Skip to content
Civil Services Notes Civil Services Notes Civil Services Notes

Monetary and Credit Policy

Monetary and Credit Policy

Section titled “Monetary and Credit Policy”

2020-06-09 18:58:02

Monetary Policy

Section titled “Monetary Policy”
  • Influences money supply, interest rates to control inflation, output etc used by Central Bank.
  • Objective :
    • accelerate growth, price stability
    • stabilise exchange rate, balance saving and investment
  • Can be
    • expansionary : increases supply of money traditionally used to combat unemployment or
    • contractionary : sucks in excess liquidity done to control inflation,
  • Credit Policy :
    • part of MP ==at what rate credit is advanced by banks== Contractionary MP aims to reduce prices, expansionary makes more money available at cheaper rates
  • MP was earlier announced twice a year but ==Urjit Patel #committee recommended bi-monthly Monetary Policy statements== which is now in effect

Monetary Policy Committee MPC

Section titled “Monetary Policy Committee MPC”
  • Created in 2016 by the MP Framework Agreement of 2015. It is an ==agreement b/w Gov and RBI for price stability through inflation targeting==
  • Primary objective of price stability keeping in mind gowth and complexity of economy
  • ==6 mem panel headed by RBI Gov==, 3 independent mem selected by GOI for 4 yr period, fixes rates like Repo
  • Central Gov to fix inflation target once in 5 yrs
  • decision taken through voting

Instruments of Monetary Policy - Quantitative and Qualitative Tools

Section titled “Instruments of Monetary Policy - Quantitative and Qualitative Tools”

![[Pasted image 20220219181328.png |600]]

Quantitative Tools

1. Repo

Section titled “1. Repo”
  • ready forward contract, RBI lends to Banks, used for managing supply
  • agreement of repurchase is also signed ie RBI would buy them back at somepoint in future
  • ==is the policy rate now it replaced bank rate==
  • signals the financial institutions to change their lending and borrowing rates
  • open only for specific duration in the day.
  • Long term Repo

2. Reverse Repo

Section titled “2. Reverse Repo”
  • Interest given by RBI to Banks who offer short term loans to it. Used by banks to park their surplus.
  • ==RBI borrows from market== to absorb excess liquidity, is lower than Repo
  • only done in securities approved by RBI

3. Statutory Liquidity Ratio SLR

Section titled “3. Statutory Liquidity Ratio SLR”
  • portion of fixed deposits and demand liabilities kept in cash, securitiesv (Dated Securities of GOI, Treasury Bill and State Development Loans), gold, excess CRR balance.
  • Controls expansion of bank credit, ensures solvency etc.
  • Long term tool.

4.Cash Reserve Ratio CRR

Section titled “4.Cash Reserve Ratio CRR”
  • portion of deposits (Demand ie Current and Savings Account and Time deposits ie Fixed and Recurring) bank should keep with RBI in cash form.
  • no interest is earned on them, no upper and lower limit.
  • 90% of CRR req on daily basis, 100% of CRR on fortnight.
  • Short term tool used in serious circumstances.

5. Marginal Standing Facility MSF

Section titled “5. Marginal Standing Facility MSF”
  • ==more liquidity available at higher rate of interest aka penal rate==
  • when LAF is exhausted, done for overnight borrowings when SLR limit is breached
  • before this role was done by Bank rate
  • Bank rate : rate at which commercial banks can borrow from RBI w/o providing any security. It now acts as a penal rate.
  • ==RRBs can now access MSF==

6. Call Money Market1

Section titled “6. Call Money Market1”
  • [[006 Finanacial Market - Money and Capital Market#5 Call Money aka Notice Money |Call Money]]
  • Participants in Call Money market include Schedule Commercial banks SCBs excluding Rural banks, Cooperative Banks other than Land Development Banks, Insurance.
  • Prudential Limits in borrowing and lending transaction are specified by RBI.
  • Under call money market funds are transacted for overnight and under notice money market funds are transacted for period of 2-14 days.
  • Used to meet short term liquidity shortage.
  • Borrowers include SCBs, Cooperative Banks and Primary Dealers PDs and Lenders include SCBs, Cooperative banks, Primary Dealer PDs, Select AIFIs, Select Insurance Companies, Select Mutual Funds.

7. Liquidity Adjustment Facility LAF

Section titled “7. Liquidity Adjustment Facility LAF”
  • Tool for monetary policy control that allows banks to borrow money through Repos.
  • used to meet daily mismatches, min credit limit is 5cr
  • For SCBs excluding RRBs ==Now RRBs can access LAF and MSF== and Primary Dealers for them to park their excess fund with RBI on an overnight basis against collateral of Govt securities.
  • Under LAF banks are permitted to borrow only a certain % of its NDTL if it requires then if should do it through [[#5 Marginal Standing Facility MSF|Marginal Standing Facility]].
  • Certain Scheduled Urban Cooperatives can also use LAF but they need to have min CRAR of 9% and are Core Banking System CBS enabled.

8. Uniform External Benchmark

Section titled “8. Uniform External Benchmark”
  • all new floating personal/retail/MSME loans linked to 1 of the 4 benchmarks of RBI it Repo, 91 day T Bill, 182 day T-Bill, other benchmark of FBIL

FBIL : Financial Benchmarks India Pvt Ltd under Companies Act 2013, independent benchmark administrator

Reserve Requirements : fraction of total deposits it is not lent to public

9. LCR Liquidity Coverage Ratio LCR

Section titled “9. LCR Liquidity Coverage Ratio LCR”
  • The liquidity coverage ratio is the requirement whereby banks must hold an amount of high-quality liquid assets that’s enough to fund cash outflows for 30 days.
  • Liquidity ratios are similar to the LCR in that they measure a company’s ability to meet its short-term financial obligations.
  • promotes short term resilience, no upper and lower limit
  • ensure sufficient High Quality Liquid assets to survive stress for 30 days

10. Incremental CRR

Section titled “10. Incremental CRR”
  • special CRR rates eg post demonetisation
  • 100% incremental CRR for deposits for rest it was 4%

11. Standing Deposit Facility SDFS

Section titled “11. Standing Deposit Facility SDFS”
  • allows ==banks with extra liquidity to deposit it with RBI and get interest worth reverse repo==
  • to address surge in capital inflows. RBI pays an interest rate on it.
  • it is an imp tool to suck out excess liquidity from the economy
  • Recommended by Urjit Patel and does not require collateral for liquidity absorption.

12. OMO

Section titled “12. OMO”
  • purchase and sale of gov securities
  • ==does not change the total stock of gov security== #important
  • RBI carries it through Commercial Banks

2 Kinds of OMO are

  • Outright Purchase PEMO : permanent
  • Repurchase Agreement REPO : short term

Qualitative Tool Aka Selective Credit Control

Section titled “Qualitative Tool Aka Selective Credit Control”
  • do not change quantum of liquidity, RBI directs the usage of bank credit so it changes how much is available to a particular sector
  • Directives to banks
  • Credit Authorisation Scheme : discontinued in 1982 aim was to watch flow of credit to the borrowers closely and also ensure that commercial banks are lending loans of large amount as per the credit appraisal and actual requirement of the borrower.
  • Publicity
  • Margin Requirement : money kept aside whenever banks lend to a specific sector.
    • ==high MR decreases credit flow to that particular sector==
    • lowered to inc credit flow
  • Rationing of Credit : ==Maximum limit to loans, advance that can be made to a particular sector==,
    • done to check credit flow
  • Moral Suasion : changing behaviour of banks to adhere to policy ex through closed door meetings, severity of inspections, appeals etc.

Other Definitions

Section titled “Other Definitions”

Base Rate

Section titled “Base Rate”
  • SCBs cannot lend below this rate except by RBI authorisation
  • Marginal Cost of Fund based Lending Rate MCLR replaced it in 2016
  • quicker transmission of RBI rate cuts it is determined internally by bank
  • Development of Base rate. Prime Lending Rate -> Benchmark prime Lending Rate BPLR in 2003 -> Base rate in 2010.

Market Stabilisation Bonds

Section titled “Market Stabilisation Bonds”
  • to counter the excess foreign money coming in and being converted into Rupees, absorbs it aka sterilisation but sterilisation is done with Govt securities whereas MSS bonds were specially devised.
  • Special bonds floated by RBI on behalf of the govt for purpose of absorbing excess liquidity.
  • Mostly shorter tenure bonds less than 6 months in maturity but can differ.
  • MSS bonds are issued by way of auctions and are very similar to T Bills/ Dated securities
  • They earn a return and qualify for SLR that banks need to maintain in form of short tenured treasury bills and govt bonds.
  • Was first started in 2004.

Interest Rate and Their Importance

Section titled “Interest Rate and Their Importance”
  • rate that is charged by lender on his lendings to the borrower. It is a percentage of the principal. #concept
  • Increased interest rate leads to inc borrowing cost.
  • inflation, need for growth, promotion of savings, Govs need to borrow drive changes in it
  • no longer regulated depends on market conditions but Repo, CRR can influence it
  • Floating rates are linked to an underlying benchmark ex Gsecs; Fixed cannot be change both together is called flexible
  • Negative interest rates :
    • to spur demand, revive economy in advanced economies, prevent currency appreciation
    • ==excess reserves of banks parked w/ Central banks are charged==
    • makes lending of banks cheaper pushing IR down

Inflation Targeting

Section titled “Inflation Targeting”
  • by 2016 amendment to RBI 1934 Act
  • Gov sets target in consultation w/ RBI as a percent of [[006 Inflation#CPI |CPI]]
  • agreed on by RBI and Gov to keep it in a fixed range it requires convergence of fiscal and monetary policy
  • Urjit Patel #Committee 2014
    • to exmine monetary policy framework
    • suggested to use CPI for deciding policy changes
    • inflation target of 2-6%

Liquidity Trap :

Section titled “Liquidity Trap :”
  • It is a situation where interest rates are very low and savings rates are high renderinng monetary policy as ineffective.
  • It is caused when people hoard cash because they expect adverse event ex deflation, insufficient aggregate demand, or war.
  • ==interest rates and reserve requirements are lowered to stimulate demand but it is not impacted, happens during recession to avoid this QE is attempted==
  • interest rate becomes so low that people prefer to hold cash instead of depositing

Quantitative Easing

Section titled “Quantitative Easing”
  • central bank buys fin instruments that are normally not accepted, print fresh money to buy them as well as de risking lending rates and supply of money

Taper Tantrum

Section titled “Taper Tantrum”
  • QE is a short term solution its continuation leads to creation of asset bubbles, closing it in phases is called Tapering
  • During Tapering rates become dearer and investors find other places to invest their money in, also leads to selling of stocks and bonds
  • when QE ends it also ends foreign currency coming into India implicating the Forex reserves, exchange rate
  • These are called Taper tantrums

Financial Dev and Stability Council FSDC

Section titled “Financial Dev and Stability Council FSDC”
  • non statutory council under Mo Finance. Raghuram Rajan #committee 2008 recom it.
  • strengthen, institutionalise mechanism of maintaining fin stability
  • Mo Finance is Chair and mem are heads of all Financial sector regulators viz RBI, SEBI, PFRDA, IRDA other mem are Finance Secy, Secy of DEA etc
  • FSDC Sub committee is headed by RBI Governor
  • Deals w/ Fin Stability, Fin sector dev, inter regulatory co-ordination, Fin literace etc
  • Not a statutory body

Financial Stability Board FSB

Section titled “Financial Stability Board FSB”
  • International body
  • estd under G20 after the 2009 London Summit
  • has 68 mem, had no legal norm its charter is informal and non binding
  • bring together various stakeholders to improve fin stability

Monetary Transmission

Section titled “Monetary Transmission”
  • Process by which a central banks monetary policy signals are passed on via the financial system to influence firms and households is known as monetary transmission.
  • It reflects in the areas such as money market rates, bond yields, bank deposits, lending rates and asset prices such as stock prices and house prices.
  • Recently, monetary transmission has been weak on 3 accounts Rate structure, Quantity of Credit and Term Structure.
    • Rate Structure : Weighted Average lending rate WALR of SCBs have not declined despite reduction in repo rate. Credit spread (difference b/w repo rate and WALR) was the highest level in this decade.
    • Term Structure : Term structure of interest rates means the yield curve. It shows the interest rates of similar quality bonds at different maturities. It reflects the expectation of market participants about future changes in interest rates and their assessment of monetary policy condition.
      • Cut in policy rate had some impact on short term interest rate that fell but had negligible impact impact in the long-term securities market.
      • To decrease the long term interest rate RBI purchased long term Gsecs and sold short terms aka Operation twist which led in significant fall in long term rates.
    • Credit Growth : it has been declining despite a decrease in policy rates. This fall was led by services sector and MSMEs.
Section titled “Trends in Monetary Policy Management”

Prelims PYQ

Section titled “Prelims PYQ”

![[Pasted image 20220107125714.png]]

![[Pasted image 20220107125728.png]] ![[Pasted image 20220107125739.png]]

![[Pasted image 20220107125752.png]]

![[Pasted image 20220107125803.png]]

Footnotes

Section titled “Footnotes”

  1. https://rbi.org.in/scripts/NotificationUser.aspx?Id=1752&Mode=0 ↩