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RBI's Monetary Policy Simplified

In this week’s FinMail we bring to you the basic version of how RBI’s Monetary Policy works, how it uses the tools available to it to regulate the money supply and to achieve the targeted economy. We also take a look at the latest monetary policy and what it means for us.

The previous quarter’s GDP contracted by 23.9%. RBI in its monetary policy expected GDP to contract by at least 9.5% in this quarter ending in September. While this is positive news, India has now entered into a technical recession. A technical recession is defined as two consecutive quarters of negative growth. So while the numbers of GDP are in and are negative, there are steps that the Government will take to gain control over the economy and steer it towards progression. These steps are like reins, which are used to steer the economic influence of the people towards a path that the controller of the economy i.e. the government thinks will be in the collective interest. And because all of the people combined is an economy as a whole, it is usually where the economy steers towards. Now there are numerous steps that the government can use to steer the economy towards a particular path but they are divided into two major policies:

i) Monetary Policy and ii) Fiscal Policy

Monetary Policy and Fiscal Policy are the two major tools that are used to influence the nation’s economic activity at large.

Fiscal Policy is a policy that is used by the government to influence the economic mindset through government spending policies and taxation policies. Not going into the depth of it, let’s jump straightaway to the monetary policy.

Monetary Policy

Monetary Policy is a policy that is used by the nation’s central bank to stimulate the interest rates in the economy directly or indirectly through controlling the supply of money. Monetary policy involves decisions that are aimed to affect or achieve the goals related to inflation, liquidity, consumption pattern, or aggregate demand. The ultimate goal is to affect the growth of the economy by taking control of the money supply and interest rates to affect the parameters mentioned above. Now the fiscal policy is undertaken by the government yearly through annual budgets or interim budgets or occasionally when there is an acute need for a package (like during May) but monetary policy is framed by the RBI and is undertaken bi-monthly, so as the latest numbers of the GDP for Q2 of FY 20–21 came out, people were waiting on how the RBI would react and what stance it would have to take control of the troubled economy. So, this week we have simplified the basics of Monetary Policy plus a look at what the latest policy means for us. So without further ado, let’s jump right into understanding the current Monetary Policy. The Latest Monetary Policy On Friday, December 4th, RBI came up with its bi-monthly monetary policy and these were the major takeaways of it:

  • The Repo Rate and the Reverse Repo Rate were kept unchanged at 4% and 3.35% respectively.

  • CPI Inflation is projected at 6.8% in Q3, 5.8% in Q4 of FY 2020–21.

  • Overall GDP of the year is expected at -7.5% revised from -9.5% earlier.

  • The marginal standing facility and bank rate remain unchanged at 4.25%.

These were the major highlights of the latest Monetary Policy and before we look at what it means for us, let us understand the tools that RBI has and how they are used to frame a Monetary Policy that aims towards economic progress.

Tools Available with RBI to control Money Supply.

Repo Rate Repo rate is the rate at which RBI lends money to the banks. Let’s say HDFC Bank is having a shortage of funds, in that case, it can borrow money from the RBI by providing G-Secs as collateral. RBI will charge some % of interest, such rate is called repo rate.

Reverse Repo Rate Reverse Repo Rate is the rate at which a bank lends its extra funds to RBI. If SBI is having extra funds, it can lend those funds to RBI against which RBI will pay interest. Such an interest rate is called Reverse Repo Rate. In this case, too RBI will provide G-Secs as collateral to SBI.

MSF — Marginal Standing Facility MSF is the rate at which RBI lends money to the bank on an overnight basis. It is the lending limit available over and above the limit of lending at Repo Rate and thus MSF rate is higher than Repo Rate.

Liquidity Adjustment Facility — LAF LAF is a financing tool that is used to help the bank in solving short-term cash shortages. This facility is just like borrowing using Repo Rate but in this facility, the banks deal with other banks and not with RBI. One bank with excess cash will lend to another bank with cash shortage with eligible securities that are used as collateral.

Open Market Operations Open Market Operations are Operations of Buying and Selling G-Secs simultaneously in the market to gain control over liquidity. It is done to stimulate short-term interest rates in the market. OMO includes buying short-term G-Secs and selling long-term G-Secs or vice versa. This helps RBI to maintain control over interest rates in the economy.

Market Stabilisation Scheme — MSS To pull out the excess money flowing in the economy i.e. if there is excess liquidity in the market, RBI uses MSS. Under MSS, RBI steps in to curb extra liquidity by selling Government Securities and sucking the extra money from the market. It is different from OMO in a way that, OMO involves simultaneous selling and buying of G-Secs while MSS only involves selling G-Secs.

SLR — Statutory Liquidity Ratio SLR is a ratio for reserve requirements that a bank should maintain with them. Such reserves could be in form of cash, gold, PSU bonds, or RBI-approved securities. This ratio states the minimum amount of reserves a bank should have before lending out the extra money. This ratio helps RBI control the growth of the Bank’s lending activities.

CRR — Cash Reserve Ratio CRR is a % of total deposits in a bank that it should hold at all times in the form of cash or Cash Equivalents. This amount is stored at the bank’s facility or securely placed at RBI. CRR exists to protect banks from running out of cash when there is an unusual rise in demands of cash by depositors.

Bank Rate Bank Rate is the rate at which RBI lends money to the banks. An important thing to note here is bank rate is only used for short-term lending and does not involve collateral. Bank Rate is different from Repo Rate in the case that bank rates are the lending rate at which only commercial banks can borrow money from RBI and do not need to provide securities in exchange.

Corridor The corridor is a range that is used by RBI to understand the liquidity in the money market. It is basically the difference between a lower reverse repo rate and a higher ceiling rate of MSF. The Corridor range is the range at which normal call money rates should move in the market. So for example, if the lower reverse repo rate is 5% and the upper MSF is 9%, then the corridor is 5–9%. This is the range at which call money rates should typically range. If it is above or below the range, there is a liquidity crisis in the economy and RBI decides to jump in.

Well, that was some heavy stuff. 10 different weapons available with the RBI to control the money supply and interest rates. So how do they work and how do they affect us, individuals? Let’s jump right in. So you see RBI now has the tools with it and how it has got a huge task to ensure the vision and the objective of economic progress. RBI frames the monetary policy keeping in focus the liquidity in the market or as we say supply of money, inflation, and interest rates. Now let us understand how RBI uses these rates to lay its control on the money supply.

How these rates affect the Loan Rates or Deposit Rates? The tools as we discussed earlier like Repo Rate, Reverse Repo Rate, or Bank Rates are the rates at which funds are available to the bank. Now if the bank is getting funds at low costs, then the bank will also lend at lower rates to individuals and businesses. And if the banks are acquiring funds at high costs, they will also lend at higher interest rates.

How does Monetary Policy work? Let’s assume that the Indian Economy is moving towards progression and development. Now to boost the progress, the economy needs more resources in the form of capital. And one way to acquire capital is through loans. So what RBI will do with the Monetary Policy is that it will frame it in such a way to bring the lending rates down and thus it will mean that loans will be easily available at lesser interest rates. This will encourage businesses and other entities to borrow more money and use it for their expansion. This will mean more production, more employment, and more money will start flowing in the market and thus the economy will start moving towards progress.

As the lending rates are lower, the interest rates on deposits will also be lower and thus people will have less incentive to save. And because there is ample money supply i.e. there is more money in the hands of people, they will start spending more and thus pushing up the prices of products and services which will eventually lead to higher inflation. Again as the lending rates are low, people will borrow more to spend more, further pushing inflation to high levels, and at a point when the inflation is rising and going out of control, that is where RBI will step in with a different approach.

With Inflation rising and too much money rotating in the market, RBI will have to jump in and do something to bring things back to normal. So it will now frame the monetary policy in such a way that will reduce the money supply in the market. So here RBI will increase the cost of loans available to the banks, making loans costlier. With loans getting costlier, the businesses will have to pay more interest rates if they want to borrow. This will reduce their motivation to expand by using borrowed funds and use the money that they already have to expand. So there will be less incentive to spend and more incentive to save. Because, as lending rates will go up, banks will start offering higher interest rates on deposits too and thus it will incentivize people to save more. This way eventually the money supply in the market will start to come down as there will be more savers and fewer spenders. It is good up to a certain extent but if it continues for a longer period, economic progress will slow down and aggregate demand will fall leading to lesser production and unemployment. And again RBI will have to step in with an approach of expansion.

This way the cycle goes on and the RBI tries to maintain an optimum balance between both approaches and ultimately promote economic progress. The important thing to note here is that both approaches are important. It is the optimum level between both approaches that RBI tries to work on to steer the economy towards progress.

What does the latest Monetary Policy mean for you?

So after understanding how a monetary policy works typically, let us have a look at what the latest policy means for us. RBI kept the repo rate, reverse repo rate, MSF rate, and Bank Rate unchanged because the RBI wants to incentivize people to spend more to push the aggregate demand while keeping Inflation in control. This means loans will not get cheaper and your EMIs won’t change too but it also means that bank deposit rates would not go further down. RBI anticipates controlling the inflation rate while ensuring that people get back to spending as usual before the Pandemic will promote overall economic progress. That is it folks in this week’s Newsletter and we will see you next week.

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