UNIT- IV

The Reserve Bank of India

The RBI is the central bank of India. It was established in 1935 under
a special act of the parliament. The RBI is the main authority for the
monetary policy of the country. The main functions of the RBI are to
maintain financial stability and the required level of liquidity in
the economy.

The RBI also controls and regulates the currency system of our
economy. It is the sole issuer of currency notes in India. The RBI is
the central banks that control all the other commercial banks,
financial institutes, finance firms etc. It supervises the entire financial
sector of the country.

Instruments of Monetary Policy

Monetary policy is a way for the RBI to control the supply of money
in the economy. So these credit policies help control the inflation and
in turn help with the economic growth and development of the
country. So now let us take a look at the various instruments of
monetary policy that the RBI has at its disposal.

1] Open Market Operations

Open Market Operations is when the RBI involves itself directly and
buys or sells short-term securities in the open market. This is a direct
and effective way to increase or decrease the supply of money in the
market. It also has a direct effect on the ongoing rate of interest in the
market.

Let us say the market is in equilibrium. Then the RBI decides to sell
short-term securities in the market. The supply of money in the
market will reduce. And subsequently, the demand for credit facilities
would increase. And so correspondingly the rate of interest would
also see a boost.

On the other hand, if RBI was purchasing securities from the open
market it would have the opposite effect. The supply of money to the
market would increase. And so, in turn, the rate of interest would go
down since the demand for credit would fall.

2] Bank Rate

One of the most effective instruments of monetary policy is the bank

rate. A bank rate is essentially the rate at which the RBI lends money
to commercial banks without any security or collateral. It is also the
standard rate at which the RBI will buy or discount bills of
exchange and other such commercial instruments.

So now if the RBI were to increase the bank rate, the commercial
banks would also have to increase their lending rates. And this will
help control the supply of money in the market. And the reverse will
obviously increase the supply of money in the market.

3] Variable Reserve Requirement

There are two components to this instrument of monetary policy,

namely – The Cash Reserve Ratio (CLR) and the Statutory Liquidity
Ratio (SLR). Let us understand them both.

Cash Reserve Ratio (CRR) is the portion of deposits with the

commercial banks that it has to deposit to the RBI. So CRR is the
percent of deposits the commercial banks have to keep with the RBI.
The RBI will adjust the said percentage to control the supply of
money available with the bank. And accordingly, the loans given by
the bank will either become cheaper or more expensive. The CRR is
a great tool to control inflation.
The Statutory Liquidity Ratio (SLR) is the percent of total deposits
that the commercial banks have to keep with themselves in form of
cash reserves or gold. So increasing the SLR will mean the banks
have fewer funds to give as loans thus controlling the supply of
money in the economy. And the opposite is true as well.

4] Liquidity Adjustment Facility

The Liquidity Adjustment Facility (LAF) is an indirect instrument for

monetary control. It controls the flow of money through repo rates
and reverse repo rates. The repo rate is actually the rate at which
commercial banks and other institutes obtain short-term loans from
the Central Bank.

And the reverse repo rate is the rate at which the RBI parks its funds
with the commercial banks for short time periods. So the RBI
constantly changes these rates to control the flow of money in the
market according to the economic situations.

5] Moral Suasion

This is an informal method of monetary control. The RBI is the

Central Bank of the country and thus enjoys a supervisory position in
the banking system. If there is a need it can urge the banks to exercise
credit control at times to maintain the balance of funds in the market.
This method is actually quite effective since banks tend to follow the
policies set by the RBI.

What Is the Money Market?

The money market is where short-term financial instruments, i.e. securities with a holding
period of one year or less, are traded. Examples of money market instruments include:
• Bankers’ acceptances. Bankers’ acceptances are a form of payment that’s
guaranteed by the bank and is commonly used to finance international transactions
involving goods and services.
• Certificates of deposit (CDs). Certificate of deposit accounts are time deposits that
pay interest over a set maturity term.
• Commercial paper. Commercial paper includes short-term, unsecured promissory
notes issued by financial and non-financial corporations.
 • Treasury bills (T-bills). Treasury bills are a type of short-term debt that’s issued by
the federal government. Investors who purchase T-bills can earn interest on their
money over a set maturity term.

These types of money market instruments can be traded among banks, financial institutions,
and brokers. Trades can take place over the counter, meaning the underlying securities are not
listed on a trading exchange like the New York Stock Exchange (NYSE) or the Nasdaq.
You may be familiar with the term “money market” if you have ever had a money market
account. These are separate from the larger money market that is part of the global economy.
As far as how a money market account works goes, these bank accounts allow you to deposit
money and earn interest. You may be able to write checks from the account or use a debit
card to make purchases or withdrawals.

How Does the Money Market Work?

The money market effectively works as a short-term lending and borrowing system for its
various participants. Those who invest in the money market benefit by either gaining access
to funds or by earning interest on their investments. Treasury bills are a great example of the
money market at work.

When you buy a T-bill, you are essentially agreeing to lend the federal government your
money for a certain amount of time. T-bills mature in one year or less from their issue date.
The government gets the use of your money for a period. Once the T-bill matures, you get
your money back with interest.

What Is the Capital Market?

The capital market is the segment of the financial market that’s reserved for trading of long-
term debt instruments. Participants in the capital market can use it to raise capital by issuing
shares of stock, bonds, and other long-term securities. Those who invest in these debt
instruments are also part of the capital market.

The capital market can be further segmented into the primary and secondary market. Here’s
how they compare:
• Primary market. The primary market is where new issuances of stocks and bonds
are first offered to investors. An initial public offering or IPO is an example of a
primary market transaction.
• Secondary market. The secondary market is where securities that have already
been issued are traded between investors. The entity that issued the stocks or bonds is
not necessarily involved in this transaction.

How Does the Capital Market Work?

The capital market works by allowing companies and other entities to raise capital. Publicly-
traded stocks, bonds, and other securities are traded on stock exchanges. Generally speaking,
the capital market is well-organized. Companies that issue stocks are interested in raising
capital for the long-term, which can be used to fund growth and expansion projects or simply
to meet operating needs.
In terms of the difference between capital and money market investments, it usually boils
down to three things: liquidity, duration, and risk. While the money market is focused on the
short-term, the capital market is a longer-term play. Capital markets can deliver higher
returns, though investors may assume greater risk.

Understanding the capital market is important because of how it correlates to economic

movements. The capital market helps to create stability by allowing companies to raise
capital, which can be used to fund expansion and create jobs.

Differences Between Money Markets and Capital Markets

When comparing the money market vs. capital market, there are several things that separate
one from the other. Knowing what the key differences are can help to deepen your
understanding of money markets and capital markets.

Purpose
Perhaps the most significant difference between the money market and capital market is what
each one is designed to do. The money market is for short-term borrowing and lending.
Businesses use the money market to meet their near-term credit needs. Funds are relatively
safe, but typically will not see tremendous growth.

The capital market is also designed to help businesses and companies meet credit needs. The
emphasis, however, is on mid- to long-term needs instead. Capital markets are riskier, but
they may earn greater returns over time than the money market.

Length of Securities
The money market is where you will find short-term securities, typically with a maturity
period of one year or less, being traded. In the capital market, maturity periods are usually not
fixed, meaning there is no specified time frame. Companies can use the capital market to
fund long-term goals, with or without a deadline.

Financial Instruments
As mentioned, the kind of financial instruments that are traded in the short-term money
market include bankers acceptances, certificates of deposit, commercial paper, and Treasury
bills. The capital market is the domain of stocks, bonds, and other long-term securities.

Nature of Market
The structure and organization of the money market is usually informal and loosely
organized. Again, securities may be traded over-the-counter rather than through a stock
exchange. With the capital market, trading takes place primarily through exchanges. This
market is more organized and formalized overall.

Securities Risk
Risk is an important consideration when deciding on the best places to put your money. Since
the money market tends to be shorter term in nature, the risk associated with the financial
instruments traded there is usually lower. The capital market, on the other hand, may entail
higher risk to investors.

Liquidity
Liquidity is a measure of how easy it is to convert an asset to cash. One notable difference
between capital and money market investments is that the money market tends to offer
greater liquidity. That means if you need to sell an investment quickly, you’ll have a better
chance of converting it to cash in the money market.

Length of Credit Requirements

The money market is designed to meet the short-term credit requirements of businesses. A
company that needs temporary funding for a project that’s expected to take less than a year to
complete, for example, may turn to the money market. The capital market, on the other hand,
is designed to cover a company’s long-term credit requirements with regard to capital access.

Return on Investment
Return on investment or ROI is another important consideration when deciding where to
invest. When you invest in the money market, you’re getting greater liquidity with less risk
but that can translate to lower returns. The capital market can entail more risk, but you may
be rewarded with higher returns.

Timeframe on Redemption
Money market investments do not require you to hold onto them for years at a time. Instead,
the holding period and timeframe to redemption is likely one year or less. With capital market
investments, there is typically no set time frame. You can hold onto investments for as long
as they continue to meet your needs.

Relevance to Economy
The money market and capital market play an important role in the larger financial market.
Without them, businesses would not be able to get the short- and long-term funding they
need.

Here are some of the key differences between money markets and capital markets with regard
to their economic impacts:

• The money market allows companies to realize short-term goals.

• Money market investments allow investors to earn returns with lower risk.

• Capital markets help to provide economic stability and growth.

• Investors can use the capital market to build wealth.

Money Market Capital Market
Offers companies access to short-term Provides stability by allowing companies
funding and capital, keeping money moving access to long-term funding and capital.
through the economy.
Investors can use interest earned from money Investors can use returns earned from capital
market investments to preserve wealth. market investments to grow wealth.
Money market investments are typically less Capital market investments tend to be more
volatile, so they’re less likely to negatively volatile, so they offer greater risk and reward
impact the financial market or the investor. potential.

The term’ economic reform’ usually refers to changes made to existing laws and policies. India
introduced several Economic Reforms In India to promote economic stability and improve the
economy. The primary aim of these was to establish a good economic standing and cater to the
need for Economic Reforms of the country and its people. India faced a major crisis in 1991, after
which it had to find ways to improve its economic situation and had to take steps to introduce
new reforms. Since India’s independence, the country’s financial sector has seen significant
changes.

Banking Reforms, 1969:

 The nationalisation of banks is referred to as banking reform.

 Indira Gandhi, India’s only female Prime Minister, took a crucial step in 1969 by
nationalisation of 14 banks to meet the growing demand for bank nationalisation.

 The nationalisation of banks resulted in centralisation of banking services, which

promoted uniformity.

 Nationalised Banking services meant that there would not be a monopoly in this sector.

 Along with these benefits, nationalisation made credit accessible for all, not just the
privileged section of society.

 Lack of sufficient credit and inefficient banking sector operation were the reasons for this
step.

 As a result, banks can run more efficiently, and the public’s trust in them has grown.

 Several Non-Banking Financial Institutions (NBFIs) and Banking Financial Institutions

(BFIs) have also emerged in this industry.
Abolishing ‘Privy Purse,’ 1971
The ‘Privy Purse’ was a reward or payment made to the royal families of princely states that were
forced to join independent India in 1947.

 This step aimed to take away all the authority from these families by paying or rewarding
them.

 Indira Gandhi argued for its elimination in 1971 to promote equal rights for all citizens and
lower the government’s revenue deficit.

 It was a significant setback for the Indian royalty, who now had to pay taxes and were no
longer exempted from the law.

Stopping the ‘Licence Raj,’ 1991

 Before obtaining a licence to operate, a company needed to gain the support of 80
government companies. This was done to discourage private companies and businesses
from being set up.

 Even after acquiring the licence, the companies had to face restrictions.

 In 1991, the Licence Raj was stopped, and private businesses could be set up easily.

 Dr Manmohan Singh, the then-Finance Minister, was instrumental in ending the Licence
Raj in India.

New Economic Policy, 1991:

 After the crisis of 1991, Economic Reforms In India were introduced to improve the
country’s situation.

 The New Economic Policy of 1991 has three essential components: liberalisation,
privatisation, and globalisation, also known as LPG.

 Increased competition, higher demand, adoption of new technology, development of

human resources and skills, and increased focus on customers have been some of the
benefits of these reforms.

 Since the liberalisation process began, the Indian marketplace has opened up to both
private and public sector enterprises.

 The private sector was encouraged to grow, and only 8 industries were restricted to the
public sector in 1991.
  This growth of the private sector is known as privatisation.

 Slowly, the country began to carry out enterprises with foreign organisations. A change
popularly called globalisation.

Black Money (Undisclosed Foreign

Income and Assets) and Imposition of
Tax Act, 2015
 It is an act of the Indian Parliament to combat black money, hidden foreign assets, and
income.

 It involves imposing tax and penalties on such income.

 The Lok Sabha passed this Act on May 11, 2015, and the Rajya Sabha on May 13,
2015.

 This law aims to bring income and assets held outside the country back into the country.

 Failure to obey the rules under this Act has serious outcomes, including fines and
possibly imprisonment.

Foreign Direct Investment (FDI) in

various sectors
 Foreign direct investment (FDI) is a useful source of funding for the development of
Indian enterprises and the economy.

 When foreign corporations invest directly in Indian companies, Indian companies benefit.

 At the ‘India ideas’ conference on July 22, 2020, Indian Prime Minister Narendra Modi
declared that India had managed to attract 20% more FDI than it did in 2019.

 Inflows of foreign direct investment into India in 2019-2020 were 74 billion dollars, up
20% from the previous year.

Goods and Services Tax (GST):

After nearly 20 years of implementationof VAT under the Vajpayee government, Prime Minister
Narendra Modi finally put GST into effect on July 1, 2017. Following are some benefits of GST:
  The establishment of a single national market, a push for the “Make in India” project,
increased investment and jobs, a simplified tax structure, ease of doing business.

 Procedures that are more automated and make better use of information technology.

 Compliance costs are reduced, and agriculture, trade, and industry benefit.

 It benefits small traders and enterprises.

 It removes the application of taxes at every stage of supply.

 Although GST has been criticised, its benefits exceed its drawbacks.

Demonetisation, 2016:
On November 8, 2017, Prime Minister Narendra Modi announced the demonetisation of all Rs.
500 and Rs. 1,000 banknotes. The following are the goals of making such an announcement:

 Reduce the use of black money, increase cash in the banking system, stop the handling
of fake currency, reduce all possible finances for terrorists.

 Many limits were placed on the government’s plan to stifle it. The general public ran into
several issues in meeting the standards on such short notice.

 According to recent estimates, India is still recovering from the demonetisation shock
despite the rise in popularity of digital payments and cashless transactions.

National Institute for Transforming India (NITI) Aayog

 Narendra Modi established the NITI Aayog on May 24, 2014, to replace the long-standing
Planning Commission.

 The goal of this was to fulfil the Need for Economic Reforms.

 The NITI Aayog is the Indian government’s top policy thinktank, offering directional and
policy suggestions.

Considering ‘start-ups’ as a new business model:

The Indian government’s ‘Start-Up India’ scheme aims to increase employment and income
development in the country. On January 16, 2016, Narendra Modi announced the introduction of
this scheme, which includes the following benefits: –

 The scheme assisted in having a better workflow, financial assistance, easy access to
government bids, and increased networking opportunities.
 Increased competitiveness, higher transparency, comprehensive digitisation, increased
innovation, and increased policy stability have all been achieved due to reforms.