In the second part of the two-part series, we will have a look at what monetary policy is. Did you know that recently RBI conducted auctions for government bonds but did not accept any bids? Let us understand this issue in context of the Monetary policy to get a better understanding of RBI’s issue.
If you missed the first part, you can read it here: Understanding Fiscal Policy.
Crux of the Matter
What Is Monetary Policy?
Monetary policy refers to the actions taken by a nation’s central bank to control the money supply to achieve macroeconomic goals that promote sustainable economic growth. Like Fiscal Policy, Monetary policy can be classified as expansionary or contractionary.
This policy consists of management of money supply and interest rates, which aids in achieving macroeconomic objectives such as controlling consumption, liquidity, inflation, etc.
These are achieved by modifying the interest rates, regulating foreign exchange rates, buying or selling government bonds, etc.
Components Of Interest Rate Lever
It is a rate at which the central bank of a country lends money to commercial banks. An increase in repo rate results in an increase in the interest rate at which banks can borrow and thereby at which the public can borrow and save. This eventually leads to the public borrowing less and decreasing money and credit flow in the economy as people may not want to borrow at high costs.
A decrease in repo rate generally results in a decrease in interest rates. This eventually leads to an increase in credit and money flow in the economy as people can borrow cheaply.
As of 6th August 2020, RBI kept the repo rate unchanged at 4%.
Credit Reserve Ratio (CRR)
It is a certain percentage of the total bank deposits that a bank has to keep with the Central Bank (here RBI). Banks cannot utilize this amount for any commercial or economic activity and it remains in the current account, not earn any interest.
An increase in CRR, strips the banks of cash, and resultantly banks cannot lend more loans. On the other hand, a decrease leads to surplus cash in the hands of a bank to incentivise them to lend more.
As of March 2020, CRR was 3%.
Statutory Liquidity Ration (SLR)
SLR is the percentage of total bank deposits that a bank has to invest in securities, primarily central and state government’s. As opposed to in CRR, in SLR deposits banks earn interest on the investments, albeit a lower one.
Similar to CRR, increase in SLR leaves the bank with less cash to lend, which can possibly fetch a higher interest. A decrease leaves a bank with more cash to lend at rates higher than what government securities fetch.
As of April 2020, SLR was 18.00%
CRR, SLR, etc also ensure that banks don’t become insolvent.
Government Securities And OMOs
G-Sec or Government Security is a tradeable, fixed interest bearing debt instrument issued by a central or state government. Treasury Bills are short term securities, with a maturity of less than a year, whereas bonds/notes are long term securities.
Government’s banker RBI buys and sells G-Sec to manage the money supply in the economy – the process known as Open Market Operations.
To increase the money supply in the economy, RBI will purchase bonds, and to decrease the money supply (also to raise money for the government), RBI will sell the bonds.
RBI’s Recent Issue With OMOs
On September 24, RBI rejected all bids worth ₹66,473 crores – six times the offer of ₹10,000 crores – saying the yields demanded by participants were high. Experts say that if RBI accepted the yield, it would have meant that government will have to borrow at a higher cost. As the government’s banker, RBI would obviously not want that.
The RBI thinks that the yield asked for by market was higher than what RBI would have liked; on the other hand, the market is saying that with no rate cut and large scale OMO, the rates should have been higher as inflation and government borrowing concerns remain.
– Harihar Krishnamoorthy,
Treasury Head, First Rand Bank
- The Keynesian Revolution was a fundamental reworking of economic theory concerning the factors determining employment levels in the overall economy. The revolution was set against the then orthodox economic framework, namely neoclassical economics.
- Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods.
- Sher Shah Suri was the founder of the Suri Empire in India, with its capital in Sasaram in modern-day Bihar. He is often credited for introducing the currency of rupee or rupiyah.