Question

What are the instruments of monetary policy of RBI? How does RBI stabilize money supply against exogenous shocks?

Answer 1

The monetary policy (credit policy) of RBI involves the two instruments given in the flow chart below:

Quantitative Measures

Quantitative measures refer to those measures that affect the variables, which in turn affect the overall money supply in the economy.

Instruments of quantitative measures:

1. Bank rate − The rate at which central bank provides loan to commercial banks is called bank rate. This instrument is a key at the hands of RBI to control the money supply.

Increase in the bank rate will make the loans more expensive for the commercial banks; thereby, pressurising the banks to increase the rate of lending. The public capacity to take credit will gradually fall leading to the fall in the volume of credit demanded. The reverse happens in case of a decrease in the bank rate. The increased lending capacity of banks as well as increased public demand for credit will automatically lead to a rise in the volume of credit.

2. Varying reserve ratios

The reserve ratio determines the reserve requirements, wherein banks are liable to maintain reserves with the central bank.

The three main ratios are:

(i) Cash Reserve Ratio (CRR)

It refers to the minimum amount of funds that a commercial bank has to maintain with the Reserve Bank of India, in the form of deposits. For example, suppose the total assets of a bank are worth Rs.200 crores and the minimum cash reserve ratio is 10%. Then the amount that the commercial bank has to maintain with RBI is Rs.20 crores. If this ratio rises to 20%, then the reserve with RBI increases to Rs.40 crores. Thus, less money will be left with the commercial bank for lending. This will eventually lead to considerable decrease in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.

(ii) Statuary Liquidity Ratio (SLR)

SLR is concerned with maintaining the minimum reserve of assets with RBI, whereas the cash reserve ratio is concerned with maintaining cash balance (reserve) with RBI. So, SLR is defined as the minimum percentage of assets to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit is reduced by increasing this liquidity ratio and vice-versa. In the previous example, this can be understood as rise in SLR will restrict the banks to pump money in the economy, thereby contributing towards decrease in money supply. The reverse case happens if there is a fall in SLR, as it increases the money supply in the economy.

3. Open Market Operations (OMO)

Open Market operations refer to the buying and selling of securities in an open market, in order to affect the money supply in the economy. The selling of securities by RBI will wipe out the extra cash balance from the economy, thereby limiting the money supply, whereas in the case of buying securities by RBI, additional money is pumped into the economy stimulating the money supply.

Qualtative Measures

The measures that affect the credit qualitatively are

1. Marginal Requirements

The commercial banks’ function to grant loan rests upon the value of security being mortgaged. So, the banks keep a margin, which is the difference between the market value of security and the loan value. For example, a commercial bank grants loan of Rs.80,000 against security of Rs.1,00,000. So, the margin is calculated as 1,00,000 − 80,000 = 20,000. When the central bank decides to restrict the flow of money, then the margin requirement of loan is raised and vice-versa in the case of expansionary credit policy.

2. Selective Credit Control (SCC’s)

An instrument of the monetary policy that affects the flow of credit to particular sectors positively and negatively is known as selective credit control. The positive aspect is concerned with the increased flow of credit to the priority sectors. However, the negative aspect is concerned with the measures to restrict credit to a particular sector.

3. Moral Suasions

A persuasion technique followed by the central bank to pressurise the commercial banks to abide by the monetary policy is termed as moral suasion. This involves meetings, seminars, speeches and discussions, which explains the present economic scenario and thereby persuading the commercial banks to adapt the changes needed. In other words, this is an unofficial monetary policy that exercises the power of talk.