Monetary Tools to Control the Market

(A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% . For example, if the Federal Reserve Board raises interest rates by 25 basis points, it means that rates have risen by 0.25% percentage points. If rates were at 2.50%, and the Fed raised them by 0.25%, or 25 basis points, the new interest rate would be 2.75%)

1. Cash Reserve Ratio: * Introduction: It is the amount of funds that the banks have to keep with the RBI. * It is a central bank regulation that sets the minimum fraction of customer deposits and notes that each commercial bank must hold as reserves with the RBI. * Cash Reserve Ratio is also used as a tool in monetary policy by changing the amount of funds available for banks to make loans with. * Effects on money supply: If the reserve requirement set by the RBI is high, the amount of funds with the commercial banks to loan out would be low thereby leading to lower money creation in the economy and vice versa. * RBI uses the CRR to drain out excessive money from the system * India’s CRR – 4% January 2013 as per RBI

2. Statutory Liquidity Ratio: 23% * Introduction: It is the money a commercial bank needs to preserve in the form of cash or gold or government approved securities (bonds) and shares) before providing credit to the customers. * It is determined by the RBI in order to control the expansion of bank credit. * It is a percentage of total demand and time liabilities (demand- savings , current a/c and time- fixed deposits) * It is used to regulate the credit growth in India. * SLR ensures solvency of commercial banks. * Effects on money supply: The RBI can increase the SLR to contain inflation and suck liquidity in the market. Higher the SLR, lower would be the money circulation as a commercial bank’s power to lend would come down and vice versa.

3. Repo Rate and Reverse Repo Rate: (repo is the short form for repurchase agreement) * Introduction: It is the rate at which the RBI lends money to commercial banks. * It is an instrument of monetary policy. * Whenever banks have any shortage of funds they can borrow from the RBI against securities held by them. * A reduction in the repo rate helps banks get money at a cheaper rate. * Importance in the economy: When RBI wants to decrease the lending activities in the country, it will increase the Repo Rate. Once the Repo Rate is increased, the cost of funds to banks from RBI will increase and it will in turn increase the lending rates to customers. This will reduce the lending transactions. But if the RBI feels the need of more lending activities, it will decrease the Repo Rate and reduce the cost of funding. This will translate into lower rates on loans and lending will pick up. * 7.75% 29/01/2013 * Reverse Repo Rate: It is the rate at which the RBI borrows money from commercial banks. * If banks have excess amount with them, they can park the surplus money with RBI and earn interest on this. The interest on such amount is called Reverse Repo Rate. * Effects on money supply: RBI will increase the reverse Repo rate, if it wants to reduce liquidity in the system. Banks will be tempted to park money with RBI rather than lending, if this rate is high. * 6.75% 29/01/2013 * The repo rate is always 1% higher than the reverse repo rate.