two types – expansionary and contractionary.

An expansionary monetary policy is implemented by reducing interest rates. It results in increasing market liquidity. Its primary aim is to boost the money supply in an economy. 

On the other hand, a contractionary monetary policy is executed by increasing interest rates. As a result, it reduces market liquidity. This contractionary monetary policy comes into play when we need to decrease the money supply in an economy. 

For an economy to grow sustainably, you need to consider price stability. For this, the Indian Government sets an inflation goal for five years in consultation with the RBI. 

Furthermore, the RBI regulates the policies to control inflation and induce price stability. This is why India’s current inflation framework is flexible. It is also known as the Flexible Inflation Targeting Framework (FITF). 

The Central Government has also introduced the Monetary Policy Framework (MPF), Monetary Policy Committee (MPC), and Monetary Policy Process (MPP). These are the topics for another day.

Today, let’s focus on the monetary policy tools that exist. So, let’s dive in.

Instruments of Monetary Policy 101

Simply put, the RBI regulates the money supply of our country’s economy. They use a specific set of instruments to do so. You should also know that it also aids in inflation control.

Also, these qualitative tools of monetary policy are responsible for India’s economic growth and development. Let’s have a look!

  1. Repo Rate: 

Repo rate is the fixed interest rate at which the RBI supplies money to commercial banks. It helps banks to meet short-term fund requirements. 

As a result, this helps the RBI to maintain market liquidity and control inflation.

  1. Reverse Repo Rate: 

It is the interest rate at which the Reserve Bank of India borrows money from commercial banks to meet short-term fund needs. 

Reverse Repo is crucial for the RBI to maintain steady liquidity during times of need. 

  1. Liquidity Adjustment Facility (LAF): 

It is an instrument that controls money indirectly. LAF assists the RBI in managing liquidity. In turn, this provides economic stability to banks. 

RBI does this by offering the opportunity to borrow money through repurchase agreements or Repos. Also, it helps make loan agreements with the RBI via reverse repo rates. Furthermore, this aid banks in overcoming any short-term cash shortage during economic instability or stressful situations. 

In a nutshell, LAF helps regulate inflation by increasing or reducing the money supply.

  1. Marginal Standing Facility (MSF): 

It is a unique facility available for scheduled commercial banks. MSF helps them to borrow an additional amount from the Reserve Bank when the inter-bank liquidity dries completely. 

Do note that the Marginal Standing facility only offers a borrowing facility at an interest rate higher than the repo rate.

  1. Bank Rate: 

It is by far the most effective tool among all monetary policies. 

The bank rate is the determined interest rate at which the RBI provides loans to private banks. Also, RBI provides these loans without any collateral. 

Lower bank rates aid in expanding the economy. However, a higher bank rate will help control inflation. Let’s understand this better with an example.

Say the RBI needs to increase the bank rate for some reason. Then, commercial banks are bound to hike their lending rates. As a result, the supply of money is under control. 

For just the reverse situation, the money supply is in abundance. But, this will spike inflation. So, RBI has to increase the bank rate to control inflation when needed.

  1. Cash Reserve Ratio (CRR): 

The CRR is the minimum public deposit mandatory for any commercial bank to maintain at all times. 

In return, Cash reserve Ratio helps to regulate the money supply of our country’s economy.

  1. Statutory Liquidity Ratio (SLR): 

The RBI has mandated that commercial banks maintain a certain percentage of gold, cash, or other security deposits before offering any credit to their customers. It is known as the Statutory Liquidity Ratio, aka SLR. 

Banks need to make sure that they follow the SLR reserve criteria strictly.

  1. Open Market Operations (OMOs): 

This is a situation where RBI gets involved directly or indirectly. It is the open market operation when RBI sells or buys short-term securities in the open market. 

When OMOs happen, the money supply boosts or decreases in the market. Moreover, the constant interest rate is directly affected.

Let us help you understand this with an example.

Say the RBI decides to buy a few short-term securities from the market. Due to this, the money supply in the market will increase. 

Consequently, the credit facility demands would reduce. As a result, the rate of interest will also decrease.

On the other hand, the interest rate would spike if the RBI were to sell short-term securities in the market. Also, the demand for credit will rise. 

So, this is how the monetary policy tool OMO affects our economy in both ways.

  1. Market Stabilisation Scheme (MSS): 

The scheme aims to absorb surplus liquidity. In this, a stock of securities is handed over to the RBI. The securities mainly include bonds or treasury bills.

RBI uses those securities to dive into the market. This keeps a check on the market’s liquidity. 

Final Words

Now you know why the Central Bank handles the instruments of Monetary Policy with the utmost attention. This is the only way to keep a check on our country’s economic development.