Wednesday, 26 February 2025

Economy CA

1. BANKING AND MONETARY POLICY

1.1. MONETARY POLICY OF RBI

It is a set of actions available to a nation's central bank (RBI in India) to achieve sustainable
economic growth and maintain price stability by controlling the money supply and
in uencing interest rates.

Monetary policy transmission is the process by which changes in the RBI's key policy rates
(like the repo rate, which is the rate at which banks borrow money from the RBI) in uence
interest rates for loans, savings, and investments in the economy.

The RBI Act of 1934 (amended in 2016) gives the legal authority to the RBI to control
monetary policy in India.

The Central Government, in consultation with the RBI, decides on an in ation target based
on the Consumer Price Index (CPI), which measures the average change in prices of goods
and services people buy.

• Flexible In ation Targeting: This means that the in ation target is set, but there is
some exibility. The current target is 4% in ation, with a range of +/- 2%. This
means in ation can be between 2% and 6% without breaching the target. This
system is in place until March 2026.

Types of Tools of Monetary Policy:

1. Quantitative Tools

•Known as: General tools of monetary policy (MP).

•Nature: Indirect in nature; they affect the overall credit supply and money ow in the
economy.
Examples:

1. Open Market Operations (OMO): Buying and selling of government securities to

regulate the money supply.
2. Bank Rate: The rate at which the RBI lends money to commercial banks. Increasing
or decreasing this rate impacts lending behaviour.
3. Cash Reserve Ratio (CRR): The minimum percentage of a bank’s deposits that must
be kept with the RBI. Higher CRR limits banks’ lending capacity.

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 4. Statutory Liquidity Ratio (SLR): The percentage of commercial banks' net demand
and time liabilities they must maintain in the form of liquid assets (e.g., government
securities).
5. Marginal Standing Facility (MSF): A facility that allows banks to borrow from the
RBI in emergencies at a rate higher than the repo rate.
6. Liquidity Adjustment Facility (LAF): Includes both the Repo Rate (where RBI
lends to banks) and the Reverse Repo Rate (where RBI borrows from banks),
affecting liquidity in the banking system.

2. Qualitative Tools

•Known as: Selective instruments of RBI’s monetary policy.

•Nature: Directly affect the distribution and direction of credit to speci c sectors or
purposes.
• Purpose: To control where and how credit is used, targeting speci c sectors of the
economy.
Examples:

1. Rationing of Credit: Imposing limits on the amount of credit banks can lend to
certain sectors.
2. Regulation of Credit for Consumption Purposes: Restricting credit for non-
productive or consumption-based purposes (e.g., luxury goods).
3. Variation of Margin Requirements: Setting the minimum amount of down payment
required for loans, to control excessive borrowing.
4. Moral Suasion: Persuading or urging banks to adopt speci c lending policies, usually
to in uence sectors with high risk or to prioritize growth in certain areas (e.g.,
agriculture).
5. Direct Action: The RBI takes direct action against banks that fail to follow
regulations, such as imposing penalties or restricting their lending abilities.

Sterilization by RBI:

Sterilization refers to the process used by the Reserve Bank of India (RBI) to manage excess
liquidity in the economy. The goal is to stabilize in ation and minimize uctuations in the
currency exchange rate, particularly when there is an in ux of foreign capital or other factors
that lead to excess money supply.

Tools Used for Sterilization:

1. Open Market Operations (OMOs)
2. Cash Reserve Ratio (CRR)
3. Market Stabilization Scheme (MSS):
◦ What it is: A speci c tool used to absorb excess liquidity in the system by
issuing government securities.

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 ◦
How it helps: MSS helps sterilize the excess liquidity created by RBI's
foreign exchange interventions, ensuring that it does not lead to in ation or
destabilize the currency.
By using these tools, the RBI ensures that the economy maintains price stability and avoids
undue uctuations in the value of the Indian Rupee.

Types of Monetary Policy

1. Expansionary Monetary Policy

• Purpose: To stimulate economic growth by increasing the money supply and

lowering interest rates.

• Key Features:

◦Lower interest rates: Makes borrowing cheaper for businesses and

individuals.
◦ Increased borrowing: Businesses and individuals borrow more, which boosts
demand and investment.
◦ Boost to liquidity: Increases money supply, consumption, and capital ow,
stimulating economic activity.
◦ Effects on economy: Leads to higher in ation, increased aggregate demand,
higher investment, and increased output.
• RBI Actions:

◦
Buying Government Securities (G-Secs): Through Open Market
Operations (OMOs), the RBI buys government securities, injecting money
into the banking system.
◦ Reducing CRR, SLR, Repo Rate, Reverse Repo Rate, and Bank Rate:
These actions increase the amount of money available for lending and reduce
the cost of borrowing, stimulating economic activity.
2. Contractionary Monetary Policy

• Purpose: To control in ation and stabilize the economy by reducing the money
supply.

• Key Features:

◦Higher interest rates: Makes borrowing more expensive for businesses and
individuals.
◦ Reduced borrowing: Businesses and individuals are less likely to borrow,
leading to decreased consumption and investment.
◦ Decrease in liquidity: Reduces money supply, consumption, and investment,
cooling down in ationary pressures.
◦ Effects on economy: Leads to lower in ation, reduced demand, and may
result in higher unemployment due to reduced business activity.
• RBI Actions:

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 ◦ Selling Government Securities (G-Secs): Through Open Market
Operations (OMOs), the RBI sells government securities, taking money out
of circulation.
◦ Increasing CRR, SLR, Repo Rate, Reverse Repo Rate, and Bank Rate:
These actions reduce the amount of money available for lending, increase
borrowing costs, and slow down economic activity.
Monetary Policy Committee (MPC)

The Monetary Policy Committee (MPC) was constituted under Section 45ZB of the RBI
Act, 1934 (amended in 2016). This amendment empowers the Central Government to form
the MPC to guide the formulation of India's monetary policy.

The primary objective of the MPC is to maintain price stability while simultaneously
supporting the growth of the economy. Price stability refers to controlling in ation within a
target range, ensuring that in ation does not rise too high or fall too low.

The MPC consists of 6 members:

1. Governor of RBI (Ex-of cio chairperson)

2. Deputy Governor of RBI (in charge of monetary policy)
3. Three external members appointed by the Central Government, based on their
expertise in economics, banking, and nance.
4. One government representative (usually from the Ministry of Finance).

• Each member of the MPC has one vote.

• The Governor of RBI has a casting vote in case of a tie (if there is a 3-3 split among
the members).
• The MPC meets at least four times a year to review and make decisions on monetary
policy.
• These meetings are typically held every two months.
• The quorum for a meeting is 4 members.

The Reserve Bank of India (RBI) recently injected ₹25,000 crore into the banking system
using the Variable Rate Repo (VRR) tool to address a liquidity de cit. This means that
there wasn't enough money circulating in the banks, so the RBI stepped in to help by lending
money to banks to ensure that there’s enough liquidity for the smooth functioning of the
economy.

What is Variable Rate Repo (VRR)?

The Variable Rate Repo (VRR) is a tool used by the RBI to inject short-term liquidity into
the banking system. Here's how it works:

• The VRR is a market-determined rate. This means the rate at which banks can borrow
money from the RBI under VRR is decided by the market conditions but is typically
lower than the standard Repo Rate (but never below the Reverse Repo Rate).

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 • Duration: It applies to loans with a term of more than one day, usually up to 14 days.
• Why VRR?: If banks are hesitant to borrow at the standard Repo Rate (which is set
by the RBI’s Monetary Policy Committee) because market interest rates are lower, the
RBI offers the Variable Rate Repo as an alternative. This makes borrowing cheaper
or more attractive for the banks during times of tight liquidity.

• Repo Rate: The rate at which banks borrow money from the RBI, xed by the RBI’s
Monetary Policy Committee. It’s a primary tool for controlling in ation and liquidity
in the economy.
• VRR: A more exible rate for short-term borrowing when banks need liquidity, but
are reluctant to borrow at the higher Repo Rate.
Just like the VRR injects liquidity into the banking system, the Variable Rate Reverse Repo
(VRRR) is used to absorbexcess liquidity. If there is too much money in the system, the RBI
uses VRRR to withdraw some of that excess money, ensuring the economy doesn’t overheat
and in ation doesn’t rise too quickly.

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