Lecture 17

Demand for Money and Keynes’ Liquidity Preference Theory of Interest!

Why people have demand for money to hold is an important issue in
macroeconomics. The level of demand for money not only determines the
rate of interest but also prices and national income of the economy.
Classical economists considered money as simply a means of payment or
medium of exchange.

In the classical model, people therefore demand money in order to make

payments for their purchase of goods and services. In other words, they
want to keep money for transactions purposes. On the other hand, J.M.
Keynes laid stress on the store of value function of money.

According to him, money is an asset and people want to hold it so as to

take advantage of changes in the price of this asset, that is, the rate of
interest. Therefore, Keynes emphasised another motive for holding money
which he called speculative motive.

As will be explained in detail below, under speculative motive people

demand to hold money balances to take advantages from the future
changes in the rate of interest, or what means the same thing, from the
future changes in bond prices.

An essential point to be noted about people’s demand for money is that

what people want is not nominal money holdings but real money
balances (This is also referred to as simply real balances). This means
that people are interested in the purchasing power of their money
holdings, that is, the value of money balances in terms of goods and
services which they could buy.

Thus, people would not be interested in merely nominal money holdings

irrespective of the price level, that is, the number of rupee notes and bank
deposits. If with the doubling of price level, nominal money holdings are
also doubled, their real money balances would remain the same. If
people are merely concerned with nominal money holdings irrespective
of the price level, they are said to suffer from money illusion.

The demand for money has been a subject of lively debate in economics.
Interest in the study of demand for money has been due to the important
role that monetary demand plays in the determination of the price level,
interest and income.

Till recently there were three approaches to demand for money, namely,
transactions approach of Fisher, Cash-balance approach of Cambridge
economists, Marshall and Pigou and Keynes theory of demand for
money. However, in recent years Baumol, Tobin and Friedman have put
forward new theories of demand for money. We critically examine below
all these theories of demand for money.

Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:

Liquidity preference of a particular individual depends upon several
considerations. The question is: Why should the people hold their
resources liquid or in the form of ready money when he can get interest
by lending money or buying bonds?

The desire for liquidity arises because of three motives:

(i) The transactions motive,

(ii) The precautionary motive, and

(iii) The speculative motive.

The Transactions Demand for Money:

The transactions motive relates to the demand for money or the need for
money balances for the current transactions of individuals and business
firms. Individuals hold cash in order “to bridge the interval between the
receipt of income and its expenditure”.

In other words, people hold money or cash balances for transactions

purposes, because receipt of money and payments do not coincide. Most of
the people receive their incomes weekly or monthly while the expenditure
goes on day by day.

A certain amount of ready money, therefore, is kept in hand to make

current payments. This amount will depend upon the size of the
individual’s income, the interval at which the income is received and
the methods of payments prevailing in the society.
The businessmen and the entrepreneurs also have to keep a proportion of
their resources in money form in order to meet daily needs of various
kinds. They need money all the time in order to pay for raw materials
and transport, to pay wages and salaries and to meet all other current
expenses incurred by any business firm. It is clear that the amount of
money held under this business motive will depend to a very large extent
on the turnover (i.e., the volume of trade of the firm in question).

The larger the turnover, the larger, in general, will be the amount of
money needed to cover current expenses. It is worth noting that money
demand for transactions motive arises primarily because of the use of
money as a medium of exchange (i.e. means of payment).

Since the transactions demand for money arises because individuals

have to incur expenditure on goods and services during the receipt of
income and its use of payment for goods and services, money held for
this motive depends upon the level of income of an individual.

A poor man will hold less money for transactions motive as he spends less
because of his small income. On the other hand, a rich man will tend to
hold more money for transactions motive as his expenditure will be
relatively greater.

The demand for money is a demand for real cash balances because
people hold money for the purpose of buying goods and services. The
higher the price level, the more money balances a person has to hold in
order to purchase a given quantity of goods.

If the price level doubles, then the individual has to keep twice the
amount of money balances in order to be able to buy the same quantity
of goods. Thus the demand for money balances is demand for real rather
than nominal balances.

According to Keynes, the transactions demand for money depends only

on the real income and is not influenced by the rate of interest. However,
in recent years, it has been observed empirically and also according to
the theories of Tobin and Baumol transactions demand for money also
depends on the rate of interest.

This can be explained in terms of opportunity cost of money holdings.

Holding one’s asset in the form of money balances has an opportunity
cost. The cost of holding money balances is the interest that is foregone
by holding money balances rather than other assets. The higher the
interest rate, the greater the opportunity cost of holding money rather
than non-money assets.

Individuals and business firms economise on their holding of money

balances by carefully managing their money balances through transfer
of money into bonds or short-term income yielding non-money assets.
Thus, at higher interest rates, individuals and business firms will keep
less money holdings at each level of income.

Precautionary Demand for Money:

Precautionary motive for holding money refers to the desire of the people
to hold cash balances for unforeseen contingencies. People hold a
certain amount of money to provide for the danger of unemployment,
sickness, accidents, and the other uncertain perils. The amount of money
demanded for this motive will depend on the psychology of the
individual and the conditions in which he lives.

Speculative Demand for Money:

The speculative motive of the people relates to the desire to hold one’s
resources in liquid form in order to take advantage of market
movements regarding the future changes in the rate of interest (or bond
prices). The notion of holding money for speculative motive was a new
and revolutionary Keynesian idea.

Money held under the speculative motive serves as a store of value as

money held under the precautionary motive does. But it is a store of
money meant for a different purpose. The cash held under this motive is
used to make speculative gains by dealing in bonds whose prices
fluctuate.

If bond prices are expected to raise which, in other words, means that the
rate of interest is expected to fall, businessmen will buy bonds to sell
when their prices actually rise. If, however, bond prices are expected to
fall, i.e., the rate of interest is expected to rise, businessmen will sell
bonds to avoid capital losses. Nothing is certain in the dynamic world,
where guesses about the future course of events are made on precarious
basis businessmen keep cash to speculate on the probable future changes
in bond prices (or the rate of interest) with a view to making profits.
Given the expectations about the changes in the rate of interest in future,
less money will be held under the speculative motive at a higher current
rate of interest and more money will be held under this motive at a
lower current rate of interest.

The reason for this inverse correlation between money held for
speculative motive and the prevailing rate of interest is that at a lower
rate of interest less is lost by not lending money or investing it, that is, by
holding on to money, while at a higher current rate of interest holders
of cash balance would lose more by not lending or investing.

Thus the demand for money under speculative motive is a function of the
current rate of interest, increasing as the interest rate falls and
decreasing as the interest rate rises. Thus, demand for money under this
motive is a decreasing function of the rate of interest.

This is shown in Fig. 18.2. Along X-axis we represent the speculative

demand for money and along the X-axis the current rate of interest The
liquidity preference curve LP is a downward sloping towards the right
signifying that the higher the rate of interest, the lower the demand for
money for speculative motive, and vice versa.

Thus at the high current rate of interest or, a very small amount OM is
held for speculative motive. This is because at a high current rate of
interest more money would have been lent out or used for buying bonds
and therefore less money would be kept as inactive balances. If the rate
of interest falls to Or’, then a greater amount of money OM’ is held under
speculative motive. With the further fall in the rate of interest to Or’,
money held under speculative motive increases to OM.
 Roles & Functions of RBI

In this section, we are going to discuss the various functions of the

Reserve Bank of India. The Reserve Bank of India Act of 1934 entrust all
the important functions of a central bank to the Reserve Bank of India.
The most important function of a central bank is to maintain the
internal and external value of the currency and operate the financial
system to the advantage of the country. In order to discharge these
crucial responsibilities, the RBI undertakes the following functions-

 Issue of Currency Notes:

Since its inception, the RBI has been enjoying the monopoly of note issue.
Under Section 22(1) of the Reserve Bank of India Act, the Bank has the
sole right to issue bank notes of Rs. 2 and above denominations. The
distribution of one rupee notes and coins all over the country is
undertaken by the Reserve Bank as agent of the Government. Notes issued
by the RBI are known as bank notes while one rupee notes of the Central
Government are known as currency notes. The Reserve Bank has a
separate Issue Department which is entrusted with the issue of currency
notes.

 Banker to Government :

The second important function of the Reserve Bank of India is to act

as Government’s banker, agent and adviser. The Governments receive
and disburse large sums of money every day. Their receipts include
mainly taxes, duties and other charges. If these large amounts of
transactions are left unregulated and uncoordinated, that may cause
instability in the money market. Thus, the central bank acts as the
custodian of the Government funds. Further, the RBI assists the
Government in floating loan and management of public debt, i.e. the
debt which the Government owes to the public. The Reserve Bank also acts
as an agent of Central Government and of all State Governments in
India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business. Apart from these, RBI as the
central bank also provides funds to the Government to meet the short-
term financial needs by issue of treasury bills. Another function the RBI
performs as the central bank is to provide ‘ways and means’ advances to
the Government. These ‘ways and means’ advances are normally taken
by the State Governments and are wiped out as and when Government
 receipts are deposited in the accounts with it. The Central Government
can raise funds by issuing securities (Government I.O.U.) to the Reserve
Bank.

 Bankers' Bank and Lender of the Last Resort :

The Reserve Bank of India acts as the bankers' bank. The

RBI not only keeps deposits of the commercial banks but also lends them
in emergencies and for this purpose it is called the lender of the last
resort. The RBI under Section17 of the Reserve Bank of India Act, 1934
refinance and rediscount the bills of exchange, promissory notes and
other eligible commercial papers to the scheduled commercial banks. The
RBI also provides refinance to the scheduled commercial banks for
increasing their involvement in the lending to the priority sectors. For
encouragement of the co-operative banks, the RBI provides loan in
subsidized interest. When commercial banks exhaust their liquidity at a
point of time they approach the RBI for assistance.

Another aspect of this function is that the RBI is vested with statutory
authority to perform its duty of controlling the volume of credit and
money supply and maintaining the money supply of the economy. Hence,
the RBI Act as the banker of the banks in keeping the required liquid
and statutory reserves of the commercial banks.

According to the provisions of the Banking Companies Act, 1949, every

scheduled bank was required to maintain with the Reserve Bank a cash
balance equivalent to 5 per cent of its demand liabilities and 2 per cent
of its time liabilities in India. By an amendment in 1962, the
distinction between demand and time liabilities was abolished and
banks have been asked to keep cash reserves equal to 3 per cent of their
aggregate deposit liabilities. The minimum cash requirements can be
changed by the Reserve Bank of India.

Controller of Credit :

The Reserve Bank of India is the controller of credit of the economy. As

mentioned earlier, the RBI has the power to influence the volume of
credit created by commercial banks in India. It can do so through
monetary policy, the bank rate, statutory reserve ratio, cash reserve ratio
or through open market operations. The RBI has the statutory power to
increase or decrease the deposit of the scheduled commercial banks
 required to be deposited with it in order to control the credit creation
capacity of banks. When the RBI increase the limit of deposits required to
make with it, this reduces the liquidity with the banking system resulting
in contraction of credit .On the other hand, when the RBI decrease the
limit, banks enjoys more liquid cash with the system and result in credit
expansion in the economy. According to the Banking Regulation Act,
1949, the Reserve Bank of India can ask any particular bank or the
whole banking system not to lend to particular groups or persons on the
basis of certain types of securities. Since 1956, selective methods of credit
control are increasingly being used by the Reserve Bank.

Custodian of Foreign Exchange Reserves:

The Reserve Bank of India is the custodian of the foreign exchange

reserve of the country and has the responsibility to maintain the official
rate of exchange. The maintenance of external value of the rupee is an
essential function of the Reserve Bank of India. It does so through
regulating and controlling the foreign exchange transactions.
Exchange control means exercise of control over the foreign exchange
earnings and disbursement of a country. The Foreign Exchange
Management Act empowers the RBI to issue direction for the
administration of exchange control. For this purpose the RBI has set up
separate department called Foreign Exchange Control department. The
main functions of this department are –

 Granting licenses to the authorised dealers

 Granting licenses to the money changers
 Ascertain the foreign exchange reserve position on continuous basis.
 Issuing direction in regard to regulation and relaxation for the foreign
exchange payments.
 Fixing the rates of foreign currencies against rupee currency.
 Providing custodian services for the foreign exchange.

Regulatory Function:

The RBI is the primary regulator of banks. The Reserve Bank of India Act,
1934, and the Banking Regulation Act, 1949 have given the RBI wide
powers of supervision and control over the entire banking system. In
exercise of the powers under these Acts, the RBI regulates the entry into
banking business by licensing, exercise controls over shareholding and
voting powers of shareholders, exercises control over managerial persons,
 and regulates the business of the bank by permitting and prohibiting
certain business. RBI also supervises the functioning of the banks
operating in the country by inspecting and issuing directions from time
to time in public interest and in the interest of the banking system as a
whole. It also gives directions to the bank to adhere the norms laid down
by it or by the Bank for International Settlement for maintaining an
international standard in the operations of banks relating to capital
adequacy, asset classification, income recognition, management
quality, efficiency, liquidity and surveillance. The bank also regulates
the functions of other banks by giving directions in respect of interest
rates, lending limits, investment limit and other matter. The RBI is
authorised to carry out periodical inspections of the banks and to call
for returns and necessary information from them. Under the Reserve
Bank of India (Board of Financial Supervision) Regulations 1994, a
separate Board for Financial Supervision (BFS) was set up within the
Bank. The objective of this Board is to strengthen supervision and
surveillance over the financial system and to provide a sharper focus to
supervisory policy and skills. This Board covers banks, non-banking
financial institutions and other para-banking institutions.
The regulatory and supervisory functions of the RBI may be summed up
as follows:

1. Power to issue license to the new banks as well as to the existing banks for
branch expansion;
2. Power of appointment and removal of banking board/personnel;
3. Powers to regulate the business of banking;
4. Power to give directions on functioning of banks from time to time;
5. Power to inspect and supervise banks;
6. Power to conduct audit of the banks;
7. Powers relating to moratorium, amalgamation and winding up;
8. Power to impose norms of practice and maintenance of accounts;
9. Power to collect and furnish credit information ;
10. Power to impose penalty;

Promotional Function:

The RBI under promotional or development functions, has initiated

measures for setting up institutions to spread banking infrastructure
and to ensure a more equitable distribution of credit. It has contributed
for expansion of money market by developing bill market
 scheme. Expanding the organized sector of money market, the RBI
reduced the dependency on the indigenous money lenders. The Bank
now performs a variety of developmental and promotional functions,
which, at one time, were regarded as outside the normal scope of central
banking. 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. Accordingly, the Reserve
Bank has helped in the setting up of the Industrial Finance Corporation
of India (IFCI), the State Finance Corporations (SFCs), the Deposit
Insurance Corporation in 1962, the Unit Trust of India in 1964, the
Industrial Development Bank of India in 1964, the Agricultural
Refinance Corporation of India in 1963 and the Industrial
Reconstruction Corporation of India in 1972. These institutions were set
up directly or indirectly by the Reserve Bank to promote saving habit
and to mobilise savings, and to provide industrial finance as well as
agricultural finance.
The promotional role of the RBI can be summarised as under :

1. Introduction of Bill market scheme in1952;

2. Establishment of Financial Institutions like IDBI,SIDBI,IFCI,ICICI,IRBI;
3. Promotion of agriculture by establishment of National Bank for
Agricultural and Rural Development (NABARD) and Agricultural
College, Pune;
4. Promotion of Regional Rural Banks (RRBs) and thereby extending
banking facilities to the rural areas;
5. Development of foreign trade by helping in establishment of the Export –
Import Bank and facilitating the opening of branches in foreign centres
by the Indian banks;
6. Development of money market by helping in establishment of Discount
and Finance House of India Ltd;
7. Promotion of housing sector by establishing the National Housing Bank;
8. Establishment of Deposit Insurance and Credit Guarantee Corporation of
India.
Monetary Policy

Monetary policy is concerned with the measures taken to regulate the

supply of money, the cost and availability of credit in the economy.
Further, it also deals with the distribution of credit between uses and
users and also with both the lending and borrowing rates of interest of
the banks. In developed countries the monetary policy has been usefully
used for overcoming depression and inflation as an anti-cyclical policy.

However, in developing countries it has to play a significant role in

promoting economic growth. As Prof. R. Prebisch writes, “The time has
come to formulate a monetary policy which meets the requirements of
economic development, which fits into its framework perfectly.” Further,
along with encouraging economic growth, the monetary policy has also
to ensure price stability, because the excessive inflation not only has
adverse distribution effect but hinders economic development also.

It is important to understand the distinction between objectives or goals,

targets and instruments of monetary policy. Whereas goals of monetary
policy refer to its objectives which, as mentioned above, may be price
stability, full employment or economic growth, targets refer to the
variables such as supply of money or bank credit, interest rates which are
sought to be changed through the instruments of monetary policy so as
to attain these objectives.

The various instruments of monetary policy are changes in the supply of

currency, variations in bank rates and other interest rates, open market
operations, selective credit controls, and variations in reserve require-
ments. We shall first explain below the objectives or goals of monetary
policy in a developing economy with special reference to those adopted by
Reserve Bank of India.

After having explained the objectives we shall explain role of monetary

policy in promoting economic growth in a developing country like
India. In the end we will explain monetary policy of reserve Bank of
India in different periods of planned development, especially soft interest
and liberal credit policy adopted by Reserve Bank of India since 1996.

Objectives of Monetary Policy:

Before explaining in detail the monetary measures undertaken by RBI to
regulate credit and growth of money supply, it is important to explain
the objectives of monetary policy pursued of RBI in formulation of its
policy. Since monetary policy is one instrument of economic policy, its
objectives cannot be different from those of overall economic policy.

The three important objectives of monetary policy are:

1. Ensuring price stability, that is, containing inflation.

2. To encourage economic growth.

3. To ensure stability of exchange rate of the rupee, that is, exchange

rate of rupee with the US dollar, pound sterling and other foreign
currencies.

Let us explain below these objectives in some detail:

Price Stability or Control of Inflation:
It may be noted that each instrument of economic policy is better suited
to achieve a particular objective. Monetary policy is better suited to the
achievement of price stability that is, containing inflation. To quote C.
Rangarajan, a former Governor of Reserve Bank of India. “Faced with
multiple objectives that are equally relevant and desirable, there is
always the problem of assigning to each instrument the most appropriate
target or objective. Of the various objectives, price stability is perhaps the
one that can be pursued most effectively by monetary policy.

In a developing country like ours, acceleration of investment activity in

the context of supply shocks in the agricultural sector tends to be
accompanied by pressures on prices and, therefore, monetary policy has
much to contribute in the short-run management.”

Thus, achieving price stability has remained the dominant objective of

monetary policy of Reserve Bank of India. It may however be noted that
price stability does not mean absolutely no change in price at all. In a
developing economy like ours where structural changes take place
during the process of economic growth some changes in relative prices do
occur that generally put upward pressure on prices. Therefore, some
changes in price level or, in other words, a certain rate of inflation is
inevitable in a developing economy.

Thus, price stability means reasonable rate of inflation. A high degree of

inflation has adverse effects on the economy.
First, inflation raises the cost of living of the people and hurts the poor
most. Therefore, inflation has been described as enemy No. 1 of the poor.
Inflation sends many people below the poverty line.

Secondly, inflation makes exports costlier and, therefore, discourages

them. On the other hand, due to higher prices at home people are
induced to import goods to a large extent. Thus, inflation has an
adverse effect on the balance of payments.

Thirdly, when due to a higher rate of inflation value of money is rapidly

falling, people do not have much incentive to save. This lowers the rate of
saving on which investment and economic growth depend. Fourthly, a
high rate of inflation encourages businessmen to invest in the productive
assets such as gold, jewellery, real estate etc.

An expert committee on monetary reforms headed by Late Prof. S.

Chakravarty suggested 4 per cent rate of inflation as a reasonable rate
of inflation and recommended that monetary policy by RBI should be so
formulated that ensures that rate of inflation does not exceed 4 per cent
per annum.

Emphasising the importance of price stability from the viewpoint of

India’s balance of payments, Prof. Rangarajan writes, “The increasing
openness of the economy, the need to service external debt and the
necessity to improve the share of our exports in a highly competitive
external environment require that the domestic price level not be
allowed to rise unduly, particularly since our major trading partners
have had notable success in recent years in achieving price stability.

Economic Growth:
Promoting economic growth is another important objective of the
monetary policy. In the past Reserve Bank has been criticised that it
pursued the objective of achieving price stability and neglected the
objective of promoting economic growth.

Monetary policy can promote economic growth through ensuring

adequate availability of credit and lower cost of credit. There are two
types of credit requirements of businesses. First, they have to finance their
requirements of working capital and for importing needed raw
materials and machines from broad. Secondly, they need credit for
financing investment in projects for building fixed capital. Easy
availability of credit at low interest rate stimulates investment and
thereby quickens economic growth.

However, during the seventies, eighties and the first half of nineties,
Reserve Bank followed a tight monetary policy under which Cash Reserve
Ratio (CRR) and Statutory Liquidity Ratio (SLR) were continually
raised to restrict the availability of credit for private sector. Besides,
lending rates of interest were kept at high levels which discouraged
private investment. This tight monetary policy worked against promoting
growth.

However, in the opinion of Prof. Rangarajan, there is no conflict between

the objectives of price stability and growth. Price stability, according to
him, is a means to ensure economic growth. To quote him, “It is price
stability which provides the appropriate environment under which
growth can occur and social justice can be ensured.” In our opinion, this
may be true in the long run but in the short run there exists tradeoff
between growth and inflation. To ensure higher economic growth the
adequate expansion of money supply and greater availability of credit
at a lower rate of interest is needed.

But large expansion in money supply and bank credit leads to the
increase in aggregate demand which tends to cause a higher rate of
inflation. This raises the issue of what is acceptable tradeoff between
growth and inflation, that is, what rate of inflation is acceptable to
promote growth through appropriate monetary policy. Expert Committee
on monetary policy headed by Late Prof. Chakravarty suggested a target
of 4 per cent as “the acceptable rise in prices”.

According to it, the growth of money supply and availability of credit

should be so regulated that rate of inflation does not exceed 4 per cent
per annum. However, C. Rangarajan, former Governor of Reserve Bank
fixed a higher target, namely, 5 to 6 per cent rate of inflation in the
context of objective of achieving 6 to 7 per cent rate of economic growth.
To quote him, “keeping the price and growth objectives in view the money
supply growth should be so regulated that inflation rate comes down
initially to 6 to 7 per cent and eventually to 5 to 6 per cent. That indeed
must be the goal of monetary policy.”

It may be noted that in the context of the openness of the economy and
floating exchange rate system, as is the case of the Indian economy
today, the objective of achieving higher rate of economic growth through
monetary measures may also conflict with objective of exchange rate
stability, that is, value of rupee in terms of the US dollar and other
foreign currencies.

Whereas prevention of the depreciation of rupee requires tightening of

monetary policy, that is raising of interest rate, reducing liquidity of the
banking system so that banks restrict their credit supply, the promotion
of growth objective requires lower lending rates of interest and greater
availability of credit for encouraging private investment. It is this
dilemma of conflicting objectives of achieving economic higher growth
or price stability which is being presently faced in India (August 2000).

Exchange Rate Stability:

Until 1991, India followed fixed exchange rate system and only
occasionally devalued the rupee with the permission of IMF. The policies
of floating exchange rate and increasing openness and globalisation of
the Indian economy, adopted since 1991 have made the exchange rate
of rupee quite volatile. The changes in capital inflows and capital
outflows and changes in demand for and supply of foreign exchange,
particularly US dollar, arising from the imports and exports cause great
fluctuations in the foreign exchange rate of rupee.

In order to prevent large depreciation and appreciation of foreign

exchange rate Reserve Bank has to take suitable monetary measures to
ensure foreign exchange rate stability. Owing to the fixed exchange rate
system prior to 1991 the concern about foreign exchange rate had not
played a significant role in the formulation of monetary policy. At the
time of writing this Section (August 2000) Reserve Bank is worried about
Fastly depreciation of the Indian rupee against US dollar. The value of
rupee has gone down below Rs. 48 per dollar Reserve Bank has of take
some monetary measures to prevent the fall in the value of rupee.

Today, the exchange rate of rupee is determined by demand for and

supply of foreign exchange (say, US dollar). When there is mismatch
between demand for and supply of foreign exchange, external value of
rupee changes.

For instance Presently, in (August 2000) depreciation of rupee as

against US dollar has been caused by the increase in demand for dollars
from (1) the corporate sector for financing their imports, (2) Foreign
Institutional Investors (FII) who wanted to take out their dollars from
India (i.e., capital outflow) to the US where interest rates have recently
risen, and (3) increase in demand for US dollar by the Indian banks on
the instructions of the public sector undertakings for financing necessary
imports from abroad. Since export earnings and capital inflows which
determine the supply of dollars have not risen adequately, mismatch
between dollars and supply of dollars has arisen causing the
depreciation of rupee as against the US dollar.

To arrest the fall in value of rupee Reserve Bank (1) raised the bank rate
from 7 per cent to 8 per cent on August 2000 and thus sending signals to
the banks to raise their lending rates. (2) Cash reserve ratio (CRR) was
raised from 7 per cent to 7.5 per cent to reduce the liquidity in the
banking system (0.5 per cent hike in cash reserve ratio was expected to
reduce lendable resources of the banks by about Rs 3,800 crores).

Thus, through rise in the cost of credit and reduction in the availability
of credit, borrowing from the banks were discouraged which was
expected to reduce the demand for dollars. The higher interest rates in
India would also discourage foreign institutional investors and Indian
corporate to invest abroad. This will also work to reduce the demand for
dollars which will prevent the fall in the value of the rupee.

Alternatively, to prevent the depreciation of the rupee, Reserve Bank can

release more dollars from its foreign exchange reserves. The release of
more dollars by Reserve Bank will increase the supply of US dollars in the
foreign exchange market and will therefore tend to correct the
mismatch between demand for and supply of the US dollars. This will
help in stabilising the exchange rate of the rupee. It is clear from above
that in the context of flexible exchange rate system, Reserve Bank has to
intervene frequently to achieve stability of exchange rate at a
reasonable level.