Professional Documents
Culture Documents
Monetary Policy, Rep, SLR, CRR, Qualitative Tools
Monetary Policy, Rep, SLR, CRR, Qualitative Tools
- Mrunal - http://mrunal.org -
1. Prologue
2. What is monetary policy?
3. Quantitative Tools
1. #1: Reserve Ratios (SLR and CRR)
2. #2: Open Market Operation (OMO)
3. #3: Policy Rate
4. Bank Rate
1. Liquidity Adjustment facility (LAF)
2. LAF Repo Rate
3. Marginal Standing facility (MSF)
4. Reverse repo Rate
5. Repo Rate in recent years:
4. Monetary Policy: limitations
5. Qualitative Tools
1. #1: Margin Requirements/ LTV
2. #2: Consumer credit regulation
3. #3: Selective credit control
4. #4: Moral Suasion
6. Monetary policy tools: Quantiative vs Qualitative
7. Appendix
1. #1: Why High SLR and High CRR are bad?
2. #2: Narsimhan (I) Committee 1991
3. #3: Narsimhan (II) Committee 1998
8. Mock Questions
Prologue
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.
1/18
10/28/2014
collection will also decrease. Then government has less money to spend on
education, healthcare, social sector, defense, law and order = poverty, disease,
crime.
by the way
TERM
meaning
DEFLATION
stagnation + inflation
prices and wages rise
but people cant find jobs, companies cant find
customers.
STAGFLATION
REFLATION
No
Quantitative Tools
#1: Reserve Ratios (SLR and CRR)
SLR A Bank has to set aside this much money into gold or RBI approved securities.
A Bank has to set aside this much as reserve. Bank cannot lend it to anyone.
CRR
Bank earns no interest rate or profit on this.
23%
4%
100 cr.
-4 cr
-23 cr.
100-4-23=73
Cores.
2/18
10/28/2014
3/18
10/28/2014
2.
3.
4.
5.
6.
7.
8.
SBI raises its loan interest rate (to keep profit margin same)
Businessmen borrow less money from SBI.
Businessmen donot start new business. Donot expand existing business
Less jobs
Less income
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
Mock Question
In 2013, UPSC walla asked a very chillar question from this topic.
In context of Indian Economy, Open Market Operation refers to
a.
b.
c.
d.
Answer choice
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
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.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcomi
4/18
10/28/2014
Only 1
2 and 4
1 and 3
2, 3 and 4
5/18
10/28/2014
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 definition]
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 prices to attract people into buying more
things.
Thus inflation is reduced.
Lets update our (stupid) table
Policy
dear money
cheap money
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
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcomi
6/18
10/28/2014
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
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcomi
7/18
10/28/2014
MSF
Minimum Rs. 1 crore.
dear money
To fight inflation
cheap money
To fight deflation
Increase them.
Decrease them.
increase it
decrease it
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcomi
8/18
10/28/2014
Repo rate
Reverse Repo
Marginal
Standing
Facility
increase it
decrease it
its value is linked with Repo, hence cannot be increased/decreased
independently.
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.
2.
3.
4.
5.
6.
7.
SBI raises its loan interest rate (to keep profit margin same)
Businessmen borrow less money from SBI.
Businessmen donot start new business. Donot expand existing business.
Less jobs
Less income
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcomi
9/18
10/28/2014
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.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
10/18
10/28/2014
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 Rajan changes his repo rate, will 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.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
11/18
10/28/2014
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.
Qualitative tools
Qualitative Tools
#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 100http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
12/18
10/28/2014
Rationing
of credit
Direct
action
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
13/18
10/28/2014
Lets recap
Qualitative
1.
2.
3.
4.
5.
6.
Only 2 and 3
Only 1 and 2
Only 1 and 3
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.
2.
3.
4.
Only 2 and 3
Only 1 and 2
Only 1 and 3
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
RBI does advice those
statement incorrect. Because RBI doesnt Advice they just banks. We saw it under
order the banks- be it SLR, CRR, PSL. RBI doesnt advice, RBI Moral Suasion. Therefore,
gives orders and direction. Therefore statement #3 is
Statement #3 is right.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
14/18
10/28/2014
wrong.
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.
Answer (B)
Appendix
These are the topics I wanted to discuss in the article, but they would break the flow of
other topics. Hence writing them @bottom:
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
15/18
10/28/2014
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45
=45 x 0.4 =18
crore.
=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.
16/18
10/28/2014
[Note: list of recommendations not exhaustive, Ive only highlighted important topics that
show evolution of banking sector in recent times.]
Mock Questions
1. With open market operations, RBI can
a. increase liquidity in the economy, but cannot decrease it
b. decrease liquidity in the economy, but cannot increase it
c. Can increase or decrease liquidity in the economy to control money supply.
d. None of above.
2. By which of the following methods, government can reduce money supply in the
economy?
a. taxation
b. sale of securities to public
c. both A and B
d. neither A nor B
3. During the period of deflation
a. RBI should use dear money policy to combat it
b. Government should reduce its tax rates.
c. both A and B
d. Neither A nor B.
4. IF prices are lowered without causing unemployment, we call it:
a. stagflation
b. reflation
c. disflaction
d. Disinflation.
5. Which of the following contains correct set of quantitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. open market operations, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
6. Which of the following contains correct set of qualitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. credit rationing, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
Q7. To counter the effect of deflation, which of the following steps should RBI initiate?
1. decrease reserve ratios
2. buy government securities through open market operation
3. increase policy rate
Answer choices
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
Q8. To counter inflation, which of the following steps should RBI initiate?
1. Increase reserve ratios
2. sell government securities through open market operation
3. Increase policy rate
Answer choices
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
17/18
10/28/2014
Choices:
a.
b.
c.
d.
only 1
only 2
only 1
all 1,2
and
and
and
and
2
3
3
3
only 1 and 2
only 2 and 3
only 1 and 3
all 1, 2 and 3
only 1
only 2
only 1
all 1,2
and
and
and
and
2
3
3
3
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upcom
18/18