800 Prelims Questions with Video Explainers + Tikdams
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If you haven’t read the article on inflation, read it before proceeding further
In the last article we understood, although both inflation and deflation are bad for economy, deflation is worse and policymakers always have to guard against possible deflationary tendencies. In this respect, inflation becomes a necessary evil. One of the major adverse effect of inflation is due to uncertainty it creates in the minds of investors and risk of hyperinflation. Policymakers therefore want low and stable inflation in the economy.
What that target level should be is decided either by parliament by law or informally by govt and central bank. As we saw inflation helps in labour market adjustment and as emerging economies undergo rapid transition, slightly higher inflation helps in that adjustment. For this reason. while inflation target is about 2% in developed economies, it is 4-5% in developing economies.
In India RBI and govt signed an agreement for long term inflation target of 4% with 2% range either side i.e. 2-6% inflation.
Earlier, there was no explicit target for inflation (no inflation targeting), RBI used to target multiple indicators as objectives of monetary policy
Inflation has been a perennial problem for India. As we saw inflation is due to demand supply mismatch i.e. demand for goods being higher than supply. To control inflation, monetary authority i.e. RBI formulates monetary policy.
As the name suggests it is policy formulated by monetary authority i.e. central bank which happens to be RBI in case of India.
It deals with monetary i.e money matters i.e. affects money supply in the economy.
Eg. CRR,SLR,OMO,REPO etc
What is fiscal policy then?
It is formulated by finance ministry i.e. government. It deals with fiscal matters i.e. matters related to government revenues and expenditure.
Revenue matters- tax policies, non tax matters such as divestment, raising of loans, service charge etc
Expenditure matters– subsidies, salaries, pensions, money spent on creation of capital assets such as roads, bridges etc.
Monetary policy and fiscal policy together deal with inflation.
Demand pull inflation is when people have more money to buy goods. It is easier for RBI to control as it can decrease the money supply in the economy, less money would lead to fall in prices.
But supply side inflation can not be dealt with by RBI. RBI can’t build roads or change agri policies to ensure smooth movement of grains. It does not control prices of oil or other commodities. Here role of government through fiscal policy becomes important.
It’s clear from what we have learnt so far that to control inflation, RBI will have to decrease money supply or increase cost of fund so that people do not demand goods and services.
Tools available with RBI
Reserve ratio- Banks have to set aside certain percentage of reserves as cash or RBI approved assets.
They are of two types
This reserve requirement is calculated on bank’s net demand (current and savings account) and time liabilities (Fixed deposits) which is roughly equivalent to total bank deposits.
At present CRR is 4% and SLR is 21.50% . But what if RBI tomorrow raised CRR or SLR, what would be it’s impact.
|Total deposits||CRR (parking with RBI) No interest here||SLR (Investment in liquid assets mainly govt securities)||Amount available for lending|
Consider interest rate as price for a commodity called money/ cash and apply demand supply principle of less commodity, higher prices i.e less money, higher interest rates
Less money with the banks # demand for money same # apply demand supply principle # interest rate will rise # costlier for you and I to borrow money to buy car # demand for car down # apply demand supply principle # cost of car will come down
Similarly business will borrow less # less expansion of business activity # wages will come down # less money with people # less demand for goods # prices wall
Net effect is that interest rate rises and prices fall.
Money becomes costlier when interest rate rises and when RBI makes money to become costlier or dearer, it is said to be following dear money policy. As money supply decreases in the economy, i.e. contraction in money supply, it is also known as contractionary monetary policy.
Businesses postpone expansion due to high cost of credit and investment comes down in the economy which drags down growth rates and hurts employment. That’s the reason why corporates and government always clamour for policies which lead to interest rate cuts such as reduction in CRR, SLR. Investment is thus negatively correlated with higher interest rates.
2. Open market operations (OMO)– As the name indicates this refers to operations conducted by the RBI in open market i.e. RBI does not directly ask banks to do anything. In this policy, RBI buys and sells government securities in the open market to control money supply.
We talked about government security in SLR as well, what is this government security?
Govt security is a type of debt instrument on which govt pays regular interest. As chances of default on govt securities is practically zero, they are also called gilt-edges securities.
What happens when RBI sells government securities?
|Total deposits at present||OMO||Banks govt securities worth||Amount available for lending|
|100||RBI sells secuties worth 10 rs, banks buy||20+10||100-(20+10) =70|
|100||RBI buys govt securities worth 10rs||20-10||90|
You can clearly observe that amount available for lending has come down i.e. money supply has contracted.
money going from the banks to the RBI # less money with the banks # dear money # higher interest rates # costlier for us to borrow to buy cars # less demand for cars # prices decrease
In effect, govt securities increases with banks when RBI sells govt securities.
Doesn’t this look eerily similar to phenomenon when RBI raises SLR, only difference being then banks were forced to raise their holding of securities. This way RBI suck out liquidity from the market.
Opposite happens when RBI buy securities, it then injects liquidity in the market.
So basically to control inflation, RBI will sell securities and suck out liquidity from the market.
OMOs are used more to control temporary mismatches in liquidity due to foreign capital flow, a policy known as sterilization.
|Total money supply at present||Net Foreign Investment||Investors convert $ into rs to invest in INDIA
|Eventual money supply|
|1000||1$ = 67rs||67||1000+67=1067|
When foreign investors invest in Indian economy, they buy rupees and sell dollars. RBI absorbs dollars and issues rupees. Net effect is that rupee supply or liquidity is increased in the economy. Higher liquidity or money supply chasing similar amount of goods will lead to inflation. RBI has to suck out excess liquidity from the market i.e. sterilize economy from capital flows.
What RBI would do
Undertake OMOs and sell government securities.
|Total money supply before foreign investment||Net Foreign Investment||Money supply after foreign investment
|RBI’s response||Money supply|
|1000||1$ = 67rs||1067||Sell govt securities||Less than 1067|
Note that I didn’t mention RBI would bring money supply to 1000 as with FDI, productive capacity would rise and to that extent goods worth say 1020 may be manufactured in INDIA and in that scenario to keep inflation stable, RBI needs to sell securities worth 20rs only. What would be the actual growth is essentially a data dependent judgement call.
When investors bring back their money, they will sell rupees and buy dollars. RBI will absorb rupees resulting in less liquidity in the market. To adjust this RBI will buy govt securities and inject liquidity in the market.
RBI uses another instrument to keep the liquidity intact, it is known as Market Stabilization Scheme (MSS).
At present bank rate is 7.75%. Bank rate is not the main tool to control money supply these days. Nowadays, RBI uses LAF ( liquidity adjustment facility) Repo rate as the main tool, to control money supply.
What’s the use of Bank rate then?
Penal rates are linked with Bank rate. For example, If a bank doesn’t maintain CRR, SLR as per the prescribed limit, penalty is prescribed as per bank rate.
It’s clear if RBI raises bank rate, costlier for banks to borrow from RBI # interest rate rises # repeat same story # costlier for you and I to borrow money to buy car # demand for car down # apply demand supply principle # cost of car will come down
It’s evident from the name that RBI uses such instruments to adjust liquidity and money supply.
#1. REPO rate – REpurcahse OBligation
Rate at which banks buy from RBI on a short term basis.
What do they have to repurchase?
On the Urjit Patel Committee’s recommendation — that the RBI stop fixing the repo rate in its quarterly reviews, and instead move to rate-setting on an ongoing basis, RBI started auctioning 7 day and 14 days term repo. In term repo, rate is market determined unlike overnight repo where RBI decides rate. Also RBI has restricted access to overnight repo to .25% on NDTL.
Clearly if RBI raises repo # costlier for banks to borrow # interest rate rises # repeat same story # costlier for you and I to borrow money to buy car # demand for car down # apply demand supply principle # cost of car will come down
#2. Reverse Repo as the name suggests is reverse of repo i.e. rate RBI pays to banks to park excess funds into RBI.
Reverse repo is linked to repo with,
Reverse repo = repo – 1
#3. Marginal Standing facility–
Penal rate at which banks can borrow money from the central bank over and above what is available to them through the rep window.
It is penal rate, hence REPO + 1
Reverse Repo + 1 = REPO; REPO + 1 = MSF
Under MSF banks can use up to 1% of securities from SLR.
Let’s recap all this. To control inflation RBI will follow dear or contractionary monetary policy to reduce money supply in the economy. It will increase reserve ratios (CRR,SLR), sell government securities under OMOs or raise various rates such as REPO, MSF, Bank rates etc.
But we see in India, even when RBI decreases rates banks don’t pass on the benefits to consumers and when banks raise interest rates when RBI raises rates, inflation does not come down. This suggest monetary policy is highly ineffective in India.
Why banks don’t pass on the benefits of rate cut to consumers?
RBI cut repo rate by 125bp last year but banks decreased lending rate only by 60bp.
Government and RBI’s response to improve monetary transmission
But why is RBI unable to control inflation even when banks immediately raise lending rates?
We have talked about quantitative tools so far but RBI also has some qualitative tools in its kitty which are not important for exams. So in brief
They are Selective tools- can affect money supply in a specific sector of economy unlike general quantitative tools which affect money supply in the whole economy.
By now we have understood that govt and corporate are more interested in low interest rates which support investment and growth while primary task of RBI is to control inflation, keeping prices stable and thus protecting purchasing power of money. This is not to say that govt and corporate do not want low inflation, they do but their primary focus lie elsewhere. It is in this context that autonomy of RBI to decide on monetary policy matters becomes so important.
At present sole authority vests with RBI governor who is advised by a technical expert committee whose advice is not binding. Government intends to replace it with a monetary policy committee (recommended by FSLRC and Urjit Patel committee and followed in many countries) with members both from within and outside RBI.
Two important questions arise-
Ideal committee would be one with RBI majority or equal members with casting vote with the governor without any veto. This along with explicit inflation target would give enough autonomy to go along with accountability.
To follow the story of Monetary Policy Committee and Autonomy of RBI, click here
#1. With reference to inflation in India, which of the following statements is correct?
#2. Which one of the following is likely to be the most inflationary in its effect?
#3. A rise in general level of prices may be caused by
Select the correct answer using the codes given below.
#4. With reference to Indian economy, consider the following:
Which of the above is/are component/components of Monetary Policy?
#5. When the Reserve Bank of India reduces the Statutory Liquidity Ratio by 50 basis points, which of the following is likely to happen?
#6. Supply of money remaining the same when there is an increase in demand for money, there will be
#7. If the interest rate is decreased in an economy, it will
#8. In the context of Indian economy; which of the following is/are the purpose/purposes of ‘Statutory Reserve Requirements’?
#9. An increase in the Bank Rate generally indicates that the
#10. The Reserve Bank of India (RBI) acts as a bankers‘ bank. This would imply which of the following?
Select the correct answer using the codes given below:
#11. Which of the following is/are long term policy tools
Select the correct response
#12. Which of the following measures would result in an increase in the money supply in the economy?
Other articles to understand basics of economics-