[Updated on 27th Feb 2022]
The RBI’s Monetary Policy Committee (MPC) meets every two months/ bi-monthly to review its monetary policy.
[Read: The Monetary Policy Committee (MPC) Explained]
Monetary policy is the action taken by the RBI to control the amount of money supply in the economy.
RBI has several monetary policy tools at its disposal to influence the money supply. They are Repo rate, Reverse Repo rate, Liquidity Adjustment Facility (LAF), Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Marginal Standing Facility (MSF), Bank rate, Open market operations (OMO) and Marginal Stability Scheme (MSS)
Monetary Policy Tools
Repo rate
Repo rate is the rate at which a bank borrows from the RBI against the collateral of Government securities. This borrowing is on an overnight basis.
To illustrate, if a bank wants to borrow money from RBI, it sells government securities to the RBI. The bank makes an agreement with the RBI to repurchase these securities later at a predetermined rate. The interest rate charged on such borrowings is the Repo rate. The current repo rate is 4 %. It means that if a bank sells Government security to the RBI at Rs.100, it will buy back the security at Rs.104.
If this rate increases, it becomes expensive to borrow from the RBI. Therefore, banks increase their lending rates. Hence, lending activities decline. (Repo rate ↑ ⇒ money supply ↓)
Reverse repo rate
Reverse repo is the rate at which banks keep their excess funds with the RBI against the collateral of Government securities on an overnight basis. If the reverse-repo rate increases, banks find it more profitable to keep its funds with RBI. Hence, lending activities decline (Reverse repo rate ↑ ⇒ money supply ↓). The current Reverse Repo rate is 3.35%.
Liquidity adjustment facility (LAF)
It is the use of repo and reverse repo rates to control the money supply in the economy. This facility is used by the banks to adjust the day to day mismatches in liquidity.
Besides the overnight repo and reverse repo (explained earlier), RBI also uses term repo auctions to manage liquidity. (This is used when the banks need funds for relatively longer duration like 3 days, 7 days, 14 days). [You may read this article for more details on LAF- indianeconomy.net].
Cash Reserve Ratio (CRR)
It is the percentage of deposits that a bank has to keep as reserves with the RBI. When the Government increases CRR, the bank has to keep a larger percentage of its deposits as reserves. It has lesser funds available to lend. Its capacity to lend decreases. Hence, the money supply also decreases. (CRR ↑ ⇒ money supply ↓). The current CRR is 4%.
Statutory Liquidity Ratio
It is the percentage of deposits that a bank has to invest in risk-free assets such as cash, gold, or Government securities. When the Government increases SLR, the bank has to keep a larger percentage of its deposits in cash, gold, and Government securities. It has a lesser amount to lend to consumers and businesses. Hence, the money supply decreases. (SLR ↑ ⇒ money supply ↓). The current SLR is 18 %.
Marginal Standing Facility (MSF)
This is a mechanism by which Commercial banks can borrow from the RBI against Government securities for emergency needs on an overnight basis. Thus, it is similar to the Liquidity Adjustment Facility (LAF).
It is used by the banks when they need additional funds, and they cannot use LAF as they do not have Government securities to keep as collateral. In this, banks can sell Government security from its SLR quota also. The MSF rate is always higher than the Repo rate. There is a limit to the borrowings under MSF. Banks can borrow up to 1 % of their deposits under this facility. (MSF rate ↑ ⇒ money supply ↓). The current MSF rate is 4.25 %.
Bank rate
Bank rate is the rate at which RBI lends funds to the commercial banks. Unlike the repo rate, there is no repurchase agreement in the Bank rate. It is also the rate at which the RBI purchases (rediscounts) bills of exchange or commercial papers from the banks. If this rate increases, it becomes expensive to borrow from the RBI. Therefore, banks increase their lending rates. Hence, lending activities decline. (Bank rate ↑ ⇒ money supply ↓) The current bank rate is 4.25 %.
Open Market Operations (OMO)
It is the buying and selling of Government securities by the RBI. If the RBI has to increase the money supply, it purchases government securities from the market. If the RBI has to decrease the money supply, it sells Government securities in the market.
Marginal Stability Scheme (MSS)
Under MSS, if there is an excess money supply in the economy, RBI intervenes by selling Government securities (like Treasury Bills, Cash Management Bills & Dated securities.). This helps to withdraw the excess liquidity from the system. But, unlike OMO, the money raised through the selling of securities is kept in a separate account known as MSS account. The amount kept in the MSS account is only used for redemption of securities issued under the MSS. (You may read this article to learn about MSS in detail: Marginal Stability Scheme)
These are the monetary policy tools used by the Central bank. The RBI makes changes in these rates to control the money supply in the economy.
Economyria is now on Telegram. For a simplified analysis of topics related to economy/ business/ finance, subscribe to Economyria on Telegram
References:
Lol, Bank rate is not the rate at which banks borrow from RBI. It is the rate at which the central bank rediscounts the bills of exchange from the commercial bank. The rate which you have described at which the RBI actually gives any such loan to the commercial banks is the MSF rate that is a specific percentage of the total demand and time liabilities.
Bank rate is the rate at which the banks borrow from the RBI. This lending is in the form of discounting/ rediscounting the Bills.
MSF rate is also the rate at which the banks borrow from the RBI. The mechanics of borrowing is the same as that of Repo, that is, through the repurchase of securities. However, the rate is above the repo rate. Banks can borrow funds up to one percent of their net demand and time liabilities (NDTL) under MSF. It is used when the banks have exhausted all other borrowing options and need emergency funds.
Isn’t the current Repo Rate pegged at 4% and the Reverse Repo Rate at 3.35%?
Hey, you are absolutely right. This post was last updated on 10th December 2019 as mentioned at the beginning 🙂