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BANKING AND MONETARY POLICY — Economics STD 12 Commerce — Question

Gujarat BoardEnglish MediumSTD 12 CommerceEconomicsBANKING AND MONETARY POLICY5 Marks
Question
Explain In detail Quantitative instruments of $RBI's$ monetary policy.
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Answer

$1.$ Introduction:
  • Monetary policy is the policy which regulates the demand for money and supply of money in the economy.
  • In India, $\text{RBI}$ maintains the stability with development in country and control the monetary supply by monetary policy.
  • To implement all this, there are two types of instruments:
$(a)$ Quantitative instrument
$(b)$ Qualitative instrument.
$2.$ Quantitative Measures of Monetary Policy:
  • Reserve Banks quantitative credit control instruments has same effect on all types of credit.
  • So these instruments are also known as General measures.
  • These instruments are also known as quantitative instruments of Reserve Bank used for credit control which are as follows:
$(1)$ Bank Rate:
  • When commercial banks face shortage of funds then they borrow funds on credit from $\text{RBI}$.
  • The rate at which $\text{RBI}$ lends money to the commercial banks for long term is called Bank rate.
  • $\text{RBI}$ gives credit to commercial bank on the security.
  • Generally, when the economy is under the grip of inflation, bank rate is increased to control inflation.
  • During the time of deflation, bank rate is decreased.
  • To control the inflation, bank rate is increased, so commercial Bank has to pay more rate of interest to $\text{RBI}$. Commercial Banks for this reason increases the bank rate.
  • General public has to take credit loans from commercial banks at high rate of interest.
  • So general public reduce to take credit loans from commercial banks, by this supply of money reduces.
  • So the rate of inflation is controlled by such policy.
  • During the first four decades of planning in India, bank rate instruments were used more.
  • For e.g. In $1953,$ Bank rate was $3.5\%$ in $1991$ it was $12\%. \text{RBI}$ avoided to use bank rate from last decade.
  • During this period to control supply of money, instead of bank rate, repo rate and reverse repo rate were used. Bank rate is a long term rate.
  • Bank rates are stable for long period of time. In $2016,$ the bank rate was $7\%.$
$(2)$ Repo Rate and Reverse Repo Rate:
  • When commercial bank face shortage of funds, they take short term funds from $\text{RBI}$ for $1$ day, $7$ days or $15$ days by selling the securities which are held with $\text{RBI}$ and repurchase it at a particular rate.
  • This rate is called Repo rate.
  • During inflation, $\text{RBI}$ had increases repo rate, so that commercial bank had borrow less credit, and general public gets credit at higher rate.
  • In an economy, money supply decreases and inflation is controlled.
  • While during deflation Reserve Bank decreases repo rate, increases banks credit, increases money supply and try to control deflation.
  • When $\text{RBI}$ needs short term funds they sell government securities to commercial banks for short term period of and repurchases it at given rate.
  • It is called Reverse Repo Rate.
  • If reverse repo rate is high, commercial banks are getting more to give credit to $\text{RBI}$, so there is decrease in lending incentives to general public and ultimately money supply decreases and inflation is controlled .
  • In Opposite way during deflation when $\text{RBI}$ decreases reverse repo rate, which decrease in supply of credit for general public and money supply increases deflation will be controlled.
  • Following is the situation of Repo and Reverse Repo Rate in last few years:
Year Repo Rate$($In$\%)$ Reverse Repo Rate $($in$\%)$
January, $2016$ $6.50\%$ $5.50\%$
March, $2010$ $5\%$ $3.50\%$
April, $2016$ $6.5\%$ $6.00\%$
  • In general sense, Reverse Repo rate is less than Repo rate.
  • To maintain the monetary liquidity and to control big changes in call money rate ,such instruments are used.
$(3)$ Marginal Standing Facility $\text{(MSF):}$
  • $MSF$ is a situation of distress emergency when $\text{RBI}$ gives credit to commercial banks for maintaining its stability. During acute cash shortage banks borrow money from $\text{RBI}$ against approved government securities.
  • This rate is higher than Repo Rate.
  • For E.g. In $2016$, this rate was $7\%$ and Repo rate was $6.5\%.$
$(4)$ Cash Reserve Ratio $(\text{CRR}):$
  • All the commercial banks have to keep certain minimum cash reserves with the $\text{RBI}$.
  • Its main objective is that there should be sufficient cash balances with all commercial banks.
  • $CRR$ fulfils the need of comfortable amount of cash reverses, in case of many customers start withdrawing their deposits and banks have to provide cash against their deposits.
  • By using such instrument Resever bank affects on credit policy of commercial banks This instrument is used to control inflation.
  • During inflation, central bank increases cash reserve ratio.
  • Credit creation capacity of all banks reduces supply of money reduce inflation and by this credit facility also decreases.
  • Under the $\text{RBI}$ Act $1934,$ all commercial banks have to keep minimum cash reverses with the $\text{RBI}$.
  • Initially during the time of independence, $\text{CRR}$ was decided to be $5\%$ of demand deposit and $2\%$ was of time deposits, since $1962$ such difference in deposit was removed.
  • If $\text{RBI}$ has to follow inflationary monetary policy, $\text{CRR}$ will increase, if deflationary monetary policy, $\text{CRR}$ will decrease.
$(5)$ Statutory Liquidity Ratio $\text{(SLR):}$
  • Under the 'Banking Regulation Act' all the commercial bank apart from and in addition to $\text{CRR}$ they have to keep total percentage of deposits in the form of Cash, Gold, Government securities, etc.
  • That is called Statutory Liquidity Ratio.
  • In India $25\% \text{SLR}$ is there on total deposits.
  • If commercial banks do not agree upon the $\text{SLR}$ fixed by $\text{RBI}$ than $\text{RBI}$ takes higher bank rate from such to fulfills the criteria.
  • $\text{SLR}$ decrease the capacity of banks to give loans and advances.
  • If the rate of $\text{SLR}$ is more it diverts bank funds from loans and advances to approved government securities.
  • It helps to meet government expenditures.
  • Such type of investment reduces.
  • The blow investment for private sector opposite happen, if rate of $\text{SLR}$ is less than credit for government sector decreases and private sector increases.
  • For this reason, individuals get more credit facility.
  • By $\text{SLR}$, the reliability of banks also rises as a result finances became less risky.
$(6)$ Open Market Operations:
  • Open Market Operations refer to the buy and sale of government securities by the Resever bank in the open market.
  • When $\text{RBI}$ sells government securities the supply of money reduces in an economy and when it purchases government securities the supply of money increases.
  • This type of instrument $\text{RBI}$ uses to control the inflation or deflation situation.
  • During Inflation, $\text{RBI}$ sells off the government securities to banks and general people.
  • So there is reduction in supply of money, during deflation $\text{RBI}$ purchases its government securities, increase the money supply.
  • Open Market operations of buying selling government securities policy affect the monetary supply in an economy. Before $1991,$ this instrument was not used in India as such market of buying and selling of government securities was not developed.
$(7)$ Sterilization Policy:
  • Generally, when there is excessive inflow of foreign exchange in India, the economic balance of the country is disrupted.
  • To make such situation in control $\text{RBI}$ buys sells its government securities equal to the amount of inflow of foreign exchange.
  • Thus, it sterilizes its balance sheet.
  • So that there is monetary balance.
  • This policy of $\text{RBI}$ is known as Sterilization policy.

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