Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
- Mrunal - http://mrunal.org -
Prologue
Next article is about RBI appointed Urjit Patel Committee on Monetary policy
framework.
But before dwelling into that, we must recap the basic concepts of what is monetary
policy: its tools and limitations. Otherwise Urjit wont make much sense.
Hence in a way, this whole article is a prologue to next article.
1/24
9/4/2014
STAGFLATION
REFLATION
meaning
yes
Quantitative Tools
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upco
2/24
9/4/2014
100 cr.
-4 cr
-23 cr.
100-4-23=73
Cores.
100 cr
-40
-15
45 cr.
You can see, when Rajan has raised reserve ratio, money with SBI is reduced (from 73 crores
to just 45 crores.)
What will be its implication?
Imagine youre a money lender. Youve 100 crore rupees and you must make Rs.1 crore
profit in a year.
Obviously, you should lend it @1% interest rate. (because 1% of 100 crore = 1 crore.)
But what if youve only 2 crore rupees, and you still want to make Rs.1 croer profit in a
year?
Now you must lend it @50% interest rate. (because 50% of 2 cores = 1 crore.)
Observe that as money decreased (from 100 to 2), loan interest rate increased (from 1%
to 50%).
Same happens when SBI is left with less money (after RBI increases reserve ratio).
Lets prepare a flow chart.
Situation: Economy has inflationary trend. Prices of goods and services increasing every day.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upco
3/24
9/4/2014
4/24
9/4/2014
2.
3.
4.
5.
6.
7.
8.
SBI raises its loan interest rate (to keep profit margin same)
Businessmen borrow less money from SBI.
Businessmen donot start new business. Donot expand existing business
Less jobs
Less income
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
dear money
To fight inflation
Increase them.
RBI sell securities
cheap money
To fight deflation
Decrease them.
RBI buy securities
Mock Question
In 2013, UPSC walla asked a very chillar question from this topic.
In context of Indian Economy, Open Market Operation refers to
a.
b.
c.
d.
5/24
9/4/2014
Lets solve a bit more complicated MCQ from 2012s CSAT paper.
Q.Which of the following measures would result in an increase in the money supply in
economy?
1.
2.
3.
4.
Answer choice
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
2, 3 and 4
Whenever you face such multiple statement type MCQs, always use elimination method.
First find a statement that is definitely right or definitely wrong and eliminate choices
accordingly.
Focus on first statement Purchase of government securities from public by central
bank: will it increase money supply in the system?
Imagine Rajan puts an ad in newspaper: bring your Sabzi (vegetables), Ill buy it. Junta
gives him their own veggies, Rajan gives them money. (a classic buy and sell).
Ultimate result: money supply increased in the system- because junta got the money.
Meaning #1 definitely correct.
If you think it on technical terms. Central bank purchases government securities=OMO
(Open market operation), where money shifts hands from RBI to people.
Hence money supply increased. (In reality, money doesnt go to aam admi directly,
but those bankers and non-banking institutions who participate in OMO). Anyways, #1
is right, Eliminate choices that do not have #1
a.
b.
c.
d.
Only 1
2 and 4
1 and 3
2, 3 and 4
6/24
9/4/2014
Counter- argument?
What if Rajan subsequently sells those (Mohans) securities to bankers. Then bankers
money reduced. Hence #3 is wrong. Therefore final answer A only 1.
So, whats the final answer: is it A or is it C?
Ultimate judge= UPSCs official answer key uploaded on their site.
In 2012s Question paper Test series A, this is Q77: and its official answer is C.
Therefore, both 1 and 3 are correct.
Anyways, what to do in the exam?
Skip
If you dont know the concept better skip.
Attempt This question is attemptable if you dont drag the logic too much in statement #3.
Yes, it can be put under mark and review because this is not an absolute fact/
Mark n absolute definition type MCQ. If you apply some concepts, you can eliminate
Review. wrong choices. But still if doubt persists in the mind (e.g whether Statement 3 is
right or not) then its always safe to skip and avoid negative marking.
By the way, What about Statement #2: Deposit of currency in commercial banks by the
public. (Will it increase money supply or not?)
Viewpoint 1: yes. Because bank can used it to expand loanable credit. (as explained in
Money creation topic in Class 12 NCERT Macroeconomics page 39 onwards).
Viewpoint 2: no. (Because Bank will have to put some money aside as CRR- so that
much money is less in the system.)
Either way it doesnt change the answer. Because We know that statement 1 is definitely
correct. And there is no option where (1,2) are given simultaneously.
Anyways, Moving onSo far, RBI has two tools under monetary policy:
1. reserve ratios (SLR, CRR)
2. Open market operation.
Third and the most important quantitative tool is
Bank Rate
When banks borrow long term funds from RBI. Theyve to pay this much interest rate
to RBI. [Note: different books give different explanation of Bank Rate. I've used NDTV's
definition]
At present, Bank rate= 9%
Collateral: nothing. (Bank can borrow money without pledging government securities to
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upco
7/24
9/4/2014
RBI)
Bank rate is not the main tool to control money supply these days.
Nowadays, RBI uses LAF Repo rate as the main tool, to control money supply.
Ok then Whats the use of Bank rate?
Penal rates are linked with Bank rate. For example, If a bank doesnt maintain CRR,
SLR as per the prescribed limit.
Then RBI can impose penalty interest on such notorious bank.
At present, Penalty rate = Bank rate + 3% (or 5% in some cases)
Meaning if Bank rate = 9% then penalty rate=9+3=12%
Anyways, what if RBI wants to fight inflation using bank rate as a tool?
Obviously they should increase bank rate. That way it becomes harder (more expensive) for
banks to borrow from RBI.=> SBI increases its loan rates (to keep the profit margin same).
Result?
Less people get home loan, bike loan, business loans.
Less business expansion
Less jobs
Less incomes
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
Thus inflation is reduced.
Lets update our (stupid) table
Policy
Tool
Reserve Ratio (CRR, SLR)
Open Market Operation (OMO)
Bank rate
dear money
To fight inflation
Increase them.
RBI sell securities
Increase
cheap money
To fight deflation
Decrease them.
RBI buy securities
decrease
8/24
9/4/2014
If client borrows money from RBI (for short term) then client has to pay this much
interest rate to RBI. At present Repo is 8%. (article written on 29th Jan 2014)
If client lends money to RBI (for short term) then RBI has to pay this much
Reverse
interest rate to client. RBI doesnt like headache. So they made a simple formula:
Repo
Reverse repo rate= Repo MINUS 1%=8-1=7%.
Repo
Collateral:
Problem with running a adda/gambling-den = sometimes client drinks too much desi
liquor and passes out on floor. Sometimes he even dies because of hooch. Sometimes
police raids the den, and clients run away with cash and register.
If such things happen, Rajan will be at loss. So, he demands government securities as
collataral. So even if client doesnt repay money on time, Rajan can sell those securities
(in open market operations) and recover money.
Scenario
SBI chairman Arundhati mam wants to borrow Rs.100 crore (for short term).
She gives her stash of government securities to Rajan.
Rajan gives her Rs.100 crore.
Madam Also signs an agreement
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upco
9/24
9/4/2014
I, Arundhati Bhattacharya, agree to buy same securities from Rajan, at 108 crores after
14 days.
Notice that she has agreed to re-purchase same securities from Rajan. Therefore its
called Repo.
And how much interest rate did she pay on this loan? [108-100]/100=8%. Thats our
repo rate.
Important:
Recall that SBI also has to keep part of her money in RBI approved securities (under
SLR).
So Madam cannot USE those government securities to borrow under Repo Rate from
Rajan.
That leads to a new topic
MSF
Minimum Rs. 1 crore.
10/24
9/4/2014
securities.)
dear money
To fight inflation
cheap money
To fight deflation
Increase them.
Decrease them.
increase it
decrease it
increase it
decrease it
its value is linked with Repo, hence cannot be increased/decreased
independently.
its value is linked with Repo, hence cannot be increased/decreased
independently. Besides MSF= temporary firefighting, cash
mismanagement.
We learned that Rajan doesnt use Bank rate much, to control money supply.
We learned that Rajan doesnt decide Reverse repo and MSF. (theyre automatically
-1% and +1% of Repo rate).
Thus the only thing Rajan has to decide under monetary policy= Repo rate. Therefore,
Repo rate is called the policy rate
Lets revisit out flow chart:
Situation: Economy has inflationary trend. Prices of goods and services increasing every
day.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
11/24
9/4/2014
SBI raises its loan interest rate (to keep profit margin same)
Businessmen borrow less money from SBI.
Businessmen donot start new business. Donot expand existing business.
Less jobs
Less income
Less demand
Ultimately shopkeeper will bring down the prices to attract people into buying more
things.
dear money
cheap money
To fight inflation To fight deflation
Increase them.
Decrease them.
Open Market Operation (OMO) RBI sell securities RBI buy securities
Policy Rate (Repo Rate)
Increase it
Decrease it
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
12/24
9/4/2014
From above above graph, you can see RBI has frequently changed its repo rate to combat
both inflationary and deflationary trend. But Youd agree that inflation has not been
contained. No matter what number juggling or statistical interpretations are given- the
hardship of common man has not stopped- be it milk, petrol, onion, LPG anything.
Agreed that prices of onion, sugar, pulses and food are subject to vagaries of monsoon
and black marketeering. Rajan cannot do anything about it.
Agreed that crude oil prices are subject to rupee-Dollar exchange rate, external factors
and governments de-regulation of their prices. Rajan doesnt have much control over
this.
But still even in the non-food, non-fuel type commodities- RBIs monetary policies have
failed to curb inflation. WHY? Observe the following image.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
13/24
9/4/2014
Suppose Vijay Mallay got 100 crore loan from State Bank of India. If you trace the source
of that money, itll turnout 60-70 crores came from banks savings account, fixed deposit etc.
Rajan lends money in repo rate yes, but that doesnt mean banks depend only on Rajan to
arrange the cash for its clients.
Suppose Rajan reduces repo rate from 8% to 5%. Banks are not legally required to reduce
their loan interest rates.
The current system is following:
Banks are free to decide their base rate. E.g. SBIs base rate is 10%.
It means SBI wont loan money to anyone at an interest rate lower than 10% (except
those farmers under Interest subvention scheme.)
SBI will link all of its loan products with Base rate. For example
SBI Base rate =10%
Calculation
Result
Car loan
Two wheeler loan
Education loan (upto 4 lakh)
Home loan for women (upto 75 lakh)
10.75%
18.25%
13.5%
10.10%
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
14/24
9/4/2014
Meaning if SBI changes her Base rate then all of above loan interest rates will change
automatically.
If Rajan changes his repo rate, will SBI change her base rate?
Not always.
Because those common men are the main suppliers of money to SBI.
RBI is not the main supplier of money to SBI.
SBI will only change its base rate, when she feels necessary for its own profit / loss
compared to its competitors.
Does it mean Repo rate system is bogus and ineffective?
Not always.
In developing countries like India, most people park their money in only four things:
savings account, fixed deposit (FD), provident fund and LIC. Weve mutual funds,
weve NPS, weve ULIPs, weve Rajiv Gandhi equity savings scheme
but most people (particularly the older generation) feels insecure in into such new
things. Therefore lot of money flows into Savings accounts and fixed deposits= SBIs
main source of money.
But, In advanced economies, like USA, people dont invest large portion their income in
savings account or FD. Theyve variety of investment options. So, for those American
banks, their own Central bank (US Feds) is a significant money supplier.
Hence US Feds monetary policy shows faster impact on their American Banks, THAN
Rajans monetary policy on Desi banks.
15/24
9/4/2014
Qualitative tools
1. Reserve ratios
2. OMO
Well see them in a moment
3. Policy rate (Repo Rate)
Qualitative Tools
#1: Margin Requirements/ LTV
Mallya wants to borrow from SBI. He pledges his companys shares worth Rs.100
crores as collateral.
For such loans, Rajan can prescribe margin, say 65%.
In that case even if Mallya pledges 100 crores worth shares, SBI can give him 10065=only 35 Crore rupees as loan.
Using this tool, Rajan can control money supply. e.g. during inflation, he should
increase margin requirement, so Mallya can borrow less=> less job=>less income=>less
demand=>prices reduced.
If Rajan changes repo rate, it is not compulsory for SBI to change her loan interest rates.
(we saw how Alok Nath keeps giving money to SBI, so they are not entirely dependent
on Rajan.)
But if Rajan changes margin requirements, then SBI and all other banks must obey it. In
other words, this tool has direct impact on money supply.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
16/24
9/4/2014
In case #2: some of the lower-middleclass families may postpone their decision to purchase
nano car (Because they cant afford higher EMIs.)
Result= less demand=>prices reduced. (indirectly- because car mechanics get less work,
number-plate painters get less orders etc. so they reduce fees to attract new clients and
retain existing clients.)
Thus, Rajan can control money supply by changing downpayment and installment
(EMI) rules.
Rationing
of credit
Direct
action
Means RBI gives punishment to erring banks. Punishment can involve: penal
interest, refuses to lend them money from LAF etc. and in worst case even
cancels their banking license.
Lets recap
Qualitative
1.
2.
3.
4.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
17/24
9/4/2014
5. Rationing of Credit
6. Direct Action
Only 2 and 3
Only 1 and 2
Only 1 and 3
1, 2 and 3
Approach:
Whenever you face such 3 statement MCQ or 4 statement MCQ, Always use elimination
method. First you find out a statement that is definitely right or definitely wrong. In above
case, we can see #2 is definitely right. RBI lends funds to banks in the times of need (Repo,
MSF)
So lets eliminate choices that dont involve statement #2
1.
2.
3.
4.
Only 2 and 3
Only 1 and 2
Only 1 and 3
1, 2 and 3
This did not help much. We still have three choices left. Observe statement #1: Other
banks retain their deposits with RBI. That is correct with respect to cash reserve ratio.
CRR is one type of deposit that banks make to RBI. (RBI doesnt pay interest on itthats a different story).
Meaning #1 is also correct eliminate choices that donot have #1
1. Only 2 and 3
2. Only 1 and 2
3. Only 1 and 3
4. 1, 2 and 3
Only two choices left and the ultimate solution = is statement #3 is correct or not?
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
18/24
9/4/2014
Viewpoint #1
The statement says RBI advises commercial banks on
monetary matters.The word advises makes this statement
incorrect. Because RBI doesnt Advice they just order the
banks- be it SLR, CRR, PSL. RBI doesnt advice, RBI gives
orders and direction. Therefore statement #3 is wrong.
Even if we accept that RBI advices, still the questions asks
what is implied by RBI as Bankers bank. So, RBI advices
moral suasion that is a monetary policy tool. RBIs not
doing it as a Banker to those banks. Therefore, Statement
#3 is definitely wrong.
Answer (B)
Viewpoint #2
RBI does advice those
banks. We saw it under
Moral Suasion. Therefore,
Statement #3 is right.
Money Banking and finance,
E Narayan Nadar (PHI
publication). He has
specifically listed this
Advice function under
Bankers bank topic.
Answer (D)
Appendix
These are the topics I wanted to discuss in the article, but they would break the flow of other
topics. Hence writing them @bottom:
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
19/24
9/4/2014
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45 cr.
From 100 crores, barely 45 crores left with the bank. But adding insult to the injury- even
here RBI mandates Priority sector lending (PSL). Meaning, at least 40% of the loans has to be
given to farmers, small businessmen, students etc. groups.
Lets update the table:
Net Demand and Time Liabilities (NDTL)
Reserve ratios
CRR (15%)
SLR (40%)
Money left with bank
PSL (40%)
Money left for big borrowers (i.e. big businessmen, upper
middleclass)
+100 cr.
(-) 15 [no profit]
(-) 40 [some profit]
=45
=45 x 0.4 =18
crore.
=45-18=27 crores.
By the way, PSL is counted on annual basis while SLR, CRR counted on fortnight basis
so above table is technically incorrect but Ive plugged in those numbers only for the
sake of explanation.
before the 90s- Government would even interfere and order public sector banks to give
PSL-loans @cheap interest rates. The local politicians would coerce the branch
manager to give PSL-loans to ineligible people. They default on loans, Branch manager
cannot recover money (because defaulter will goto civil court then taarikh pe taarikh.)
So, bank would have to forget about most of those 18 crores given in PSL loans.
Anyways you can see people deposited 100 crores in the bank yet bank is left with
barely 27 crores (over which, bank has Freedom to decide whom they should give the
loan.)
What are the consequences for businessmen?
1. High cost of credit (because bank will try to make maximum profit from those 27
crores- so bank will charge very high interest rate on the business loans- to pay off for
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
20/24
9/4/2014
Mock Questions
1. With open market operations, RBI can
a. increase liquidity in the economy, but cannot decrease it
b. decrease liquidity in the economy, but cannot increase it
c. Can increase or decrease liquidity in the economy to control money supply.
d. None of above.
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
21/24
9/4/2014
2. By which of the following methods, government can reduce money supply in the
economy?
a. taxation
b. sale of securities to public
c. both A and B
d. neither A nor B
3. During the period of deflation
a. RBI should use dear money policy to combat it
b. Government should reduce its tax rates.
c. both A and B
d. Neither A nor B.
4. IF prices are lowered without causing unemployment, we call it:
a. stagflation
b. reflation
c. disflaction
d. Disinflation.
5. Which of the following contains correct set of quantitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. open market operations, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
6. Which of the following contains correct set of qualitative instruments of monetary
policy?
a. reserve ratio, bank rate, margin requirements
b. credit rationing, margin requirements, regulation of consumer credit
c. cash reserve ratio, bank rate, open market operation
d. None of above
Q7. To counter the effect of deflation, which of the following steps should RBI initiate?
1. decrease reserve ratios
2. buy government securities through open market operation
3. increase policy rate
Answer choices
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
Q8. To counter inflation, which of the following steps should RBI initiate?
1. Increase reserve ratios
2. sell government securities through open market operation
3. Increase policy rate
Answer choices
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
22/24
9/4/2014
a.
b.
c.
d.
only 1 and 2
only 2 and 3
only 1 and 3
1, 2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1, 2 and 3
only 1 and 2
only 2 and 3
only 1 and 3
all 1,2 and 3
23/24
9/4/2014
http://mrunal.org/2014/01/banking-monetary-policy-quantitative-qualitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-before-upc
24/24