(IGP) GS Paper 1 - Economic & Social Development - "Monetary & Credit Policy"

Integrated Guidance Programme of General Studies for IAS (Pre)

Subject - Economic and Social Development
Chapter - Monetary & Credit Policy

Monetary Policy and its objectives

The use by the Central Bank of interest rate and other instruments to influence• money supply to achieve certain macro economic goals is known as monetary policy. Credit policy is a part of monetary policy as it deals with how much and at what rate credit is advanced by the banks. Objectives of monetary policy are:

  • accelerating growth of economy

  • price stability

  • exchange rate stabilization

  • balancing savings and investment

  • Generating employment and

What is Bank Rate

Bank Rate is the rate at which RBI lends long term to commercial banks. It is a tool which RBI uses for managing money supply and credit

What do you mean by SLR

It is the portion of time (fixed deposits) and demand liabilities (savings bank and current accounts) of banks that they should keep. in the form of designated liquid assets like government securities and other RBI-approved securities like, public sector bonds current account balances with other banks and gold SLR is aims at ensuring that the need for government funds is partly but surely met by the banks.

What is CRR

CRR is a monetary tool to regulate money supply. It is the portion of the bank deposits that a bank should keep with the RBI in cash form. CRR deposits earn no interest.

Open Market Operations of RBI

  • OMOs of the RBI can be described as purchase and sale of government securities in the Open market (open market essentially means banks and financial institutions) by the RBI in order to influence the volume of money and credit in the economy.

  • A purchase of government securities injects money into the market and thus expands credit; sales have the opposite effect- absorb excess liquidity and shrink credit.

Ready Forward Contracts (Repos)

  • It is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price.

  • In India, RBI lends on a short term basis to banks on the security of the government paper (repo). Banks undertake to repurchase the security at a later date- over night or few days. RBI charges a repo rate for the money it lends

  • Reverse repo is when RBI borrows from the market (absorbs excess liquidity) with the sale of securities and repurchases them the next day or after a few days. The rate at which it borrows is called reverse repo rate as it is the reverse of the repo operation.

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What is Selective Credit Controls

Certain businesses can be given more and certain others may get less credit from banks on the orders of the RBI. Thus, selective credit controls can be imposed for meeting various goals like discouraging hoarding and black-marketing of certain essential commodities by traders etc by giving them less credit

Moral Suasion

A persuasion measure used by Central bank to influence and pressure, but not force, banks into adhering to policy.

What do you mean by LAF (Liquidity Adjustment Facility)

Liquidity’ Adjustment Facility (LAF) was introduced by RBI in 2000.Under Laf, banks borrow from RBI and lend to RBI and repo and reverse repo rates based on government securities which are held above the 24% limit of SLR. Funds under LAF are used by the banks for their day-to-day mismatches in liquidity. It is different from OMOs as OMOs involve outright purchase/sale of security while Laf is for lending/borrowing.

What do you understand by MSF

Reserve Bank of India’s (RBI) introduced marginal standing facility (MSF) in May 2011. Under the MSF, banks can borrow overnight up to 1% of net demand and time liabilities (NDTL). The MSF is set 100 basis points above the repo rate — the rate at which banks borrow from RBI.

What do you mean by Base Rate

The Reserve Bank introduced base rate on Deepak Mohanty committee recommendations in 2010. It is the rate below which banks can not lend.

Reserve Bank of India

  • The central bank of the country is the Reserve Bank of India (RBI). It was established in 1935 with a share capital of Rs. 5 crores on the basis of the recommendations of the Hilton Young Commission.

  • Reserve Bank of India was nationalised in the year 1949. The general superintendence and direction of the Bank is entrusted to Central Board of Directors of 20 members, the Governor and four Deputy Governors, one Government official from the Ministry of Finance, ten nominated Directors by the Government to give representation to important elements in the economic life of the country, and four nominated Directors by the Central Government to represent the four local Boards with the headquarters at Mumbai, Kolkata, Chennai and New Delhi.

Functions of RBI

Bank Officers

  • Under Section 22 of the Reserve Bank of India Act, the Bank has the sole right to issue bank notes of all denominations. The distribution of one rupee notes and coins and small coins all over the country is undertaken by the Reserve Bank as agent of the Government.
  • RBI should maintain gold & foreign exchange reserves of Rs. 200 Cr, of which Rs. 115 Cr. should be in gold.

Banker to Government

The second important function of the Reserve Bank of India is to act as Government banker, agent and adviser. The Reserve Bank is agent of Central Government and of all State Governments in India. The Reserve Bank has the obligation to transact Government business, to receive and to make payments on behalf of the Government and to carry out their other banking operations.

Controller of Credit

The Reserve Bank of India is the controller of credit i.e. it has the power to influence the volume of credit created by banks in India.

Custodian of Foreign Reserves

The Reserve Bank of India has the responsibility to act as the custodian of India’s reserve of international currencies. It takes up operations in the forex market to stabilize the- exchange rate of rupee and ensure that there is no speculation and there is order.

Supervisory Functions

In addition to its traditional central banking functions, the Reserve bank has certain non- monetary functions of the nature of supervision of banks and promotion of sound banking in India. The Reserve Bank Act, 1934, and the Banking Regulation Act, 1949 have given the RBI wide powers of supervision and control over commercial and co-operative banks, relating to licensing and establishments, branch expansion, setting reserve ratios etc.

Promotional Functions

Since Independence, the range of the Reserve-Bank’s functions has steadily widened. The Bank now performs a variety of developmental and promotional functions. The Reserve Bank was asked to promote banking habit, extend banking facilities to rural and semi- urban areas, and establish and promote new specialised financing agencies.

Money Supply

  • This refers to the total volume of money circulating in the economy. Money supply can be estimated as narrow or broad money.
  • M1 equals the sum of currency with the public and demand deposits with the banks. It is the narrow money.
  • M3 or the broad money concept, as it is also known includes time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1

Credit Crunch/Liquidity Crunch/ Liquidity Crisis

Credit/Liquidity crunch refers to a state in which there is a short supply of money to lend to businesses and consumers and interest rates are high. It may happen when the government borrows heavily and there is crowding out of the corporate sector
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