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Understanding Monetary Policy – By Dilshad Billimoria

July 2015

Monetary Policy

Money is a unit of measure, a medium of exchange, and has value in exchange for goods and services traded.

Monetary Policy Initially started under the Chairmanship of Sukhamoy Chakroborty to assess the functioning of the Indian Monetary System.

Monetary Policy helps in stabilising the money supply in our economy, provides for price stability, helps in identifying the growth of real output, thus leading to enhanced economic growth in our country.

Reserve Bank of India is the bank to the Government of India.

The RBI controls the money supply, frames the monetary policy, is the banker to the Government, controls liquidity in the system and controls the Foreign Exchange Management in our country.

The Reserve Bank of India (RBI) infuses liquidity in the system, by creating Reserve Money.

Since Reserve Money is a liability, RBI needs to also have assets.

RBIs assets are  Foreign Exchange Assets, Gold Deposits, Government of India Securities.

To increase liquidity, or infuse money-supply in the system, RBI prints notes and to reduce or suck out liquidity from the system, RBI buys domestic assets,  from the market via Open Market Operation and Liquidity Adjustment Facility.

RBI helps creating reserve money with banks through Cash Reserve Ratio (CRR)and Statutory liquidity ratio (SLR)

According to RBI figures, the reserve money in the economy as on March 2015 is 19.2 trillion.

As mentioned above RBI creates money in the economy through money reserves with the backing of assets. This aids in money supply in the economy.

By depositing Rs 1000 in the system, the bank reserves 10% and loans out Rs 900 to the public. The public spends the RS 900 loan or deposits Rs 900 with the bank again as Fixed Deposit. The bank in turn retains 10% reserves and loans out Rs 810. The individual spends Rs 810 or deposits the same in bank FD, and again the bank retains 10% and loans Rs 729. The individual spends RS 729 or deposits the same with the bank. The bank retains 10% reserves and loans out Rs 656.The individual spends this amount or deposits in the bank. By depositing Rs 1000 in the system, RBI has created liquidity of Rs 4095 in total. (Rs 1000+900+810+729+656)

Therefore, the total reserve money deployed, has a direct correlation to the money supply in the economy. The more the reserve money deployed, the more the money supply and this could lead to high inflation if not controlled by RBI.

Repo rate or repossession rate, is the rate at which RBI lends money to banks, in exchange for securities, and reverse repo is the rate at which banks lend to RBI.

RBI controls the Repo rate by increasing or decreasing the same, depending on money supply in the system and inflation.

A reduction in repo rate, helps banks to get more funds for use in the monetary system from the RBI.

Reverse Repo is the rate at which banks lend money to RBI. the higher the Reverse repo rate, the lesser is the money supply in the system, since banks need to park more funds with RBI.

The RBI uses this tool to reduce money supply in the system.

The tools used by RBI to control money supply are the following and the rates for each of these as on March 2015 are

  1. Repo Rate which is currently at 7.50% and Reverse repo rate which is currently at 6.50%.
  2. Statutory liquidity ratio is at 21.50%
  3. Cash Reserve Ratio is at 4%
  4. Bank rate which is currently at 6.50%
  5. Marginal Standing Facility is at 8.50% (long tenure borrowing rate)
  6. Open Market operation.

RBI reduces money supply, by increasing CRR, Repo Rate, MSF and Open Market Operations.

The reverse is done by RBI when it wants to increase the money supply in the system and increase liquidity.

Dilshad Billimoria
Director and Certified Financial Planner.
Dilzer Consultants Pvt Ltd.
SEBI Registered Investment Advisor.

Source- RBI
Franklin Templeton Learning Academy

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