Tools of Money supply by RBI:
Monetary policy
Lecture 16
Section D, E and PGP- Fin 03
RAC Chair RAC Area Member RAC Cross-Area Member
Prof. Sumit Mitra Prof. Anubha S. Sinha Prof. Debabrata Chatterjee
Objectives of the class
o How does RBI increase or decrease money supply in the economy?: Tools of RBI
o Economics of Monetary policy
o Why do bank fail?
o Presentation: Fiscal deficit and Public debt
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RBI’s monetary policy tools
o We saw how RBI increases (decreases) money supply by conducting OMOs
o Another monetary policy instrument is CRR
o If RBI reduces CRR, then banks can make more loans which will lead to more
deposits, therefore “create” more money.
o A third monetary policy instrument is repo rate (the discount window)
Overnight Repo lending by RBI to
banks Funds
RBI Commercial Bank
(sells bond)
Govt bond
Next day the transaction is reversed
Govt bond
RBI Commercial Bank
(repurchases bond)
Funds
RBI charges banks the repo rate (4.40%) for this liquidity adjustment facility (LAF)
Repo vs Reverse Repo
Repo transactions are used by RBI to inject liquidity
Reverse repo is the opposite of a repo transaction which is
used by RBI to absorb liquidity
Reverse repo rate is currently 3.75% (repo rate – 65 bps)
If banks run out of government bonds to use for repo loans
(but they have to meet SLR) they can borrow at the marginal
standing facility (MSF) charged at ‘bank rate’ – currently
4.65% (repo rate + 25 bps)
Under MSF, SLR can fall below the requirement by 2%
Banks can borrow up to 1% of deposits under repo channel
LAF and the corridor of interest
rates
X+25 bps
X-25 bps
Open market Operations ( secondary market)
This refers to buying and selling of government securities by RBI to regulate
short-term money supply
If RBI wants to induce liquidity or more funds into the system, it will buy
government securities and inject funds,
If it wants to curb the amount of money out there, it will sell these to banks,
thereby reducing the amount of cash that banks have.
RBI uses this tool actively even outside of its monetary policy review to manage
liquidity on a regular basis.
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CRR (3%) vs SLR (18%)
• Both are liquidity requirements as % of deposits
• CRR Some part of deposits maintained in cash form
(with RBI), no interest earned, cushion against crisis,
instrument of monetary policy
• SLR Some part of deposits maintained in liquid
securities, interest is earned, cushion against crisis, not
an instrument of monetary policy
Controversy: RBI’s refusal to pay interest on
CRR balances
The Eco no mic Effects o f M o netary Po licy
M oney Supply
Consider money Money Supply
Interest rate, i
supply as the sum of MS
currency with the
public and demand
deposits with banks
Money Supply (M ) = C + D
The supply of
money
is fixed by the central
bank: Reserve Bank of
India Money
Money demand
Demand for
money:
Interest rate, i
Md = L (i , Y)
- +
Liquidity preference model:
Interest rate is the
opportunity cost of holding
money (paid by bonds or
banks). Negatively sloped Md
money demand curve.
When income is higher, expenditure is higher, so Money, M
people engage in more transactions that require
the use of money. Money demand curve shifts up.
Money Demand, Money Supply,
and the Equilibrium Interest Rate
The interest rate
must be such that
the supply of money
be equal to the
demand for money.
The Effects of an Increase in
Nominal Income on the Interest Rate
An increase in
nominal income
leads to an
increase in the
interest rate.
The Effects of an Increase in the Money Supply on the Interest Rate
• Expansionary
monetary policy
results in a higher
quantity of money
and lower interest
rates.
• Contractionary
monetary policy
results in a lower
quantity of money
and higher interest
rates.
Effects of Expansionary Monetary Policy on Interest
Rates, Investment, and Aggregate Demand
(a) Supply and demand (b) Demand for (c) Aggregate demand
Interest rate
Interest rate
for money investment
Price level
MS M’S
LRAS
SRAS
i a i a
P’
b b
i’ i’ P
Md
AD’
I
AD
Y Y’
0 M M’ Money 0 I I’ Real GDP
Investment
This sets off the spending
An increase in the money With the cost of borrowing multiplier process, so output
supply drives the interest lower, the amount invested demanded and GDP at price
rate down to i'. increases from I to I‘. level P increases from Y to Y‘
Bank capital requirements
Bank capital: the resources a bank’s investors have put
into the bank (includes equity, retained profits, hybrid debt
etc.)
Commercial bank’s balance sheet:Liabilities & Capital
Assets
Reserves Rs.150 Deposits Rs.750
Loans Rs.500 Capital Rs.50
Other Assets Rs.350 Other Rs.200
Liabilities
Total Rs. 1000 Total Rs. 1000
Bank capital requirements
Being highly leveraged makes banks vulnerable.
Example: Suppose a recession causes this bank’s loan
assets to fall to 450.
Then, capital = assets – liabilities = 950 – 950 = 0
Assets Liabilities & Capital
Reserves Rs.150 Deposits Rs.750
Loans Rs.450 Capital Rs.0
Other
Other assets Rs.350 liabilities Rs.200
Total Rs. 950 Total Rs. 950
Bank capital requirements
Regulatory requirement:
minimum amount of capital mandated by regulators
intended to ensure that banks will be able to pay off
depositors
forces shareholders to participate in the risks that depositors
are exposed to
higher for banks that hold more risky assets:
Required capital ratio is 8% of assets (risk weighted) under Basel
norms (9% required by RBI)
out of which at least 4.5% must be equity capital (6% required by
RBI)
Monetary Policy Transmission
Operating Intermediate Ultimate
Instruments Target Target Objectives
Primary Instrument:
Repo rate
(under the LAF)
Price
Secondary instruments: Long Term Through the
Short Term Transmission Stability
CRR Interest Rate
Interest Rate Channels (CPI Inflation
OMOs (e.g. deposit rate,
(overnight call rate) of Monetary 4% +/- 2%)
Indirect Instruments: lending rate,
Policy
Interest rate regulation bond rate)
Selective Credit Control
Moral Suasion
Inflation targeting formally adopted in India in 2015 (following Urjit Patel Committee recommendations)
Repo rate decisions taken by a 6-member MPC (monetary policy committee) with 3 RBI and 3 external
members, chaired by RBI governor (with casting vote)
