Explained - Monetary Policy, Rep, SLR, CRR, Qualitative Tools

7/28/2014 Explained: Monetary Policy, Rep, SLR, CRR, Qualitative Tools
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcomi 1/48
Mrunal
w $ Economy | Q 150
6 months ago
[Banking] Monetary
Policy: Quantitative
& Qualitative Tools, applications &
limitations MSF, LAF, Repo, OMO, CRR,
SLR, Revisited before upcoming Urjit
Article
CSAT

1. Prol ogue
2. What i s monetary pol i cy?
3. Quanti tati ve Tool s
1. #1: Reserve Rati os (SLR and CRR)
2. #2: Open Market Operati on (OMO)
3. #3: Pol i cy Rate
4. Bank Rate
1. Li qui di ty Adj ustment faci l i ty
(LAF)
2. LAF Repo Rate
3. Margi nal Standi ng faci l i ty

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4. Reverse repo Rate
5. Repo Rate i n recent years:
4. Monetary Pol i cy: l i mi tati ons
5. Qual i tati ve Tool s
1. #1: Margi n Requi rements/ LTV
2. #2: Consumer credi t regul ati on
3. #3: Sel ecti ve credi t control
4. #4: Moral Suasi on
6. Monetary pol i cy tool s: Quanti ati ve vs
Qual i tati ve
7. Appendi x
1. #1: Why Hi gh SLR and Hi gh CRR
are bad?
2. #2: Narsi mhan (I) Commi ttee 1991
3. #3: Narsi mhan (II) Commi ttee
1998
8. Mock Questi ons
Prol ogue
Next article is about RBI appointed Urjit Patel
Committee on Monetary policy framework.
But before dwelling into that, we must recap
the basic concepts of what is monetary policy:
its tools and limitations. Otherwise Urjit wont
make much sense.
Hence in a way, this whole article is a prologue
to next article.
Why RBI and Why Monetary policy?
Initially people used barter system for trading. But
the barter system had many problems (cl i ck me).
Vajiram and ravi two
teachers are there. one
from Hyderabad , who will
be covering 20% of
syllabus. as she has her... }
[Strategy]
Anthropol ogy Study-
pl an and Bookl i st by
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examination follows a
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MOHIB { So the best
thing the government
Therefore, people switched to money system.
Fi nanci al i ntermedi ates = middlemen who
help in the circular flow of money between
households and business firms.
There are two types of financial
intermediaries: banking institution and non-
banking financial institutions.
RBI controls (all) banks and (some) non-
banking financial institutions.
RBIs main job is to control Money supply in
this game, and thereby fight inflation and
deflation.
Inflation = price rise = bad for economy, you
know that by common sense.
But Defl ati on = price decrease = we can buy
things at a lower price. Isnt that good? Why is
deflation bad for economy?
Ans. Every business has fixed cost of
production say minimum light bill, phone bill,
office rent, staff salary etc. So, if prices keep
falling and falling (say of Nano car), then car
marker will suffer losses. He has no
motivation to expand business. He wants to
cut down his production costs, by firing some
of the employees= less new jobs created=
unemployment = social unrest.
If prices of everything fall- then custom duty,
VAT, excise duty, service tax- their collection
will also decrease. Then government has less
money to spend on education, healthcare,
social sector, defense, law and order = poverty,
disease, crime.
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Subj ect Paper 1 &...
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by the way
TERM meaning
Does
RBI
want it?
DEFLATION
fall in the prices (and fall
IN employment.)
No.
DISINFLATION
Fall in the prices but
without causing
unemployment.
yes
(while
fighting
inflation)
STAGFLATION
stagnation + inflation
prices and wages rise
but people cant find
jobs, companies cant
find customers.
No
REFLATION
policy to stop the fall in
price levels, but without
causing rise in the price
levels (inflation).
yes
What i s monetary pol i cy?
Policy made by the central bank.
To control money supply in the economy. (and
thereby fight both inflation and deflation).
RBI implements monetary policy using certain
tools. Two types
quantitative tool qualitative tools
Lets start from here.
matter...upsc h na iss isaue
ko solve krne k lie }
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Quanti tati ve Tool s
#1: Reserve Ratios (SLR and CRR)
SLR
A Bank has to set aside this much money
into gold or RBI approved securities.
23%
CRR
A Bank has to set aside this much as
reserve. Bank cannot lend it to anyone.
Bank earns no interest rate or profit on
this.
4%
Reserve ratio: SLR, CRR
Suppose economy is showing inflationary
trend. Prices of all goods and services are
increasing day by day.
How can RBI stop it using Reserve ratio as a
tool?
In this case, RBI should RAISE the reserve
ratios.
Observe:
Right
now
People deposited total this much money in
SBI (net demand & TIME liabilities NDTL)
100 cr.
CRR (4%) [SBI has to keep this much cash
aside for reserve]
-4 cr
SLR (23%) [SBI has to invest this much
money in RBI approved securities]
-23 cr.
Money left with SBI
100-4-
23=73
Cores.
change...
RECRUITMENT
Ex am Dat es
IBPS:11 Oct to 2 Nov
SSC-CGL 2014:19 & 26 Oct
CAT:16 & 22 Nov
CDS:26 Oct
MAT: 7 & 13 Sep
Hal l t i c k et s
upl oaded?
CSAT-2014: YES
RBI Offi cer: YES
UPPSC: YES
Bank i ng
11-Aug: IBPS 2014
06-Aug: RBI Assistants
30-Jul : Indian Bank Specialist
On 2 0 1 3 RRB s c or e
19-Aug: Baroda Gramin
MBA
23-Aug: MAT-2014
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14-Aug: I RCON Civil 20
Say RBI raises SRL to 40% and CRR to 15% then?
Originally 100 cr
SLR 40 -40
CRR 15 -15
Money left with SBI 45 cr.
You can see, when Rajan has raised reserve ratio,
money with SBI is reduced (from 73 crores to just
45 crores.)
What will be its implication?
Imagine youre a money lender. Youve 100
crore rupees and you must make Rs.1 crore
profit in a year.
Obviously, you should lend it @1% interest
rate. (because 1% of 100 crore = 1 crore.)
But what if youve only 2 crore rupees, and you
still want to make Rs.1 croer profit in a year?
Now you must lend it @50% interest rate.
(because 50% of 2 cores = 1 crore.)
Observe that as money decreased (from 100 to
2), loan interest rate increased (from 1% to
50%).
Same happens when SBI is left with less money
(after RBI increases reserve ratio).
Lets prepare a flow chart.
Si tuati on: Economy has inflationary trend. Prices
of goods and services increasing every day.
Sol uti on: RBI raised reserve ratio (CRR, SLR)
07-Aug: Delhi Elect rical 50
(2yrXP)
06-Aug: Oil I ndia direct
int erview
01-Aug: MECL: Asst.manager
Pol i c e/ Def enc e/ I nt el .
01-Sep: Army Vet s
31-Aug: Army Dental
29-Aug: Chandigarh Constbl
19-Aug: Hindi Translator ITBP
18-Aug: CDS (I I )
09-Aug: Airforce
Met eorological
08-Aug: Army NCC ent ry
05-Aug: Navy UES
05-Aug: BSF Subinsp.
02-Aug: CISF
constables(1203)
31-Jul : ITBP sub-insp
Spec i al i s t
Ent r anc e
19-Aug: CSIR NET
04-Aug: CBSE CTET
BCom/ HR/ MBA
01-Sep: I CAR account ,
admin
30-Aug: Accountant NIFFT
Ranchi
25-Aug: CPET Chennai
25-Aug: EI L Delhi
11-Aug: SBI Mgmt .XO (2-5
yrXP)
31-Jul : HUDA account
31-Jul : UPSC Specialists
various
Medi c al / Al l i ed
19-Aug: Haryana Dent al
19-Aug: Raj.Medical
14-Aug: AIIMS
Resul t: SBI is left with less money to lend.
Consequences:
1. SBI raises its loan interest rate
2. Businessmen borrow less money from SBI
3. Businessmen donot start new business. Donot
expand existing business
4. Result=Less jobs. Even existing employees
discharged. If anyone remains in the job, he
doesnt get pay raise. He starts cutting down
unnecessary expenditure (e.g. buying two
newspapers, getting his shirts ironed, drinking
tea @4PM in office and so on. Thus even
paper-wall, dhobi, chai-walla- everyones
income reduced.)
5. Result= Less income (Because of above
reasons)
6. Result= Less demand of goods and services
(because less income).
7. Ultimately shopkeeper will bring down the
prices to attract people into buying more
things.
Thus inflation is reduced.
You may doubt- what about supply side
bottlenecks, what about cost push and demand
pull inflation : Im not going into all that details at
the moment, else this article will become longer
than five kilometers.
Lets just prepare a summary table:
Policy dear money cheap money
To fight To fight
09-Aug: SAIL Doctors
09-Aug: SAIL Paramedics
28-Jul : Chandigarh
Paramedics
L egal
25-Aug: Allahabad HC
clerk,review officer
11-Aug: Ut t arakhand HC
deskjobs
Sc i enc e/ Agr i / Ot her
30-Aug: Lab Attendent NIFFT
Ranchi
14-Aug: ISRO assistants 233
29-Aug: Raj.Agro research
25-Aug: CSI R-SERC
22-Aug: Raj.Univ.Lab
At t endent s 11
22-Aug: ONGC Technician
137
20-Aug: NCL scient ist
18-Aug: Karnat aka Urban
14-Aug: SSC Western
Specialist
10-Aug: Gujarat Forensic
31-Jul : UPSC Specialists
various
28-Jul : NIFTEM non faculty
Mi s c . Des k j obs
30-Aug: clerks NIFFT Ranchi
19-Aug: SSC 10+2 Dat a
Ent ry Op
22-Aug: Raj.Univ.Clerks 29
14-Aug: BankPress Dewas
12-Aug: Western Rail Sports
01-Aug: MECL:
foremen,driver,mechanic(99)
31-Jul : Rohtak deskjobs
31-Jul : NGT
Secretary,Steno,Translators
Tool inflation deflation
Reserve Ratio (CRR,
SLR)
Increase
them.
Decrease
them.
Moving to the next (Quantitative) tool. Under
monetary policy
#2: Open Market Operation (OMO)
Open Market Operation= when RBI starts
buying/selling government securities to
control money supply.
Government securities= piece of paper. It says
something like this give me Rs.100, Ill give
you 8% interest rate for next ten years and
after that Ill repay the principle of Rs.100.
This is how government borrows from others.
Situation: Economy has inflationary trend.
Prices of goods and services increasing every
day.
Solution: RBI starts selling government
securities in open market.
Result: SBI buys them and thus SBIs lending
money is reduced. Wait. How?
Imagine Rajan is selling sabzi (vegetables). If
SBIs chairman Arundhati Madam goes to buy
vegetables. Obviously madams money will
decrease when she buys vegetables.
Then same as usual:
1. SBI left with less money to lend.
2. SBI raises its loan interest rate (to keep profit
margin same)
F ac ul t y J obs
31-Aug: NI FM
29-Aug: Raj Lect urer
22-Aug: Kot a univ.
16-Aug: Shimla Nut rit ion
14-Aug: Raj.Chemist ry
11-Aug: Jammu Uni
05-Aug: RIMSNR
05-Aug: PGIMER
31-Jul : UP Paramedic
War ni ng
Onl i ne Form Part-1
stops few days b4
deadl i ne.So DONOT wai t
ti l l l ast date.
DONOT forget/mi spl ace
reg.i d, Rol l number.
3. Businessmen borrow less money from SBI.
expand existing business
5. Less jobs
6. Less income
7. Less demand
things.
During deflation, RBI will do the reverse. (i.e. RBI
buys Sabzi from SBI). How will it stop deflation?
Think in your head.
Lets update our table
Tool
To fight
inflation
To fight
deflation
Reserve Ratio (CRR,
SLR)
Increase
them.
Decrease
them.
Open Market Operation
(OMO)
RBI sell
securities
RBI buy
securities
Mock Question
In 2013, UPSC walla asked a very chillar question
from this topic.
In context of Indian Economy, Open Market
Operation refers to
1. Borrowing by scheduled banks from RBI
2. Lending by commercial banks to industries
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom 10/48
and trade
3. Purchase and sale of government securities by
the RBI
4. None of Above
Whenever you face a GS/GK type MCQ, Youve
three choices
Skip
If you dont know the answer, Just leave it
instead of risking negative mark.
Attempt Correct answer is Opt C.
Mark n
Review.
It means youve unsure of the answer. 50:50.
So you mark the question number (say 45),
at the back of your question paper. At the
end of exam, if youre left with 10-15 free
minutes. You look at the question again,
and try to solve it.
So, should you put above question in mark n
review?
No.
Because its a definition based question. If you
dont know the definition of OMO you might
tick a wrong answer and fail. Most of the
sincere players fail in prelims because of this
reason. They push their luck in negative
marking to overcome an imaginary cutoff and
thus dig up their own grave. (especially during
last 10-15 minutes of the exam.)
Moral of the story: never put fact/definition
type MCQs in Mark-n-Review.
Lets solve a bit more complicated MCQ from
2012s CSAT paper.
Q.Which of the following measures would result
in an increase in the money supply in economy?
1. Purchase of government securities from
public by central bank
2. Deposit of currency in commercial banks by
the public
3. Borrowing by government from the central
bank.
4. Sale of government securities to the public by
central bank.
Answer choi ce
1. Only 1
2. 2 and 4
3. 1 and 3
4. 2, 3 and 4
Whenever you face such multiple statement type
MCQs, always use elimination method. First find
a statement that is definitely right or definitely
wrong and eliminate choices accordingly.
Focus on first statement Purchase of
government securities from public by central
bank: will it increase money supply in the
system?
Imagine Rajan puts an ad in newspaper: bring
your Sabzi (vegetables), Ill buy it. Junta gives
him their own veggies, Rajan gives them
money. (a classic buy and sell).
Ultimate result: money supply increased in the
system- because junta got the money.
Meaning #1 definitely correct.
If you think it on technical terms. Central bank
purchases government securities=OMO (Open
market operation), where money shifts hands
from RBI to people.
Hence money supply increased. (In reality,
money doesnt go to aam admi directly, but
those bankers and non-banking institutions
who participate in OMO). Anyways, #1 is right,
Eliminate choices that do not have #1
1. Only 1
2. 2 and 4
3. 1 and 3
4. 2, 3 and 4
Now the final answer depends on whether
statement #3 is right or wrong?
Statement #3 says Borrowing by government
from the central bank. (So, will it increase
money supply?)
How does Government borrow from Central
bank? Does Mohan just callup Rajan and
demand 1 lakh crores? No. Mohan will have to
give Rajan that much government securities
(vegetables) and Rajan will give him cash.
Is money supply increased? Yes Mohan sold
veggies to Rajan and got Money. Whenever
Rajan buys veggies and pays the money
supply is increased. (this is similar to Open
Market operation)
Besides, Mohan can then use money to pay
salaries of government staff, pay for rail-road-
bridges and other infrastructure projects, pay
for MNREGA and so on. Therefore Answer C: 1
and 3 correct.
Counter- argument?
What if Rajan subsequently sells those
(Mohans) securities to bankers. Then bankers
money reduced. Hence #3 is wrong. Therefore
final answer A only 1.
So, whats the final answer: is it A or is it C?
Ultimate judge= UPSCs official answer key
uploaded on their site.
In 2012s Question paper Test series A, this is
Q77: and its official answer is C. Therefore, both
1 and 3 are correct.
Anyways, what to do in the exam?
Skip If you dont know the concept better skip.
Attempt
This question is attemptable if you dont
drag the logic too much in statement #3.
Mark n
Review.
Yes, it can be put under mark and review
because this is not an absolute fact/
absolute definition type MCQ. If you apply
some concepts, you can eliminate wrong
choices. But still if doubt persists in the
mind (e.g whether Statement 3 is right or
not) then its always safe to skip and avoid
negative marking.
By the way, What about Statement #2: Deposit of
currency in commercial banks by the public. (Will
it increase money supply or not?)
Viewpoint 1: yes. Because bank can used it to
expand loanable credit. (as explained in
Money creation topic in Class 12 NCERT
Macroeconomics page 39 onwards).
Viewpoint 2: no. (Because Bank will have to
put some money aside as CRR- so that much
money is less in the system.)
Either way it doesnt change the answer. Because
We know that statement 1 is definitely correct.
And there is no option where (1,2) are given
simultaneously.
Anyways, Moving onSo far, RBI has two tools
under monetary policy:
1. reserve ratios (SLR, CRR)
2. Open market operation.
Third and the most important quantitative tool is
#3: Pol i cy Rate
Policy rate= in case of India its Repo rate. Before
moving further, lets refresh our concepts of Bank
rate, LAF, MSF, Repo and Reverse repo.
Bank Rate
When banks borrow long term funds from RBI.
Theyve to pay this much interest rate to RBI.
[Note: different books give different
explanation of Bank Rate. I've used NDTV's
defi ni ti on]
At present, Bank rate= 9%
Collateral: nothing. (Bank can borrow money
without pledging government securities to RBI)
Bank rate is not the main tool to control
money supply these days.
Nowadays, RBI uses LAF Repo rate as the main
tool, to control money supply.
Ok then Whats the use of Bank rate?
Penal rates are linked with Bank rate. For
example, If a bank doesnt maintain CRR, SLR
as per the prescribed limit.
Then RBI can impose penalty interest on such
notorious bank.
At present, Penalty rate = Bank rate + 3% (or
5% in some cases)
Meaning if Bank rate = 9% then penalty
rate=9+3=12%
Anyways, what if RBI wants to fight inflation using
bank rate as a tool?
Obviously they should increase bank rate. That
way it becomes harder (more expensive) for banks
to borrow from RBI.=> SBI increases its loan rates
(to keep the profit margin same). Result?
Less people get home loan, bike loan,
business loans.
Less business expansion
Less jobs
Less incomes
Less demand
Ultimately shopkeeper will bring down the
things.
Lets update our (stupid) table
Tool
To fight
inflation
To fight
deflation
Reserve Ratio (CRR,
SLR)
Increase
them.
Decrease
them.
Open Market Operation
(OMO)
RBI sell
securities
RBI buy
securities
Bank rate Increase decrease
Liquidity Adjustment f acility (LAF)
Liquidity Adjustment facility
RBI started this in 2000. You can imagine it as
a Adda/gambling den/gang-hideout where
RBIs clients gather, consumer desi liquor, play
cards, watch item songs and borrow money
from RBI (or lend Money to RBI).
By the way, who are the clients of RBI?=
Central and state governments, Banks and
non-banking financial institutions (NBFI). NBFI
further includes:
AIFI (all India finance institutions) NABARD,
SIDBI, EXIM Bank and National Housing
Bank.
Primary dealers (Morgan Stanley ,
Goldman Sachs, JP Morgan Chase,
Standard Chartered Bank, HSBC etc.)
Non-Banking financial companies.
Anyways, Under this LAF adda, RBI has two
tools:
Repo
If client borrows money from RBI (for short
term) then client has to pay this much
interest rate to RBI. At present Repo is 8%.
(article written on 29th Jan 2014)
If client lends money to RBI (for short term)
Reverse
Repo
then RBI has to pay this much interest rate
to client. RBI doesnt like headache. So they
made a simple formula: Reverse repo rate=
Repo MINUS 1%=8-1=7%.
Collateral:
Problem with running a adda/gambling-den
= sometimes client drinks too much desi
liquor and passes out on floor. Sometimes he
even dies because of hooch. Sometimes
police raids the den, and clients run away with
cash and register.
If such things happen, Rajan will be at loss. So,
he demands government securities as
collataral. So even if client doesnt repay
money on time, Rajan can sell those securities
(in open market operations) and recover
money.
LAF Repo Rate
Lets get a bit technically correct now. Observe
following image
Scenario
SBI chairman Arundhati mam wants to borrow
Rs.100 crore (for short term).
She gives her stash of government securities
to Rajan.
Rajan gives her Rs.100 crore.
Madam Also signs an agreement
I, Arundhati Bhattacharya, agree to buy same
securities from Rajan, at 108 crores after 14
days.
Notice that she has agreed to re-purchase
same securities from Rajan. Therefore its
called Repo.
And how much interest rate did she pay on
this loan? [108-100]/100=8%. Thats our repo
rate.
Important:
Recall that SBI also has to keep part of her
money in RBI approved securities (under SLR).
So Madam cannot USE those government
securities to borrow under Repo Rate from
Rajan.
That leads to a new topic
Marginal Standing f acility (MSF)
MSF mechanism is same as repo. But some
differences
LAF (Repo) MSF
Rajan says dont
come here unless
you want to
borrow minimum
Minimum Rs. 1 crore.
Rs.5 crores.
All clients are
welcome i.e.
Central and
state
governments
Banks be it
commercial
bank or RRB
or
cooperative
bank
Non-banking
financial
institutions.
Sorry. Not all clients welcome
here.
Only scheduled commercial
banks can borrow under this
window. SBI, PNB, BoB, ICICI
etc.
This MSF facility is specially
created to help them solve
short-term cash mis-match.
You (bankers)
cannot pledge
securities from
SLR quota to
borrow from this
window.
Can use securities from SLR quota.
No limit. You may
borrow as much
as you want. (as
long as you have
government
securities to
pledge to me.)
Maximum 2% of NTDL. To put this
in crude words, if SBI received 100
crores from aam-admi under
savings account, current account,
fixed deposit etc. then SBI can
borrow only upto Rs.2 crores from
RBI.
Rajan decides
Repo rate (8%
right now)
MSF = Repo Rate +1% = 8+1=9%.
(earlier this margin of 1% used to
be higher. But nowadays just 1%!)
for those who still have doubt about Repo vs MSF:
for repo borrowing, bank will need to pledge
securities to Rajan. But bank cannot use SLR-
reserved securities for this.
so, imagine if a bank is in dire need of cash, but
doesnt have spare government securities- then
they can borrow using MSF by pledging those SLR
securities. (and under MSF window, Rajan will
demand 1% higher than Repo as one type of
punishment for pledging SLR securities.)
Reverse repo Rate
Although self-explanatory. But lets check
Repo = clients borrow from Rajan and pay this
much interest rate. (short term loan)
Reverse repo= when Rajan himself borrows
from clients, then he has to pay this much
interest rate to clients.
Collateral = yes. What if police raids this
gambling-den, and Rajan runs away to Nepal?
Clients can sell Rajans Government securities
and recover their money.
Reverse repo = Repo MINUS 1% = 8-1% =7%.
Note: in official parlance, they call percentages
in basis points so 1%=100 basis points. So in
that official language, Reverse repo = Repo
MINUS 100 basis points.
Enough cheap jokes. What have we learned so
far?
That Rajan controls money supply using
monetary policy.
Under Monetary policy, Rajan has various
weapons (or tools)
1. Reserve ratios (SLR, CRR)
2. OMO: Open market operation
3. Rates: Bank rate, LAF (Repo, Reverse repo),
MSF.
We already know how to apply SLR, CRR and OMO
to fight inflation (and deflation.) let me paste the
table again.
Tool To fight inflation To fight deflation
Reserve
Ratio
(CRR, SLR)
Increase them. Decrease them.
Open
Market
Operation
(OMO)
RBI sell securities RBI buy securities
Bank Rate increase it decrease it
Repo rate increase it decrease it
Reverse
Repo
its value is linked with Repo, hence cannot
be increased/decreased independently.
Marginal
Standing
Facility
its value is linked with Repo, hence cannot
be increased/decreased independently.
Besides MSF= temporary firefighting, cash
mismanagement.
We learned that Rajan doesnt use Bank rate
much, to control money supply.
We learned that Rajan doesnt decide Reverse
repo and MSF. (theyre automatically -1% and
+1% of Repo rate).
Thus the only thing Rajan has to decide under
monetary policy= Repo rate. Therefore, Repo
rate is called the policy rate
Lets revisit out flow chart:
Situation: Economy has inflationary trend.
Prices of goods and services increasing every
day.
Solution: Rajan increases Repo rate. (say
from 7.75% to 8%).
Result: it becomes expensive for SBI to borrow
from Rajan. Theyll increase their own rates as
well.
Wait. How?
Just like how things roll in Onion biz.
If prices of Onion rise in Maharashtras wholesale
yard (in Lasangaon), then immediately, retail
veggie @Ahmedabad will also raise their onion
prices to keep the profit margin same.
Whatll be the consequences (if repo rate is hiked
/ increased)?
Consequences:
1. SBI raises its loan interest rate (to keep profit
margin same)
2. Businessmen borrow less money from SBI.
expand existing business.
4. Less jobs
5. Less income
6. Less demand
4Top
things.
Tool
To fight
inflation
To fight
deflation
Reserve Ratio (CRR,
SLR)
Increase
them.
Decrease
them.
Open Market
Operation (OMO)
RBI sell
securities
RBI buy
securities
Policy Rate (Repo
Rate)
Increase it Decrease it
Repo Rate in recent years:
Lets observe with a graph: how RBI fought
inflation/deflation in recent times using Repo rate
as the main-weapon of monetary policy.
From above above graph, you can see RBI has
frequently changed its repo rate to combat both
inflationary and deflationary trend. But Youd
agree that inflation has not been contained. No
matter what number juggling or statistical
interpretations are given- the hardship of
common man has not stopped- be it milk, petrol,
onion, LPG anything.
Agreed that prices of onion, sugar, pulses and
food are subject to vagaries of monsoon and
black marketeering. Rajan cannot do anything
about it.
Agreed that crude oil prices are subject to
rupee-Dollar exchange rate, external factors
and governments de-regulation of their
prices. Rajan doesnt have much control over
this.
But still even in the non-food, non-fuel type
commodities- RBIs monetary policies have failed
to curb inflation. WHY? Observe the following
image.
Suppose Vijay Mallay got 100 crore loan from
State Bank of India. If you trace the source of that
money, itll turnout 60-70 crores came from banks
savings account, fixed deposit etc. Rajan lends
money in repo rate yes, but that doesnt mean
banks depend only on Rajan to arrange the cash
for its clients.
Suppose Rajan reduces repo rate from 8% to 5%.
Banks are not legally required to reduce their loan
interest rates.
The current system is following:
Banks are free to decide their base rate. E.g.
SBIs base rate is 10%.
It means SBI wont loan money to anyone at
an interest rate lower than 10% (except those
farmers under Interest subvention scheme.)
SBI will link all of its loan products with Base
rate. For example
SBI Base rate =10% Calculation Result
Car loan
0.75% above
Base rate
10.75%
Two wheeler loan
8.25% above
base rate
18.25%
Education loan (upto 4
lakh)
3.5% above base
rate
13.5%
Home loan for women
(upto 75 lakh)
0.10% above
base rate
10.10%
Meaning if SBI changes her Base rate then all of
above loan interest rates will change
automatically.
If Raj an changes hi s repo rate, wi l l SBI
change her base rate?
Not always.
Because those common men are the main
suppliers of money to SBI.
RBI is not the main supplier of money to SBI.
SBI will only change its base rate, when she
feels necessary for its own profit / loss
compared to its competitors.
Does it mean Repo rate system is bogus and
ineffective?
Not always.
In developing countries like India, most people
park their money in only four things: savings
account, fixed deposit (FD), provident fund and
LIC. Weve mutual funds, weve NPS, weve
ULIPs, weve Rajiv Gandhi equity savings
scheme
but most people (particularly the older
generation) feels insecure in into such new
things. Therefore lot of money flows into
Savings accounts and fixed deposits= SBIs
main source of money.
But, In advanced economies, like USA, people
dont invest large portion their income in
savings account or FD. Theyve variety of
investment options. So, for those American
banks, their own Central bank (US Feds) is a
significant money supplier.
Hence US Feds monetary policy shows faster
impact on their American Banks, THAN Rajans
monetary policy on Desi banks.
Monetary Pol i cy: l i mi tati ons
In developing countries, Monetary fails to bring
quick results because
1. People dont have many investment
alternatives. Commercial banks have large
deposits. Rajan is not the main or even
prominent money supplier for these banks.
Whatever Rajan does, its effect will be felt only
after 6-8 months but by that time, new factors
would cause another rise in inflation and
Rajan will have to start from scratch again.
2. Non-Monetized economy: in rural areas, many
transactions are still of barter nature. (E.g.
kiranawalla cum middleman supplies seeds,
pesticides, fertilizers- in exchange of share in
farmers produce.)
3. Lack of financial inclusion. Since most people
are not in the banking net. They rely on Shroffs
and moneylenders. Many of them circulate the
black money of cops and politicians, and
charge 36% interest rate on loans. Rajan has
no control over them.
4. Monsoon uncertainty, cyclone, flood, draughts
and their effect on food production. Food
inflation =>newspaper walla, washerman,
barber, car mechanic everyone will raise their
service fees to accommodate their raised cost
of living. Rajan has no control over them.
5. Crude oil and gold import + negative effect
when rupee weakens. Rajan can try to bring
1$=Rs.65 to $1=63 Rs. But he has not enough
forex reserves to bring $1=Rs.50.
6. Fiscal deficit, illogical schemes. e.g MNREGA
worker digs a temporary road. After first rain, t
he road is wiped out= physical infrastructure
added to economy no. Wages raised..yes.
= this mismatch leads to more inflation.
7. Subsidy leakage, Black money, underground
economy.
8. And most importantly, because Rajan uses
Multi-indicator approach, he focuses on WPI
(minus food and fuel). Thats why Urjit Patel
recommends him to target CPI. More on that
in next article.
So far, we learned that RBI has two sets of
tools/instruments under monetary policy:
Quantitative tool Qualitative tools
1. Reserve ratios
2. OMO
3. Policy rate (Repo Rate)
Well see them in a
moment
Qual i tati ve Tool s
#1: Margin Requirements/ LTV
Mallya wants to borrow from SBI. He pledges
his companys shares worth Rs.100 crores as
collateral.
For such loans, Rajan can prescribe margin,
say 65%.
In that case even if Mallya pledges 100 crores
worth shares, SBI can give him 100-65=only 35
Crore rupees as loan.
Using this tool, Rajan can control money
supply. e.g. during inflation, he should
increase margin requirement, so Mallya can
borrow less=> less job=>less income=>less
demand=>prices reduced.
If Rajan changes repo rate, it is not
compulsory for SBI to change her loan interest
rates. (we saw how Alok Nath keeps giving
money to SBI, so they are not entirely
dependent on Rajan.)
But if Rajan changes margin requirements,
then SBI and all other banks must obey it. In
other words, this tool has direct impact on
money supply.
#2: Consumer credit regulation
Suppose Nano car sells @1 lakh and Rajan has
made rule that downpayment cannot be less
than 30%.
It means customer must bring Rs.30,000 from
his pocket and bank can only give him
maximum 70000 as loan.
How can Rajan fight inflation with this tool?
Increase downpayment from 30%=>50%
(meaning bank can give less loan. Customer
himself has to arrange lot of money from his
own pocket)
Rajan can make rule banks cannot accept EMI
less than 5000 on car loan. Observe:
Case #1: 100 EMIs worth 1000 each = 1,00,000.
(ignore interest rates)
Case #2: 20 EMIs worth 5000 each=1,00,000.
(ignore interest rates)
In case #2: some of the lower-middleclass
families may postpone their decision to purchase
nano car (Because they cant afford higher EMIs.)
Result= less demand=>prices reduced.
(indirectly- because car mechanics get less
work, number-plate painters get less orders
etc. so they reduce fees to attract new clients
and retain existing clients.)
Thus, Rajan can control money supply by
changing downpayment and installment (EMI)
rules.
#3: Selective credit control
Under this, Rajan can specifically instruct
bankers not to give loans to traders of certain
commodities e.g. sugar, gur, edible oil etc.
even if the said trader is ready to mortgage his
shares/bonds/factory/machine/vehicle
anything.
this prevents speculations/ hoarding of
commodities using money borrowed from
banks.
#4: Moral Suasion
Here Rajan tries to persuade the bankers to do xyz
thing. Example
1. Please reduce giving automobile loans-
instead park your money in government
securities. (above the SLR requirements.)
2. Ive reduced my repo rate, now you also
reduce your base rate.
Rajan will try to influence those bankers via- direct
meetings, conference, giving media statements,
giving speeches @public seminars, university
convocations etc. (even where bankers are not
present.) Hell do so, to build a public opinion,
media opinion and influence those bankers by
making them feel guilty.
Rationing
of credit
Found in Planned
economies/communist nations.
Here central bank will decide upper
limit to loans in each sector (heavy
industries, service, agriculture, small-
scale etc.)
So once that quota is over.
Additional loans cannot be given to
that borrowers from that sector. This
also controls money supply.
Direct
action
Means RBI gives punishment to erring
banks. Punishment can involve: penal
interest, refuses to lend them money
from LAF etc. and in worst case even
cancels their banking license.
Lets recap
Monetary pol i cy tool s: Quanti ati ve vs
Qual i tati ve
Quantitative Qualitative
1. Margin
requirements /
LTV
2. Consumer
credit
1. Reserve ratios (SLR, CRR)
2. Open Market Operation
3. Policy rate (Repo Rate)
regulation
3. Selective credit
control
4. Moral Suasion
5. Rationing of
Credit
6. Direct Action
Indirect in nature. (Even if Rajan
changes repo rate, its not
necessary SBI will immediately
change its base rate / loan
interest rates.)
Direct in nature.
(e.g. those margin
requirements)
General- they affect money
supply in entire economy- be it
housing, automobile,
manufacturing- everything.
Selective- can affect
money supply in a
specific sector of
economy e.g.
automobile.
Lets solve an Official MCQ from UPSC 2012
Question paper
Q. RBI Acts as banker s bank. Thi s woul d
i mpl y whi ch of the fol l owi ng?
1. Other banks retain their deposits with RBI
2. RBI lends funds to commercial banks in the
times of need.
3. RBI advises commercial banks on monetary
matters.
Correct Statement
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
Approach:
Whenever you face such 3 statement MCQ or 4
statement MCQ, Always use elimination method.
First you find out a statement that is definitely
right or definitely wrong. In above case, we can
see #2 is definitely right. RBI lends funds to banks
in the times of need (Repo, MSF)
So lets eliminate choices that dont involve
statement #2
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
This did not help much. We still have three
choices left. Observe statement #1: Other
banks retain their deposits with RBI. That is
correct with respect to cash reserve ratio. CRR
is one type of deposit that banks make to RBI.
(RBI doesnt pay interest on it- thats a
different story).
Meaning #1 is also correct eliminate choices
that donot have #1
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
Only two choices left and the ultimate solution =
is statement #3 is correct or not?
Viewpoint #1 Viewpoint #2
The statement says RBI advises
commercial banks on monetary
matters.The word advises makes
this statement incorrect. Because
RBI doesnt Advice they just order
the banks- be it SLR, CRR, PSL. RBI
doesnt advice, RBI gives orders and
direction. Therefore statement #3 is
wrong.
RBI does advice
those banks. We
saw it under
Moral Suasion.
Therefore,
Statement #3 is
right.
Even if we accept that RBI advices,
still the questions asks what is
implied by RBI as Bankers bank.
So, RBI advices moral suasion
that is a monetary policy tool. RBIs
not doing it as a Banker to those
banks. Therefore, Statement #3 is
definitely wrong.
Money Banking
and finance, E
Narayan Nadar
(PHI
publication). He
has specifically
listed this
Advice
function under
Bankers bank
topic.
Answer (B) Answer (D)
So, is it B or is it D? Final judge is UPSC.
They had uploaded CSAt-2012 official answer
key on their site.
This question is Test Series A, Question #75
and its official answer is D = meaning all
three statements are correct.
If you face such MCQ in exam, what should be
your approach?
Upto you. But if you start skipping all such
Skip
question (OMO, Money supply, Bankers
bank), because youre completely unaware
of those topics=that is not pardonable.it
shows youre underprepared for this exam.
You should either change your study
method or change the game- try for some
easier exam.
Attempt
This question is attemptable, if you dont
nitpick over the word advises in third
statement.
Mark n
Review
If youve thoroughly prepared the RBIs
monetary tools (both qualitative and
quantitative), you can solve it by applying
concepts/principles- particularly the moral
suasion thing. But if youre still doubtful
over whether #3 is right or wrong, then
better skip. If you skip because youre
doubtful = that is pardonable. But if you
skip because youre completely unaware of
this topic= non-bailable offense.
Appendi x
These are the topics I wanted to discuss in the
article, but they would break the flow of other
topics. Hence writing them @bottom:
#1: Why High SLR and High CRR are bad?
From the discussion so far, you might think why
Rajan only focuses on Repo rate to control money
supply. Why not simply raise SLR and CRR
requirements.
Let s check the de-meri ts of hi gh SLR and
CRR:
Prior to LPG reforms in 90s, RBI used to keep SLR
and CRR very high. Lets take an example
A Bank can two types of deposits
Deposit type examples
Time Deposit
Fixed deposit (FD) recurring
deposit.
Demand
Deposit
Savings account, current account
Using this money, bank has to count its Net
Demand and Time liabilities (NDTL), every
fortnight. Suppose its 100 crores.
Both CRR and SLR are counted on this figure.
In the old times, these reserve ratios used to
be as high as 15% and 40% respectively.
Observe the effect:
Net Demand and Time Liabilities
(NDTL)
+100 cr.
Reserve ratios
CRR (15%) (-) 15 [no profit]
SLR (40%)
(-) 40 [some
profit]
Money left with bank =45 cr.
From 100 crores, barely 45 crores left with the
bank. But adding insult to the injury- even here
RBI mandates Priority sector lending (PSL).
Meaning, at least 40% of the loans has to be given
to farmers, small businessmen, students etc.
groups.
Lets update the table:
Net Demand and Time Liabilities (NDTL) +100 cr.
Reserve ratios
CRR (15%)
(-) 15 [no
profit]
SLR (40%)
(-) 40
[some
profit]
Money left with bank =45
PSL (40%)
=45 x 0.4
=18 crore.
Money left for big borrowers (i.e. big
businessmen, upper middleclass)
=45-18=27
crores.
By the way, PSL is counted on annual basis
while SLR, CRR counted on fortnight basis so
above table is technically incorrect but Ive
plugged in those numbers only for the sake of
explanation.
before the 90s- Government would even
interfere and order public sector banks to give
PSL-loans @cheap interest rates. The local
politicians would coerce the branch manager
to give PSL-loans to ineligible people. They
default on loans, Branch manager cannot
recover money (because defaulter will goto
civil court then taarikh pe taarikh.) So, bank
would have to forget about most of those 18
crores given in PSL loans.
Anyways you can see people deposited 100
crores in the bank yet bank is left with barely
27 crores (over which, bank has Freedom to
decide whom they should give the loan.)
What are the consequences for businessmen?
1. High cost of credit (because bank will try to
make maximum profit from those 27 crores-
so bank will charge very high interest rate on
the business loans- to pay off for the staff
salaries, branch office rents and everything.)
2. Businessman cannot expand his business.
3. Less exports.
4. Less tax income for the government.
So in a way- that was also one of the factors
leading to Balance of Payment crisis (and
subsequently LPG reforms.) You can read more
about that in NCERT Class 11- chapter 2 and 3.
#2: Narsimhan (I ) Committee 1991
Plagued by problems and losses in nationalized
banks, Government of India formed this
Committee. Recommendati ons were:
1. Deregulate interest rates. Let the banks decide
their loan interest rates. Accepted. Gradually,
we moved to the Base Rate system.
2. PSL loans should be given at normal interest
rates. Accepted (but with exception=> interest
subvention- that we saw under Nachiket
articles.)
3. NPA/Loan default matter should be handled
by separate body and not civil courts. Result:
Debt recovery tribunal created in 1993.
Ultimately SARFAESI Act in 2002.
4. Reduce CRR, SLR. Accepted. Today weve them
@4% and 23% respectively.
5. Allow Private banks and foreign banks. RBI
invited applications in 1993. ICICI, Axis, HDFC
and many others got license.
6. Liberate Branch expansion policy. Done
(Except that 25% rural branching mandate we
saw under Nachiket articles).
7. Prepare NBFC regulatory framework.
Accepted.
8. Government should reduce shareholding (and
thereby its official influence) in the public
sector banks. Government agreed. Today
governments shareholding in SBI =~60%.
#3: Narsimhan (I I ) Committee 1998
Suggested more reforms.
1. allow VRS in the banks so they can get rid of
excessive staff.
2. Suggested additional Legal reforms for loan
recovery. =>SARFAESI 2002.
3. Computerization, electronic fund transfer,
legal framework => Payment and Settlement
Act=>Retail (ECS, NEFT, credit Card) +
Wholesale (RTGS)
4. Permit new private /foreign banks. RBI invited
license in 2001= Yes Bank and Kotak Mahindra
got licenses. 2013: RBI again invited
applications for bank licenses.
[Note: list of recommendations not exhaustive,
Ive only highlighted important topics that show
evolution of banking sector in recent times.]
Mock Questi ons
1. With open market operations, RBI can
1. increase liquidity in the economy, but
cannot decrease it
2. decrease liquidity in the economy, but
cannot increase it
3. Can increase or decrease liquidity in the
economy to control money supply.
4. None of above.
2. By which of the following methods,
government can reduce money supply in the
economy?
1. taxation
2. sale of securities to public
3. both A and B
4. neither A nor B
3. During the period of deflation
1. RBI should use dear money policy to
combat it
2. Government should reduce its tax rates.
3. both A and B
4. Neither A nor B.
4. IF prices are lowered without causing
unemployment, we call it:
1. stagflation
2. reflation
3. disflaction
4. Disinflation.
5. Which of the following contains correct set of
quantitative instruments of monetary policy?
1. reserve ratio, bank rate, margin
requirements
2. open market operations, margin
requirements, regulation of consumer
credit
3. cash reserve ratio, bank rate, open market
operation
4. None of above
6. Which of the following contains correct set of
qualitative instruments of monetary policy?
1. reserve ratio, bank rate, margin
requirements
2. credit rationing, margin requirements,
regulation of consumer credit
3. cash reserve ratio, bank rate, open market
operation
4. None of above
Q7. To counter the effect of defl ati on, whi ch
of the fol l owi ng steps shoul d RBI i ni ti ate?
1. decrease reserve ratios
2. buy government securities through open
market operation
3. increase policy rate
Answer choices
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. 1, 2 and 3
Q8. To counter i nfl ati on, whi ch of the
fol l owi ng steps shoul d RBI i ni ti ate?
1. Increase reserve ratios
2. sell government securities through open
market operation
3. Increase policy rate
Answer choices
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. 1, 2 and 3
Q9. Whi ch of the fol l owi ng may cause
defl ati on i n the economy?
1. RBI raises policy rate
2. RBI raises cash reserve ratio
3. RBI sells securities
Choices:
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. all 1,2 and 3
Q10. Money suppl y i n the economy, i s
affected by
1. Cheap money policy and dear money policy.
2. Open market operation and Moral Suasion.
3. Consumer credit regulation and loan to value
ratio.
Choices:
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. all 1, 2 and 3
Q11. An i ncrease i n SLR
1. will restrict the expansion of banks credit
2. will increase banks investment in safe
securities
3. will ensure solvency of the banks
choices:
1. only 1 and 2
2. only 2 and 3
3. only 1 and 3
4. all 1,2 and 3
Mains/interview type questions- after we check
Urjit Patels recommendations on strengthening
monetary policy.
Hi nts
1. can increase by buying, can decrease by
selling
2. both [or only B, depending on how UPSC
examiner interprets the effect of taxation on
money supply. In one of the reputed book on
Banking and finance, author Narayan
Nadar claimed taxation can affect money
supply.]
3. dear money policy during deflation =adds
insult to the injury of businessman. If
government reduces tax- then its revenue
collection will drastically reduce. So both
incorrect. [OR debatable- depending on how
UPSC examiner interprets the effect of taxation
during deflation.]
4. directly given in the article.
5. see the last table in the article
6. see the last table in the article
7. observe the table before the topic repo rate in
MRUNAL S RECOMMENDED BOOKLI ST
recent years
8. same as above
9. same as above
10. All correct. (Unless you nitpick and drag the
logic too much.)
11. same as above.
Visit Mrunal .org/Economy For more on Money,
Banking, Finance, Taxation and Economy.
Pr evi ousl y i n t hi s cat egor y
[Lecture] Economi c survey Chapter 5,
6 & 7: Fi nanci al Intermedi ari es,
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Subsi di es MINUS Schemes
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Pri ci ng, DTC, GAAR, Advance Tax
rul i ng expl ai ned
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[Economy] Parti ci patory Notes (P-
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Er Kewal
27/06/2014 at 15:03
Reply
Thanx a lot Sir,.its really very helpful to understand the
concepts
kirti
27/06/2014 at 15:51
Reply
Sir ur notes r vry much helpful.. Bt plz tell me a book to
cover all topics of economics n othr gk questions
kirti
27/06/2014 at 15:58
Reply
Sir ur notes are very much helpful.. But please tell me
which book should I read to cover all topics on economy
n gk based questions
abhinav misra
29/06/2014 at 12:28
Sir,
I want to thank u not only for this article or post but
everything u put up on ur website. Sir it really lefts me
amazed abt how u make such a deep research on every
topic. Seeing websites like urs really makes a person n
Reply
specially me frel that internet is a boon. Hats off to ur
marvellous efforts. Thanx a lot sir for enlightening us.
sajjan
30/06/2014 at 13:12
Reply
thanx a lots sir,really its very helpful for me..
nams
03/07/2014 at 21:14
Reply
please explain how solvency is affected in the 11th
ques.?
Nikhil Jain
06/07/2014 at 23:52
Reply
Q8 Ans is only 1.. and not given in choices
pls correct me if I am wrong.
Abhisek
07/07/2014 at 19:46
Reply
Ultimate!!!
vamshi
11/07/2014 at 00:01
Reply
thank you sir. you are a life saver..
asaraf
14/07/2014 at 04:54
Reply
Thank you for this website, you write very good articles;
love your explaining skills.
ashok kumar
20/07/2014 at 09:59
Reply
Very helpful sir
Heeraj
23/07/2014 at 19:29
Reply
Had a good laugh at the subtle jokes in between.
Great article. Loved it.
Novice
23/07/2014 at 23:25
Hello Mrunal ,
I am new to these concepts.I have few queries.
1. Under OMO : you have mentioned Result: SBI buys
them and thus SBIs lending money is reduced. Wait.
1 2 3
Reply
How?
My question is ,consider an ideal case. what if the banks
are not willing to buy those government securities,
I mean how does inflation is controlled in this case.Is
there any obligation on banks to purchase them?
I think at that time OMO will not be considered as a tool
to control inflation.is it true??
2.Under LAF Repo Rate : you have mentioned So
Madam cannot USE those government securities to
borrow under Repo Rate from Rajan.
But while differenting MSF with LAF Repo you have
mentioned
No limit. You may borrow as much as you want. (as
long as you have government securities to pledge to
me.)
Does RBI approved securities and government
securities are same?
Kindly comment
sumit gore
24/07/2014 at 10:13
Reply
Hello sir, I am very thankful to your blog. It helps a lot.
In this blog there is one mistake in concept that i
wanted to point out. DISINFLATION is not fall in price
level. It is fall in rate of inflation hence price still
increases but with less percent.
It came to my notice while i was solving MCQs at the end
of this article.
karan sharma
26/07/2014 at 23:56
Reply
I have recently joined ur website and the way u r telling
these articles it makes us understand these articles very
easily I m preparing for HPPSC so plz tell me what
should be my strategy at my initial stage
Vadarevu Prasanna Kumar
27/07/2014 at 14:09
Reply
Thank you so much sir
!
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