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Tools of Monetary Policy

Tools of Monetary Policy are as follows:

REPO RATE (Tools of Monetary Policy)

• Repo rate (rate of repurchase) refers to the interest rate at which the RBI provides short-term liquidity to banks against the collateral of government securities. 

• Increase in repo rate → borrowing from RBI expensive → banks will borrow less from RBI → less credit will be provided by banks to households→ money supply will decrease. 

• Decrease in Repo Rate→ Borrowing from RBI is cheaper→ Banks will borrow more→ More credit is available→ Money supply will increase 

►REVERSE REPO RATE

• Reverse repo rate is the rate at which the RBI borrows money from commercial banks against collateral of eligible government securities. 

• An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market. 

• A decrease in reverse repo rate means that commercial banks will get less incentive to park their funds with RBI and thus more money is available in the market increasing the money supply.

LIQUIDITY ADJUSTMENT FACILITY 

• Monetary policy instrument that the RBI uses in order to influence the liquidity conditions in the market in the short term. 

• Under the LAF window, the RBI uses various instruments to inject or absorb liquidity to or from the market respectively. 

• Repo and reverse repo rates are a part of RBI’s “Liquidity Adjustment Facility (LAF)”. 

• Depending upon the maturity period of the loans, there are different types of Repos in India. These are:

OVERNIGHT REPO AUCTIONS

Under overnight fixed repo operations the banks can borrow/park liquidity for one day from RBI at interest rate equal to repo rate/reverse repo rate pledging the government security that the banks have over and above the SLR (Statutory Liquidity Ratio) requirement. If the banks do not possess government securities beyond the SLR requirement, it cannot borrow money under the LAF window.

VARIABLE REPO AUCTIONS:

In 2013, RBI has introduced variable rate repo auctions under which banks can borrow/park money at variable repo rates decided through auctions. This instrument can be overnight or for a term. 

• If variable rate repo auction is undertaken for one day it is called overnight repo auction. 

• If it is undertaken for a term it is called term repo. 

• Term Repos: There are different types of term repos depending upon the maturity period. Some of the term repos include 7-day, 14-day, 21 day, 28-day, 56-day. 

• Interest rate on the Term repos is determined through auction and hence is usually higher than the Repo rate. 

OBJECTIVE 

• Developing the inter-bank term money market and influence market based benchmarks for pricing of loans and deposits. 

• Thus term repo helps in improving monetary policy transmission.

LONG TERM REPO OPERATIONS (LTRO) 

• New policy tool used by the RBI to inject more liquidity into the Economy. 

• Similar to the term repos, but with a longer maturity period of 1 year and 3 years. 

• Through the LTRO, the RBI seeks to inject long term liquidity into the economy at a lower interest rate. 

BASIC FEATURES

• Total Funds to be injected: Up to Rs 1 Lakh crores. 

• Interest Rate: Repo Rate. 

• Method of Operations: The LTROs would be carried out through e-Kuber

• Note: e-Kuber is the Core Banking Solution of the RBI which enables each bank to connect their single current account across the country. 

OBJECTIVE 

• To inject liquidity into the economy. 

• Reduce rate of Interest on the long-term loans. 

• Incentivise the Banks to reduce their overall lending rates and improve the monetary policy transmission NOTE: Repo Rate is always higher than Reverse Repo Rate.

MARGINAL STANDING FACILITY (MSF) (Tools of Monetary Policy)

• Liquidity management window under which banks can borrow additional overnight liquidity over and above LAF window.• Introduced to deal with unforeseen liquidity crunch because under LAF banks can borrow overnight liquidity only by pledging securities over and above the securities held under SLR requirement. 

• Under MSF, on the other hand, banks can pledge securities held for SLR purposes. However the rate of interest is higher than the repo rate. (penal rate) 

►BANK RATE

• Rate at which RBI provides long-term borrowings to its clients. Its clients include GoI, state governments, banks, financial institutions, cooperative banks etc. 

• An increase in bank rate will make borrowing from RBI expensive→money supply will tend to decrease. 

►CASH RESERVE RATIO (CRR)

• CRR refers to the percentage of total deposits of a bank to be kept with RBI in the form of cash. 

• An increase in CRR→ higher proportion of deposits to be kept with RBI by banks→ less funds are available to be provided as credit to the economy→ money supply will decrease. 

►STATUTORY LIQUIDITY RATIO (SLR) 

• SLR refers to the percentage of total deposits of a bank to be kept with itself in the form of liquid assets such as cash, gold and select government securities. 

• An increase in SLR→ higher proportion of funds to be kept aside by banks in liquid form→ less funds available to be provided as credit to the economy→ money supply will decrease. 

►OPEN MARKET OPERATIONS (OMO)

• OMO refers to sale and purchase of government securities by RBI in the open market with the aim of influencing liquidity in the economy in the medium term. 

• Open market purchase by RBI→RBI will release liquidity in the economy→ money supply will increase.

Important topics Prelims

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