Mrunalhttp://mrunal.

org

[Banking]MonetaryPolicy:Quantitative&QualitativeTools,
applications&limitationsMSF,LAF,Repo,OMO,CRR,SLR,
RevisitedbeforeupcomingUrjitArticle
PostedByMrunalOn30/01/2014@7:13pmInEconomy|244Comments
1. Prologue
2. Whatismonetarypolicy?
3. QuantitativeTools
1. #1:ReserveRatios(SLRandCRR)
2. #2:OpenMarketOperation(OMO)
3. #3:PolicyRate
4. BankRate
1. LiquidityAdjustmentfacility(LAF)
2. LAFRepoRate
3. MarginalStandingfacility(MSF)
4. ReverserepoRate
5. RepoRateinrecentyears:
4. MonetaryPolicy:limitations
5. QualitativeTools
1. #1:MarginRequirements/LTV
2. #2:Consumercreditregulation
3. #3:Selectivecreditcontrol
4. #4:MoralSuasion
6. Monetarypolicytools:QuantiativevsQualitative
7. Appendix
1. #1:WhyHighSLRandHighCRRarebad?
2. #2:Narsimhan(I)Committee1991
3. #3:Narsimhan(II)Committee1998
8. MockQuestions

Prologue
NextarticleisaboutRBIappointedUrjitPatelCommitteeonMonetarypolicyframework.
Butbeforedwellingintothat,wemustrecapthebasicconceptsofwhatismonetarypolicy:its
toolsandlimitations.OtherwiseUrjitwontmakemuchsense.
Henceinaway,thiswholearticleisaprologuetonextarticle.

WhyRBIandWhyMonetarypolicy?
Initiallypeopleusedbartersystemfortrading.Butthebartersystemhadmanyproblems(clickme).
Therefore,peopleswitchedtomoneysystem.
Financialintermediates=middlemenwhohelpinthecircularflowofmoneybetween
householdsandbusinessfirms.
Therearetwotypesoffinancialintermediaries:bankinginstitutionandnonbankingfinancial
institutions.
RBIcontrols(all)banksand(some)nonbankingfinancialinstitutions.
RBIsmainjobistocontrolMoneysupplyinthisgame,andtherebyfightinflationand

deflation.
Inflation=pricerise=badforeconomy,youknowthatbycommonsense.
ButDeflation=pricedecrease=wecanbuythingsatalowerprice.Isntthatgood?Whyis
deflationbadforeconomy?
Ans.Everybusinesshasfixedcostofproductionsayminimumlightbill,phonebill,office
rent,staffsalaryetc.So,ifpriceskeepfallingandfalling(sayofNanocar),thencarmarker
willsufferlosses.Hehasnomotivationtoexpandbusiness.Hewantstocutdownhis
productioncosts,byfiringsomeoftheemployees=lessnewjobscreated=unemployment=
socialunrest.
Ifpricesofeverythingfallthencustomduty,VAT,exciseduty,servicetaxtheircollection
willalsodecrease.Thengovernmenthaslessmoneytospendoneducation,healthcare,social
sector,defense,lawandorder=poverty,disease,crime.
bytheway
TERM
DEFLATION

meaning
fallintheprices(andfallINemployment.)

DISINFLATION Fallinthepricesbutwithoutcausingunemployment.

DoesRBIwantit?
No.
yes(whilefighting
inflation)

stagnation+inflation
pricesandwagesrise
butpeoplecantfindjobs,companiescantfind
customers.

STAGFLATION

REFLATION

policytostopthefallinpricelevels,butwithoutcausing
riseinthepricelevels(inflation).

No

yes

Whatismonetarypolicy?
Policymadebythecentralbank.
Tocontrolmoneysupplyintheeconomy.(andtherebyfightbothinflationanddeflation).
RBIimplementsmonetarypolicyusingcertaintools.Twotypes
quantitativetool qualitativetools
Letsstartfromhere.

QuantitativeTools

#1:ReserveRatios(SLRandCRR)
SLR ABankhastosetasidethismuchmoneyintogoldorRBIapprovedsecurities.
ABankhastosetasidethismuchasreserve.Bankcannotlendittoanyone.Bank
CRR
earnsnointerestrateorprofitonthis.

23%
4%

Reserveratio:SLR,CRR
Supposeeconomyisshowinginflationarytrend.Pricesofallgoodsandservicesareincreasing

daybyday.
HowcanRBIstopitusingReserveratioasatool?
Inthiscase,RBIshouldRAISEthereserveratios.
Observe:
Rightnow
PeopledepositedtotalthismuchmoneyinSBI(netdemand&TIMEliabilities
100cr.
NDTL)
CRR(4%)[SBIhastokeepthismuchcashasideforreserve]
4cr
SLR(23%)[SBIhastoinvestthismuchmoneyinRBIapprovedsecurities]
23cr.
100423=73
MoneyleftwithSBI
Cores.
SayRBIraisesSRLto40%andCRRto15%then?
Originally
SLR40
CRR15
MoneyleftwithSBI

100cr
40
15
45cr.

Youcansee,whenRajanhasraisedreserveratio,moneywithSBIisreduced(from73crorestojust
45crores.)
Whatwillbeitsimplication?
Imagineyoureamoneylender.Youve100crorerupeesandyoumustmakeRs.1croreprofit
inayear.
Obviously,youshouldlendit@1%interestrate.(because1%of100crore=1crore.)
Butwhatifyouveonly2crorerupees,andyoustillwanttomakeRs.1croerprofitinayear?
Nowyoumustlendit@50%interestrate.(because50%of2cores=1crore.)
Observethatasmoneydecreased(from100to2),loaninterestrateincreased(from1%to
50%).
SamehappenswhenSBIisleftwithlessmoney(afterRBIincreasesreserveratio).
Letsprepareaflowchart.
Situation:Economyhasinflationarytrend.Pricesofgoodsandservicesincreasingeveryday.
Solution:RBIraisedreserveratio(CRR,SLR)
Result:SBIisleftwithlessmoneytolend.
Consequences:
1.
2.
3.
4.

SBIraisesitsloaninterestrate
BusinessmenborrowlessmoneyfromSBI
Businessmendonotstartnewbusiness.Donotexpandexistingbusiness
Result=Lessjobs.Evenexistingemployeesdischarged.Ifanyoneremainsinthejob,hedoesnt
getpayraise.Hestartscuttingdownunnecessaryexpenditure(e.g.buyingtwonewspapers,
gettinghisshirtsironed,drinkingtea@4PMinofficeandsoon.Thusevenpaperwall,dhobi,

chaiwallaeveryonesincomereduced.)
5. Result=Lessincome(Becauseofabovereasons)
6. Result=Lessdemandofgoodsandservices(becauselessincome).
7. Ultimatelyshopkeeperwillbringdownthepricestoattractpeopleintobuyingmorethings.
Thusinflationisreduced.
Youmaydoubtwhataboutsupplysidebottlenecks,whataboutcostpushanddemandpullinflation
:Imnotgoingintoallthatdetailsatthemoment,elsethisarticlewillbecomelongerthanfive
kilometers.
Letsjustprepareasummarytable:
Policy

dearmoney
cheapmoney
Tool
Tofightinflation Tofightdeflation
ReserveRatio(CRR,SLR) Increasethem.
Decreasethem.
Movingtothenext(Quantitative)tool.Undermonetarypolicy

#2:OpenMarketOperation(OMO)
OpenMarketOperation=whenRBIstartsbuying/sellinggovernmentsecuritiestocontrol
moneysupply.
Governmentsecurities=pieceofpaper.ItsayssomethinglikethisgivemeRs.100,Illgive
you8%interestratefornexttenyearsandafterthatIllrepaytheprincipleofRs.100.Thisis
howgovernmentborrowsfromothers.
Situation:Economyhasinflationarytrend.Pricesofgoodsandservicesincreasingeveryday.
Solution:RBIstartssellinggovernmentsecuritiesinopenmarket.
Result:SBIbuysthemandthusSBIslendingmoneyisreduced.Wait.How?
ImagineRajanissellingsabzi(vegetables).IfSBIschairmanArundhatiMadamgoestobuy
vegetables.Obviouslymadamsmoneywilldecreasewhenshebuysvegetables.
Thensameasusual:
1.
2.
3.
4.
5.
6.
7.
8.

SBIleftwithlessmoneytolend.
SBIraisesitsloaninterestrate(tokeepprofitmarginsame)
BusinessmenborrowlessmoneyfromSBI.
Businessmendonotstartnewbusiness.Donotexpandexistingbusiness
Lessjobs
Lessincome
Lessdemand
Ultimatelyshopkeeperwillbringdownthepricestoattractpeopleintobuyingmorethings.

Thusinflationisreduced.
Duringdeflation,RBIwilldothereverse.(i.e.RBIbuysSabzifromSBI).Howwillitstop
deflation?Thinkinyourhead.
Letsupdateourtable
Policy

dearmoney

cheapmoney

Tool
Tofightinflation Tofightdeflation
ReserveRatio(CRR,SLR)
Increasethem.
Decreasethem.
OpenMarketOperation(OMO) RBIsellsecurities RBIbuysecurities

MockQuestion
In2013,UPSCwallaaskedaverychillarquestionfromthistopic.
IncontextofIndianEconomy,OpenMarketOperationrefersto
a.
b.
c.
d.

BorrowingbyscheduledbanksfromRBI
Lendingbycommercialbankstoindustriesandtrade
PurchaseandsaleofgovernmentsecuritiesbytheRBI
NoneofAbove

WheneveryoufaceaGS/GKtypeMCQ,Youvethreechoices
Skip
Ifyoudontknowtheanswer,Justleaveitinsteadofriskingnegativemark.
Attempt CorrectanswerisOptC.
Itmeansyouveunsureoftheanswer.50:50.Soyoumarkthequestionnumber(say45),
Markn
atthebackofyourquestionpaper.Attheendofexam,ifyoureleftwith1015free
Review.
minutes.Youlookatthequestionagain,andtrytosolveit.
So,shouldyouputabovequestioninmarknreview?
No.
Becauseitsadefinitionbasedquestion.IfyoudontknowthedefinitionofOMOyoumight
tickawronganswerandfail.Mostofthesincereplayersfailinprelimsbecauseofthisreason.
Theypushtheirluckinnegativemarkingtoovercomeanimaginarycutoffandthusdigup
theirowngrave.(especiallyduringlast1015minutesoftheexam.)
Moralofthestory:neverputfact/definitiontypeMCQsinMarknReview.
LetssolveabitmorecomplicatedMCQfrom2012sCSATpaper.
Q.Whichofthefollowingmeasureswouldresultinanincreaseinthemoneysupplyineconomy?
1.
2.
3.
4.

Purchaseofgovernmentsecuritiesfrompublicbycentralbank
Depositofcurrencyincommercialbanksbythepublic
Borrowingbygovernmentfromthecentralbank.
Saleofgovernmentsecuritiestothepublicbycentralbank.

Answerchoice
a.
b.
c.
d.

Only1
2and4
1and3
2,3and4

WheneveryoufacesuchmultiplestatementtypeMCQs,alwaysuseeliminationmethod.Firstfind
astatementthatisdefinitelyrightordefinitelywrongandeliminatechoicesaccordingly.
FocusonfirststatementPurchaseofgovernmentsecuritiesfrompublicbycentralbank:will
itincreasemoneysupplyinthesystem?

ImagineRajanputsanadinnewspaper:bringyourSabzi(vegetables),Illbuyit.Juntagives
himtheirownveggies,Rajangivesthemmoney.(aclassicbuyandsell).
Ultimateresult:moneysupplyincreasedinthesystembecausejuntagotthemoney.Meaning
#1definitelycorrect.
Ifyouthinkitontechnicalterms.Centralbankpurchasesgovernmentsecurities=OMO(Open
marketoperation),wheremoneyshiftshandsfromRBItopeople.
Hencemoneysupplyincreased.(Inreality,moneydoesntgotoaamadmidirectly,butthose
bankersandnonbankinginstitutionswhoparticipateinOMO).Anyways,#1isright,
Eliminatechoicesthatdonothave#1
a.
b.
c.
d.

Only1
2and4
1and3
2,3and4

Nowthefinalanswerdependsonwhetherstatement#3isrightorwrong?
Statement#3saysBorrowingbygovernmentfromthecentralbank.(So,willitincrease
moneysupply?)
HowdoesGovernmentborrowfromCentralbank?DoesMohanjustcallupRajananddemand
1lakhcrores?No.MohanwillhavetogiveRajanthatmuchgovernmentsecurities(vegetables)
andRajanwillgivehimcash.
Ismoneysupplyincreased?YesMohansoldveggiestoRajanandgotMoney.WheneverRajan
buysveggiesandpaysthemoneysupplyisincreased.(thisissimilartoOpenMarket
operation)
Besides,Mohancanthenusemoneytopaysalariesofgovernmentstaff,payforrailroad
bridgesandotherinfrastructureprojects,payforMNREGAandsoon.ThereforeAnswerC:1
and3correct.
Counterargument?
WhatifRajansubsequentlysellsthose(Mohans)securitiestobankers.Thenbankersmoney
reduced.Hence#3iswrong.ThereforefinalanswerAonly1.
So,whatsthefinalanswer:isitAorisitC?
Ultimatejudge=UPSCsofficialanswerkeyuploadedontheirsite.
In2012sQuestionpaperTestseriesA,thisisQ77:anditsofficialanswerisC.Therefore,both
1and3arecorrect.
Anyways,whattodointheexam?
Skip
Ifyoudontknowtheconceptbetterskip.
Attempt Thisquestionisattemptableifyoudontdragthelogictoomuchinstatement#3.
Yes,itcanbeputundermarkandreviewbecausethisisnotanabsolutefact/absolute
Markn definitiontypeMCQ.Ifyouapplysomeconcepts,youcaneliminatewrongchoices.But
Review. stillifdoubtpersistsinthemind(e.gwhetherStatement3isrightornot)thenitsalways
safetoskipandavoidnegativemarking.
Bytheway,WhataboutStatement#2:Depositofcurrencyincommercialbanksbythepublic.(Will
itincreasemoneysupplyornot?)

Viewpoint1:yes.Becausebankcanusedittoexpandloanablecredit.(asexplainedinMoney
creationtopicinClass12NCERTMacroeconomicspage39onwards).
Viewpoint2:no.(BecauseBankwillhavetoputsomemoneyasideasCRRsothatmuch
moneyislessinthesystem.)
Eitherwayitdoesntchangetheanswer.BecauseWeknowthatstatement1isdefinitelycorrect.
Andthereisnooptionwhere(1,2)aregivensimultaneously.
Anyways,MovingonSofar,RBIhastwotoolsundermonetarypolicy:
1. reserveratios(SLR,CRR)
2. Openmarketoperation.
Thirdandthemostimportantquantitativetoolis

#3:PolicyRate
Policyrate=incaseofIndiaitsReporate.Beforemovingfurther,letsrefreshourconceptsof
Bankrate,LAF,MSF,RepoandReverserepo.

BankRate
WhenbanksborrowlongtermfundsfromRBI.TheyvetopaythismuchinterestratetoRBI.
[Note:differentbooksgivedifferentexplanationofBankRate.IveusedNDTVsdefinition]
Atpresent,Bankrate=9%
Collateral:nothing.(BankcanborrowmoneywithoutpledginggovernmentsecuritiestoRBI)
Bankrateisnotthemaintooltocontrolmoneysupplythesedays.
Nowadays,RBIusesLAFReporateasthemaintool,tocontrolmoneysupply.
OkthenWhatstheuseofBankrate?
PenalratesarelinkedwithBankrate.Forexample,IfabankdoesntmaintainCRR,SLRas
pertheprescribedlimit.
ThenRBIcanimposepenaltyinterestonsuchnotoriousbank.
Atpresent,Penaltyrate=Bankrate+3%(or5%insomecases)
MeaningifBankrate=9%thenpenaltyrate=9+3=12%
Anyways,whatifRBIwantstofightinflationusingbankrateasatool?
Obviouslytheyshouldincreasebankrate.Thatwayitbecomesharder(moreexpensive)forbanksto
borrowfromRBI.=>SBIincreasesitsloanrates(tokeeptheprofitmarginsame).Result?
Lesspeoplegethomeloan,bikeloan,businessloans.
Lessbusinessexpansion
Lessjobs
Lessincomes
Lessdemand
Ultimatelyshopkeeperwillbringdownthepricestoattractpeopleintobuyingmorethings.
Thusinflationisreduced.
Letsupdateour(stupid)table

Policy

dearmoney
Tool
Tofightinflation
ReserveRatio(CRR,SLR)
Increasethem.
OpenMarketOperation(OMO) RBIsellsecurities
Bankrate
Increase

cheapmoney
Tofightdeflation
Decreasethem.
RBIbuysecurities
decrease

LiquidityAdjustmentfacility(LAF)
LiquidityAdjustmentfacility
RBIstartedthisin2000.YoucanimagineitasaAdda/gamblingden/ganghideoutwhere
RBIsclientsgather,consumerdesiliquor,playcards,watchitemsongsandborrowmoney
fromRBI(orlendMoneytoRBI).
Bytheway,whoaretheclientsofRBI?=Centralandstategovernments,Banksandnon
bankingfinancialinstitutions(NBFI).NBFIfurtherincludes:
AIFI(allIndiafinanceinstitutions)NABARD,SIDBI,EXIMBankandNational
HousingBank.
Primarydealers(MorganStanley,GoldmanSachs,JPMorganChase,Standard
CharteredBank,HSBCetc.)
NonBankingfinancialcompanies.
Anyways,UnderthisLAFadda,RBIhastwotools:
IfclientborrowsmoneyfromRBI(forshortterm)thenclienthastopaythismuch
interestratetoRBI.AtpresentRepois8%.(articlewrittenon29thJan2014)
IfclientlendsmoneytoRBI(forshortterm)thenRBIhastopaythismuchinterestrate
Reverse
toclient.RBIdoesntlikeheadache.Sotheymadeasimpleformula:Reversereporate=
Repo
RepoMINUS1%=81=7%.
Repo

Collateral:
Problemwithrunningaadda/gamblingden=sometimesclientdrinkstoomuchdesiliquor
andpassesoutonfloor.Sometimesheevendiesbecauseofhooch.Sometimespoliceraids
theden,andclientsrunawaywithcashandregister.
Ifsuchthingshappen,Rajanwillbeatloss.So,hedemandsgovernmentsecuritiesas
collataral.Soevenifclientdoesntrepaymoneyontime,Rajancansellthosesecurities(in
openmarketoperations)andrecovermoney.

LAFRepoRate
Letsgetabittechnicallycorrectnow.Observefollowingimage

Scenario
SBIchairmanArundhatimamwantstoborrowRs.100crore(forshortterm).
ShegivesherstashofgovernmentsecuritiestoRajan.
RajangivesherRs.100crore.
MadamAlsosignsanagreement
I,ArundhatiBhattacharya,agreetobuysamesecuritiesfromRajan,at108croresafter14
days.
NoticethatshehasagreedtorepurchasesamesecuritiesfromRajan.Thereforeitscalled
Repo.
Andhowmuchinterestratedidshepayonthisloan?[108100]/100=8%.Thatsourrepo
rate.
Important:
RecallthatSBIalsohastokeeppartofhermoneyinRBIapprovedsecurities(underSLR).
SoMadamcannotUSEthosegovernmentsecuritiestoborrowunderRepoRatefromRajan.
Thatleadstoanewtopic

MarginalStandingfacility(MSF)
MSFmechanismissameasrepo.Butsomedifferences
LAF(Repo)
MSF
Rajansaysdontcomehere
unlessyouwanttoborrow
MinimumRs.1crore.
minimumRs.5crores.
Allclientsarewelcomei.e.

Centralandstate
governments
Banksbeitcommercial
bankorRRBor
cooperativebank
Nonbankingfinancial
institutions.
You(bankers)cannotpledge
securitiesfromSLRquotato
borrowfromthiswindow.
Nolimit.Youmayborrowas
muchasyouwant.(aslongas
youhavegovernmentsecurities
topledgetome.)
RajandecidesReporate(8%
rightnow)

Sorry.Notallclientswelcomehere.
Onlyscheduledcommercialbankscanborrowunderthis
window.SBI,PNB,BoB,ICICIetc.
ThisMSFfacilityisspeciallycreatedtohelpthemsolve
shorttermcashmismatch.

CanusesecuritiesfromSLRquota.
Maximum0.75%ofNTDL.Toputthisincrudewords,ifSBI
received100croresfromaamadmiundersavingsaccount,
currentaccount,fixeddepositetc.thenSBIcanborrowonly
uptoRs.75lakhsfromRBI.
MSF=RepoRate+1%=8+1=9%.(earlierthismarginof1%
usedtobehigher.Butnowadaysjust1%!)

forthosewhostillhavedoubtaboutRepovsMSF:
forrepoborrowing,bankwillneedtopledgesecuritiestoRajan.ButbankcannotuseSLRreserved
securitiesforthis.
so,imagineifabankisindireneedofcash,butdoesnthavesparegovernmentsecuritiesthenthey
canborrowusingMSFbypledgingthoseSLRsecurities.(andunderMSFwindow,Rajanwill
demand1%higherthanRepoasonetypeofpunishmentforpledgingSLRsecurities.)

ReverserepoRate
Althoughselfexplanatory.Butletscheck
Repo=clientsborrowfromRajanandpaythismuchinterestrate.(shorttermloan)
Reverserepo=whenRajanhimselfborrowsfromclients,thenhehastopaythismuchinterest
ratetoclients.
Collateral=yes.Whatifpoliceraidsthisgamblingden,andRajanrunsawaytoNepal?Clients
cansellRajansGovernmentsecuritiesandrecovertheirmoney.
Reverserepo=RepoMINUS1%=81%=7%.
Note:inofficialparlance,theycallpercentagesinbasispointsso1%=100basispoints.Soin
thatofficiallanguage,Reverserepo=RepoMINUS100basispoints.
Enoughcheapjokes.Whathavewelearnedsofar?
ThatRajancontrolsmoneysupplyusingmonetarypolicy.
UnderMonetarypolicy,Rajanhasvariousweapons(ortools)
1. Reserveratios(SLR,CRR)
2. OMO:Openmarketoperation
3. Rates:Bankrate,LAF(Repo,Reverserepo),MSF.
WealreadyknowhowtoapplySLR,CRRandOMOtofightinflation(anddeflation.)letmepaste
thetableagain.
Policy
Tool
ReserveRatio

dearmoney
Tofightinflation

cheapmoney
Tofightdeflation

(CRR,SLR)
OpenMarket
Operation
(OMO)
BankRate
Reporate

Increasethem.

Decreasethem.

RBIsellsecurities

RBIbuysecurities

increaseit
decreaseit
increaseit
decreaseit
itsvalueislinkedwithRepo,hencecannotbeincreased/decreased
ReverseRepo
independently.
Marginal
itsvalueislinkedwithRepo,hencecannotbeincreased/decreased
StandingFacility independently.BesidesMSF=temporaryfirefighting,cashmismanagement.
WelearnedthatRajandoesntuseBankratemuch,tocontrolmoneysupply.
WelearnedthatRajandoesntdecideReverserepoandMSF.(theyreautomatically1%and
+1%ofReporate).
ThustheonlythingRajanhastodecideundermonetarypolicy=Reporate.Therefore,Repo
rateiscalledthepolicyrate
Letsrevisitoutflowchart:
Situation:Economyhasinflationarytrend.Pricesofgoodsandservicesincreasingeveryday.
Solution:RajanincreasesReporate.(sayfrom7.75%to8%).
Result:itbecomesexpensiveforSBItoborrowfromRajan.Theyllincreasetheirownratesas
well.
Wait.How?
JustlikehowthingsrollinOnionbiz.
IfpricesofOnionriseinMaharashtraswholesaleyard(inLasangaon),thenimmediately,retail
veggie@Ahmedabadwillalsoraisetheironionpricestokeeptheprofitmarginsame.
Whatllbetheconsequences(ifreporateishiked/increased)?
Consequences:
1.
2.
3.
4.
5.
6.
7.

SBIraisesitsloaninterestrate(tokeepprofitmarginsame)
BusinessmenborrowlessmoneyfromSBI.
Businessmendonotstartnewbusiness.Donotexpandexistingbusiness.
Lessjobs
Lessincome
Lessdemand
Ultimatelyshopkeeperwillbringdownthepricestoattractpeopleintobuyingmorethings.

Thusinflationisreduced.
Policy
Tool
ReserveRatio(CRR,SLR)
OpenMarketOperation(OMO)
PolicyRate(RepoRate)

dearmoney
Tofightinflation
Increasethem.
RBIsellsecurities
Increaseit

RepoRateinrecentyears:

cheapmoney
Tofightdeflation
Decreasethem.
RBIbuysecurities
Decreaseit

Letsobservewithagraph:howRBIfoughtinflation/deflationinrecenttimesusingReporateasthe
mainweaponofmonetarypolicy.

Fromaboveabovegraph,youcanseeRBIhasfrequentlychangeditsreporatetocombatboth
inflationaryanddeflationarytrend.ButYoudagreethatinflationhasnotbeencontained.Nomatter
whatnumberjugglingorstatisticalinterpretationsaregiventhehardshipofcommonmanhasnot
stoppedbeitmilk,petrol,onion,LPGanything.
Agreedthatpricesofonion,sugar,pulsesandfoodaresubjecttovagariesofmonsoonand
blackmarketeering.Rajancannotdoanythingaboutit.
AgreedthatcrudeoilpricesaresubjecttorupeeDollarexchangerate,externalfactorsand
governmentsderegulationoftheirprices.Rajandoesnthavemuchcontroloverthis.
Butstilleveninthenonfood,nonfueltypecommoditiesRBIsmonetarypolicieshavefailedto
curbinflation.WHY?Observethefollowingimage.

SupposeVijayMallaygot100croreloanfromStateBankofIndia.Ifyoutracethesourceofthat
money,itllturnout6070crorescamefrombankssavingsaccount,fixeddepositetc.Rajanlends
moneyinreporateyes,butthatdoesntmeanbanksdependonlyonRajantoarrangethecashfor
itsclients.
SupposeRajanreducesreporatefrom8%to5%.Banksarenotlegallyrequiredtoreducetheirloan
interestrates.
Thecurrentsystemisfollowing:
Banksarefreetodecidetheirbaserate.E.g.SBIsbaserateis10%.
ItmeansSBIwontloanmoneytoanyoneataninterestratelowerthan10%(exceptthose
farmersunderInterestsubventionscheme.)
SBIwilllinkallofitsloanproductswithBaserate.Forexample
SBIBaserate=10%
Carloan
Twowheelerloan
Educationloan(upto4lakh)
Homeloanforwomen(upto75lakh)

Calculation
0.75%aboveBaserate
8.25%abovebaserate
3.5%abovebaserate
0.10%abovebaserate

Result
10.75%
18.25%
13.5%
10.10%

MeaningifSBIchangesherBaseratethenallofaboveloaninterestrateswillchangeautomatically.

IfRajanchangeshisreporate,willSBIchangeherbaserate?
Notalways.
BecausethosecommonmenarethemainsuppliersofmoneytoSBI.
RBIisnotthemainsupplierofmoneytoSBI.
SBIwillonlychangeitsbaserate,whenshefeelsnecessaryforitsownprofit/losscompared
toitscompetitors.
DoesitmeanReporatesystemisbogusandineffective?
Notalways.
IndevelopingcountrieslikeIndia,mostpeopleparktheirmoneyinonlyfourthings:savings
account,fixeddeposit(FD),providentfundandLIC.Wevemutualfunds,weveNPS,weve
ULIPs,weveRajivGandhiequitysavingsscheme
butmostpeople(particularlytheoldergeneration)feelsinsecureinintosuchnewthings.
ThereforelotofmoneyflowsintoSavingsaccountsandfixeddeposits=SBIsmainsourceof
money.
But,Inadvancedeconomies,likeUSA,peopledontinvestlargeportiontheirincomein
savingsaccountorFD.Theyvevarietyofinvestmentoptions.So,forthoseAmericanbanks,
theirownCentralbank(USFeds)isasignificantmoneysupplier.
HenceUSFedsmonetarypolicyshowsfasterimpactontheirAmericanBanks,THAN
RajansmonetarypolicyonDesibanks.

MonetaryPolicy:limitations
Indevelopingcountries,Monetaryfailstobringquickresultsbecause
1. Peopledonthavemanyinvestmentalternatives.Commercialbankshavelargedeposits.Rajan
isnotthemainorevenprominentmoneysupplierforthesebanks.WhateverRajandoes,its
effectwillbefeltonlyafter68monthsbutbythattime,newfactorswouldcauseanotherrise
ininflationandRajanwillhavetostartfromscratchagain.
2. NonMonetizedeconomy:inruralareas,manytransactionsarestillofbarternature.(E.g.
kiranawallacummiddlemansuppliesseeds,pesticides,fertilizersinexchangeofsharein
farmersproduce.)
3. Lackoffinancialinclusion.Sincemostpeoplearenotinthebankingnet.TheyrelyonShroffs
andmoneylenders.Manyofthemcirculatetheblackmoneyofcopsandpoliticians,andcharge
36%interestrateonloans.Rajanhasnocontroloverthem.
4. Monsoonuncertainty,cyclone,flood,draughtsandtheireffectonfoodproduction.Food
inflation=>newspaperwalla,washerman,barber,carmechaniceveryonewillraisetheir
servicefeestoaccommodatetheirraisedcostofliving.Rajanhasnocontroloverthem.
5. Crudeoilandgoldimport+negativeeffectwhenrupeeweakens.Rajancantrytobring
1$=Rs.65to$1=63Rs.Buthehasnotenoughforexreservestobring$1=Rs.50.
6. Fiscaldeficit,illogicalschemes.e.gMNREGAworkerdigsatemporaryroad.Afterfirstrain,t
heroadiswipedout=physicalinfrastructureaddedtoeconomyno.Wagesraised..yes.=
thismismatchleadstomoreinflation.
7. Subsidyleakage,Blackmoney,undergroundeconomy.
8. Andmostimportantly,becauseRajanusesMultiindicatorapproach,hefocusesonWPI
(minusfoodandfuel).ThatswhyUrjitPatelrecommendshimtotargetCPI.Moreonthatin
nextarticle.

Sofar,welearnedthatRBIhastwosetsoftools/instrumentsundermonetarypolicy:
Quantitativetool

Qualitativetools

1. Reserveratios
2. OMO
Wellseetheminamoment
3. Policyrate(RepoRate)

QualitativeTools

#1:MarginRequirements/LTV
MallyawantstoborrowfromSBI.HepledgeshiscompanyssharesworthRs.100croresas
collateral.
Forsuchloans,Rajancanprescribemargin,say65%.
InthatcaseevenifMallyapledges100croresworthshares,SBIcangivehim10065=only35
Crorerupeesasloan.
Usingthistool,Rajancancontrolmoneysupply.e.g.duringinflation,heshouldincrease
marginrequirement,soMallyacanborrowless=>lessjob=>lessincome=>less
demand=>pricesreduced.
IfRajanchangesreporate,itisnotcompulsoryforSBItochangeherloaninterestrates.(we
sawhowAlokNathkeepsgivingmoneytoSBI,sotheyarenotentirelydependentonRajan.)
ButifRajanchangesmarginrequirements,thenSBIandallotherbanksmustobeyit.Inother
words,thistoolhasdirectimpactonmoneysupply.

#2:Consumercreditregulation
SupposeNanocarsells@1lakhandRajanhasmaderulethatdownpaymentcannotbeless
than30%.
ItmeanscustomermustbringRs.30,000fromhispocketandbankcanonlygivehim
maximum70000asloan.
HowcanRajanfightinflationwiththistool?
Increasedownpaymentfrom30%=>50%(meaningbankcangivelessloan.Customerhimself
hastoarrangelotofmoneyfromhisownpocket)
RajancanmakerulebankscannotacceptEMIlessthan5000oncarloan.Observe:
Case#1:100EMIsworth1000each=1,00,000.(ignoreinterestrates)
Case#2:20EMIsworth5000each=1,00,000.(ignoreinterestrates)
Incase#2:someofthelowermiddleclassfamiliesmaypostponetheirdecisiontopurchasenanocar
(BecausetheycantaffordhigherEMIs.)
Result=lessdemand=>pricesreduced.(indirectlybecausecarmechanicsgetlesswork,
numberplatepaintersgetlessordersetc.sotheyreducefeestoattractnewclientsandretain
existingclients.)
Thus,Rajancancontrolmoneysupplybychangingdownpaymentandinstallment(EMI)rules.

#3:Selectivecreditcontrol

Underthis,Rajancanspecificallyinstructbankersnottogiveloanstotradersofcertain
commoditiese.g.sugar,gur,edibleoiletc.
evenifthesaidtraderisreadytomortgagehisshares/bonds/factory/machine/vehicleanything.
thispreventsspeculations/hoardingofcommoditiesusingmoneyborrowedfrombanks.

#4:MoralSuasion
HereRajantriestopersuadethebankerstodoxyzthing.Example
1. Pleasereducegivingautomobileloansinsteadparkyourmoneyingovernmentsecurities.
(abovetheSLRrequirements.)
2. Ivereducedmyreporate,nowyoualsoreduceyourbaserate.
Rajanwilltrytoinfluencethosebankersviadirectmeetings,conference,givingmediastatements,
givingspeeches@publicseminars,universityconvocationsetc.(evenwherebankersarenot
present.)Helldoso,tobuildapublicopinion,mediaopinionandinfluencethosebankersbymaking
themfeelguilty.

Rationing
ofcredit

Direct
action

FoundinPlannedeconomies/communistnations.
Herecentralbankwilldecideupperlimittoloansineachsector(heavy
industries,service,agriculture,smallscaleetc.)
Sooncethatquotaisover.Additionalloanscannotbegiventothatborrowers
fromthatsector.Thisalsocontrolsmoneysupply.
MeansRBIgivespunishmenttoerringbanks.Punishmentcaninvolve:penalinterest,
refusestolendthemmoneyfromLAFetc.andinworstcaseevencancelstheirbanking
license.

Letsrecap
Monetarypolicytools:QuantiativevsQualitative
Quantitative
Qualitative

1. Reserveratios(SLR,CRR)
2. OpenMarketOperation
3. Policyrate(RepoRate)

1.
2.
3.
4.
5.
6.

Marginrequirements/LTV
Consumercreditregulation
Selectivecreditcontrol
MoralSuasion
RationingofCredit
DirectAction

Indirectinnature.(EvenifRajanchangesreporate,itsnot
necessarySBIwillimmediatelychangeitsbaserate/loan
interestrates.)

Directinnature.(e.g.thosemargin
requirements)

Generaltheyaffectmoneysupplyinentireeconomybeit
housing,automobile,manufacturingeverything.

Selectivecanaffectmoneysupplyin
aspecificsectorofeconomye.g.
automobile.

LetssolveanOfficialMCQfromUPSC2012Questionpaper
Q.RBIActsasbankersbank.Thiswouldimplywhichofthefollowing?

1. OtherbanksretaintheirdepositswithRBI
2. RBIlendsfundstocommercialbanksinthetimesofneed.
3. RBIadvisescommercialbanksonmonetarymatters.
CorrectStatement
1.
2.
3.
4.

Only2and3
Only1and2
Only1and3
1,2and3

Approach:
Wheneveryoufacesuch3statementMCQor4statementMCQ,Alwaysuseeliminationmethod.
Firstyoufindoutastatementthatisdefinitelyrightordefinitelywrong.Inabovecase,wecansee#2
isdefinitelyright.RBIlendsfundstobanksinthetimesofneed(Repo,MSF)
Soletseliminatechoicesthatdontinvolvestatement#2
1.
2.
3.
4.

Only2and3
Only1and2
Only1and3
1,2and3
Thisdidnothelpmuch.Westillhavethreechoicesleft.Observestatement#1:Otherbanks
retaintheirdepositswithRBI.Thatiscorrectwithrespecttocashreserveratio.CRRisone
typeofdepositthatbanksmaketoRBI.(RBIdoesntpayinterestonitthatsadifferentstory).
Meaning#1isalsocorrecteliminatechoicesthatdonothave#1
1. Only2and3
2. Only1and2
3. Only1and3
4. 1,2and3

Onlytwochoicesleftandtheultimatesolution=isstatement#3iscorrectornot?
Viewpoint#1
ThestatementsaysRBIadvisescommercialbanksonmonetary
matters.Thewordadvisesmakesthisstatementincorrect.
BecauseRBIdoesntAdvicetheyjustorderthebanksbeit
SLR,CRR,PSL.RBIdoesntadvice,RBIgivesordersand
direction.Thereforestatement#3iswrong.
EvenifweacceptthatRBIadvices,stillthequestionsasks
whatisimpliedbyRBIasBankersbank.So,RBIadvices
moralsuasionthatisamonetarypolicytool.RBIsnotdoingit
asaBankertothosebanks.Therefore,Statement#3is
definitelywrong.
Answer(B)

Viewpoint#2
RBIdoesadvicethosebanks.
WesawitunderMoral
Suasion.Therefore,Statement
#3isright.
MoneyBankingandfinance,E
NarayanNadar(PHI
publication).Hehas
specificallylistedthis
Advicefunctionunder
Bankersbanktopic.
Answer(D)

So,isitBorisitD?FinaljudgeisUPSC.
TheyhaduploadedCSAt2012officialanswerkeyontheirsite.
ThisquestionisTestSeriesA,Question#75anditsofficialanswerisD=meaningallthree

statementsarecorrect.
IfyoufacesuchMCQinexam,whatshouldbeyourapproach?
Uptoyou.Butifyoustartskippingallsuchquestion(OMO,Moneysupply,Bankers
bank),becauseyourecompletelyunawareofthosetopics=thatisnotpardonable.itshows
Skip
youreunderpreparedforthisexam.Youshouldeitherchangeyourstudymethodor
changethegametryforsomeeasierexam.
Thisquestionisattemptable,ifyoudontnitpickoverthewordadvisesinthird
Attempt
statement.
IfyouvethoroughlypreparedtheRBIsmonetarytools(bothqualitativeand
quantitative),youcansolveitbyapplyingconcepts/principlesparticularlythemoral
Markn
suasionthing.Butifyourestilldoubtfuloverwhether#3isrightorwrong,thenbetter
Review
skip.Ifyouskipbecauseyouredoubtful=thatispardonable.Butifyouskipbecause
yourecompletelyunawareofthistopic=nonbailableoffense.

Appendix
ThesearethetopicsIwantedtodiscussinthearticle,buttheywouldbreaktheflowofothertopics.
Hencewritingthem@bottom:

#1:WhyHighSLRandHighCRRarebad?
Fromthediscussionsofar,youmightthinkwhyRajanonlyfocusesonReporatetocontrolmoney
supply.WhynotsimplyraiseSLRandCRRrequirements.
LetscheckthedemeritsofhighSLRandCRR:
PriortoLPGreformsin90s,RBIusedtokeepSLRandCRRveryhigh.Letstakeanexample
ABankcantwotypesofdeposits
Deposittype
examples
TimeDeposit
Fixeddeposit(FD)recurringdeposit.
DemandDeposit Savingsaccount,currentaccount
Usingthismoney,bankhastocountitsNetDemandandTimeliabilities(NDTL),every
fortnight.Supposeits100crores.
BothCRRandSLRarecountedonthisfigure.Intheoldtimes,thesereserveratiosusedtobe
ashighas15%and40%respectively.Observetheeffect:
NetDemandandTimeLiabilities(NDTL)
Reserveratios
CRR(15%)
SLR(40%)
Moneyleftwithbank

+100cr.
()15[noprofit]
()40[someprofit]
=45cr.

From100crores,barely45croresleftwiththebank.ButaddinginsulttotheinjuryevenhereRBI
mandatesPrioritysectorlending(PSL).Meaning,atleast40%oftheloanshastobegivento
farmers,smallbusinessmen,studentsetc.groups.

Letsupdatethetable:
NetDemandandTimeLiabilities(NDTL)
Reserveratios
CRR(15%)
SLR(40%)
Moneyleftwithbank
PSL(40%)
Moneyleftforbigborrowers(i.e.bigbusinessmen,uppermiddleclass)

+100cr.
()15[noprofit]
()40[someprofit]
=45
=45x0.4=18crore.
=4518=27crores.

Bytheway,PSLiscountedonannualbasiswhileSLR,CRRcountedonfortnightbasisso
abovetableistechnicallyincorrectbutIvepluggedinthosenumbersonlyforthesakeof
explanation.
beforethe90sGovernmentwouldeveninterfereandorderpublicsectorbankstogivePSL
loans@cheapinterestrates.Thelocalpoliticianswouldcoercethebranchmanagertogive
PSLloanstoineligiblepeople.Theydefaultonloans,Branchmanagercannotrecovermoney
(becausedefaulterwillgotocivilcourtthentaarikhpetaarikh.)So,bankwouldhavetoforget
aboutmostofthose18croresgiveninPSLloans.
Anywaysyoucanseepeopledeposited100croresinthebankyetbankisleftwithbarely27
crores(overwhich,bankhasFreedomtodecidewhomtheyshouldgivetheloan.)
Whataretheconsequencesforbusinessmen?
1. Highcostofcredit(becausebankwilltrytomakemaximumprofitfromthose27croresso
bankwillchargeveryhighinterestrateonthebusinessloanstopayoffforthestaffsalaries,
branchofficerentsandeverything.)
2. Businessmancannotexpandhisbusiness.
3. Lessexports.
4. Lesstaxincomeforthegovernment.
SoinawaythatwasalsooneofthefactorsleadingtoBalanceofPaymentcrisis(andsubsequently
LPGreforms.)YoucanreadmoreaboutthatinNCERTClass11chapter2and3.

#2:Narsimhan(I)Committee1991
Plaguedbyproblemsandlossesinnationalizedbanks,GovernmentofIndiaformedthisCommittee.
Recommendationswere:
1. Deregulateinterestrates.Letthebanksdecidetheirloaninterestrates.Accepted.Gradually,we
movedtotheBaseRatesystem.
2. PSLloansshouldbegivenatnormalinterestrates.Accepted(butwithexception=>interest
subventionthatwesawunderNachiketarticles.)
3. NPA/Loandefaultmattershouldbehandledbyseparatebodyandnotcivilcourts.Result:Debt
recoverytribunalcreatedin1993.UltimatelySARFAESIActin2002.
4. ReduceCRR,SLR.Accepted.Todaywevethem@4%and23%respectively.
5. AllowPrivatebanksandforeignbanks.RBIinvitedapplicationsin1993.ICICI,Axis,HDFC
andmanyothersgotlicense.
6. LiberateBranchexpansionpolicy.Done(Exceptthat25%ruralbranchingmandatewesaw
underNachiketarticles).
7. PrepareNBFCregulatoryframework.Accepted.
8. Governmentshouldreduceshareholding(andtherebyitsofficialinfluence)inthepublicsector

banks.Governmentagreed.TodaygovernmentsshareholdinginSBI=~60%.

#3:Narsimhan(II)Committee1998
Suggestedmorereforms.
1. allowVRSinthebankssotheycangetridofexcessivestaff.
2. SuggestedadditionalLegalreformsforloanrecovery.=>SARFAESI2002.
3. Computerization,electronicfundtransfer,legalframework=>PaymentandSettlement
Act=>Retail(ECS,NEFT,creditCard)+Wholesale(RTGS)
4. Permitnewprivate/foreignbanks.RBIinvitedlicensein2001=YesBankandKotak
Mahindragotlicenses.2013:RBIagaininvitedapplicationsforbanklicenses.
[Note:listofrecommendationsnotexhaustive,Iveonlyhighlightedimportanttopicsthatshow
evolutionofbankingsectorinrecenttimes.]

MockQuestions
1. Withopenmarketoperations,RBIcan
a. increaseliquidityintheeconomy,butcannotdecreaseit
b. decreaseliquidityintheeconomy,butcannotincreaseit
c. Canincreaseordecreaseliquidityintheeconomytocontrolmoneysupply.
d. Noneofabove.
2. Bywhichofthefollowingmethods,governmentcanreducemoneysupplyintheeconomy?
a. taxation
b. saleofsecuritiestopublic
c. bothAandB
d. neitherAnorB
3. Duringtheperiodofdeflation
a. RBIshouldusedearmoneypolicytocombatit
b. Governmentshouldreduceitstaxrates.
c. bothAandB
d. NeitherAnorB.
4. IFpricesareloweredwithoutcausingunemployment,wecallit:
a. stagflation
b. reflation
c. disflaction
d. Disinflation.
5. Whichofthefollowingcontainscorrectsetofquantitativeinstrumentsofmonetarypolicy?
a. reserveratio,bankrate,marginrequirements
b. openmarketoperations,marginrequirements,regulationofconsumercredit
c. cashreserveratio,bankrate,openmarketoperation
d. Noneofabove
6. Whichofthefollowingcontainscorrectsetofqualitativeinstrumentsofmonetarypolicy?
a. reserveratio,bankrate,marginrequirements
b. creditrationing,marginrequirements,regulationofconsumercredit
c. cashreserveratio,bankrate,openmarketoperation
d. Noneofabove
Q7.Tocountertheeffectofdeflation,whichofthefollowingstepsshouldRBIinitiate?
1. decreasereserveratios

2. buygovernmentsecuritiesthroughopenmarketoperation
3. increasepolicyrate
Answerchoices
a.
b.
c.
d.

only1and2
only2and3
only1and3
1,2and3

Q8.Tocounterinflation,whichofthefollowingstepsshouldRBIinitiate?
1. Increasereserveratios
2. sellgovernmentsecuritiesthroughopenmarketoperation
3. Increasepolicyrate
Answerchoices
a.
b.
c.
d.

only1and2
only2and3
only1and3
1,2and3

Q9.Whichofthefollowingmaycausedeflationintheeconomy?
1. RBIraisespolicyrate
2. RBIraisescashreserveratio
3. RBIsellssecurities
Choices:
a.
b.
c.
d.

only1and2
only2and3
only1and3
all1,2and3

Q10.Moneysupplyintheeconomy,isaffectedby
1. Cheapmoneypolicyanddearmoneypolicy.
2. OpenmarketoperationandMoralSuasion.
3. Consumercreditregulationandloantovalueratio.
Choices:
a.
b.
c.
d.

only1and2
only2and3
only1and3
all1,2and3

Q11.AnincreaseinSLR
1. willrestricttheexpansionofbankscredit
2. willincreasebanksinvestmentinsafesecurities

3. willensuresolvencyofthebanks
choices:
a.
b.
c.
d.

only1and2
only2and3
only1and3
all1,2and3

Mains/interviewtypequestionsafterwecheckUrjitPatelsrecommendationsonstrengthening
monetarypolicy.
Hints
1. canincreasebybuying,candecreasebyselling
2. both[oronlyB,dependingonhowUPSCexaminerinterpretstheeffectoftaxationonmoney
supply.InoneofthereputedbookonBankingandfinance,authorNarayanNadarclaimed
taxationcanaffectmoneysupply.]
3. dearmoneypolicyduringdeflation=addsinsulttotheinjuryofbusinessman.Ifgovernment
reducestaxthenitsrevenuecollectionwilldrasticallyreduce.Sobothincorrect.[OR
debatabledependingonhowUPSCexaminerinterpretstheeffectoftaxationduringdeflation.]
4. directlygiveninthearticle.
5. seethelasttableinthearticle
6. seethelasttableinthearticle
7. observethetablebeforethetopicreporateinrecentyears
8. sameasabove
9. sameasabove
10. Allcorrect.(Unlessyounitpickanddragthelogictoomuch.)
11. sameasabove.
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