Monetary Policy and RBI

Instruments of Monetary Policy and the Reserve Bank of India

It is clear from the discussion in the previous blog that the total amount of money stock in the economy is much greater than the volume of high powered money. Commercial banks create this extra amount of money by giving out a part of their deposits as loans or investment credits. It is also evident that the total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures. All this is common knowledge to every informed individual in the economy. Why do they still keep their money in bank deposits when they are aware of the possibility of default by their banks in case of a bank run (a situation where everybody wants to take money out of one’s bank account before the bank runs out of reserves)? The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort.

Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments. It is commonly held that the government, sometimes, ‘prints money’ in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned. The government, however, has no legal authority to issue currency in this fashion. So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return. The government then pays for its expenses with this money. The money thus ultimately comes into the hands of the general public (in the form of salary or sales proceeds of defense items etc.) and becomes a part of the money supply. Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing. However, the most important role of RBI is as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy – it increases or decreases the supply of high powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors. The instruments which RBI uses for conducting monetary policy are as follows.


Open Market Operations:

RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high powered money in the economy. Suppose RBI purchases Rs 100 worth government securities from the bond market. It will issue a cheque of Rs 100 on itself to the seller of the bond. The seller will deposit the cheque in her bank, which, in turn, will credit the seller’s account with a balance of Rs 100. The bank’s deposits go up by Rs 100 which is a liability to the bank. However, its assets also go up by Rs 100 by the possession of this cheque, which is a claim on RBI. The bank will deposit this cheque to RBI which, in turn, will credit the bank’s account with RBI with Rs 100.

Total liability of RBI, or, by definition, the supply of high powered money in the economy has gone up by Rs 100. If RBI wishes to reduce the supply of high powered money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.


Bank Rate Policy:

As mentioned earlier, RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate – which is the rate of interest commercial banks have to pay RBI – if they borrow money from it in case of shortage of reserves. A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before. As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting (or resisting) secondary money creation. In short, a low (or high) bank rate reduces (or increases) rdr and hence increases (or decreases) the value of the money multiplier, which is (1 + cdr)/(cdr + rdr). Thus, for any given amount of high powered money, H, total money supply goes up


Varying Reserve Requirements:

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.

Sterilisation by RBI:

RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks. Suppose due to future growth prospects in India investors from across the world increase their investments in Indian bonds which under such circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one cannot purchase goods in the domestic market with foreign currency, a person who sells these bonds to foreign investors will exchange her foreign currency holding into rupee at a commercial bank. The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money. What kind of adjustments take place from this entire transaction? The commercial bank’s total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its vault cash, which, therefore, goes down; but the bank’s deposit with RBI goes up by an equivalent amount – leaving its total reserves unchanged). There will, however, be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount. But that means an increase in the stock of high powered money – which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in turn, will result in increased money supply in the economy. This increased money supply may not altogether be good for the economy’s health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities. People have more money in their hands with which they compete each other in the commodities market for buying the same old stock of goods. As too much money is now chasing the same old quantities of output, the process ends up in bidding up prices of every commodity – an increase in the general price level,
which is also known as inflation.

RBI often intervenes with its instruments to prevent such an outcome. In the above example, RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of high powered money and total money supply unchanged. Thus it sterilises the economy against adverse external shocks. This operation of RBI is known as sterilisation.
Money supply is, therefore, an important macroeconomic variable. Its overall influence on the values of the equilibrium rate of interest, price level and output of an economy is of great significance. We take up these issues in the next blog.

Exchange of commodities without the mediation of money is called Barter Exchange. It suffers from lack of double coincidence of wants. Money facilitates exchanges by acting as a commonly acceptable medium of exchange. In a modern economy, people hold money broadly from two motives – transaction motive and speculative motive. Supply of money, on the other hand, consists of currency notes and coins, demand and time deposits held by commercial banks, etc. It is classified as narrow and broad money according to the decreasing order of liquidity. In India, the supply of money is regulated by the Reserve Bank of India (RBI) which acts as the monetary authority of the country. Various actions of the public, the commercial banks of the country and RBI are responsible for changes in the supply of money in the economy.
RBI regulates money supply by controlling the stock of high powered money, the bank rate and reserve requirements of the commercial banks. It also sterilises the money supply in the economy against external shocks.

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