Instruments of Monetary Policy used by the RBI

Direct regulation:
Cash Reserve Ratio (CRR): Commercial Banks are required to hold a certain proportion of their deposits in
the form of cash with RBI. CRR is the minimum amount of cash that commercial banks have to keep with the
RBI at any given point in time. RBI uses CRR either to drain excess liquidity from the economy or to release
additional funds needed for the growth of the economy.
For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks will now have to keep
a lesser proportion of their total deposits with the RBI making more money available for business. Similarly, if
RBI decides to increase the CRR, the amount available with the banks goes down.
Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the
form of gold or government approved securities before providing credit to the customers. SLR is stated in terms
of a percentage of total deposits available with a commercial bank and is determined and maintained by the
RBI in order to control the expansion of bank credit. For example, currently, commercial banks have to keep
gold or government approved securities of a value equal to 23% of their total deposits.
Indirect regulation:
Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate. Whenever
commercial banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI
increases the Repo Rate, it makes borrowing expensive for commercial banks and vice versa. As a tool to
control inflation, RBI increases the Repo Rate, making it more expensive for the banks to borrow from the RBI
with a view to restrict the availability of money. The RBI will do the exact opposite in a deflationary environment
when it wants to encourage growth.
Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse
repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest
rate to commercial banks to park their money with the RBI. This results in a reduction in the amount of money
available for the banks customers as banks prefer to park their money with the RBI as it involves higher safety.
This naturally leads to a higher rate of interest which the banks will demand from their customers for lending
money to them.
The RBI issues annual and quarterly policy review statements to control the availability and the supply of
money in the economy. The Repo Rate has traditionally been the keyinstrument of monetary policy used by
the RBI to fight inflation and to stimulate growth.

Main Types of Foreign Exchange Rates

Some of the major types of foreign exchange rates are as follows: 1. Fixed Exchange Rate
System 2. Flexible Exchange Rate System 3. Managed Floating Rate System.
1. Fixed Exchange Rate System (or Pegged Exchange Rate System).

2. Flexible Exchange Rate System (or Floating Exchange Rate System).

3. Managed Floating Rate System.
1. Fixed Exchange Rate System:
Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by
the government.
1. The basic purpose of adopting this system is to ensure stability in foreign trade and capital
movements.
2. To achieve stability, government undertakes to buy foreign currency when the exchange rate
becomes weaker and sell foreign currency when the rate of exchange gets stronger.
3. For this, government has to maintain large reserves of foreign currencies to maintain the
exchange rate at the level fixed by it.
4. Under this system, each country keeps value of its currency fixed in terms of some External
Standard.
5. This external standard can be gold, silver, other precious metal, another countrys currency or
even some internationally agreed unit of account.
6. When value of domestic currency is tied to the value of another currency, it is known as
Pegging.
7. When value of a currency is fixed in terms of some other currency or in terms of gold, it is
known as Parity value of currency.
2. Flexible Exchange Rate System:
Flexible exchange rate system refers to a system in which exchange rate is determined by
forces of demand and supply of different currencies in the foreign exchange market.

1. The value of currency is allowed to fluctuate freely according to changes in demand and
supply of foreign exchange.
2. There is no official (Government) intervention in the foreign exchange market.
3. Flexible exchange rate is also known as Floating Exchange Rate.
4. The exchange rate is determined by the market, i.e. through interactions of thousands of
banks, firms and other institutions seeking to buy and sell currency for purposes of making
transactions in foreign exchange.
For, Merits and demerits of flexible exchange rate system, refer Power Booster.
Fixed Exchange Rate System Vs Flexible Exchange Rate System:

Fixed
Basis

Flexible

Exchange Rate Exchange Rate

It is officially

It is determined

fixed in terms

by forces of

Determination of gold or any demand and

of Exchange

other currency supply of foreign

Rate:

by government. exchange.

There is

There is no

complete

government

government

intervention and

control as only it fluctuates freely

government

according to

Government

has the power market

Control:

to change it.

conditions.

The exchange
rate generally
remains stable
Stability in

and only a

The exchange

Exchange

small variation rate keeps on

Rate:

is possible.

changing.

3. Managed Floating Rate System:

Traditionally, International monetary economists focused their attention on the framework of
either Fixed or a Flexible exchange rate system. With the end of Bretton Woodss system, many
countries have adopted the method of Managed Floating Exchange Rates.
It refers to a system in which foreign exchange rate is determined by market forces and central
bank influences the exchange rate through intervention in the foreign exchange market.
1. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.
2. In this system, central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close to
desired target values.
3. For this, central bank maintains reserves of foreign exchange to ensure that the exchange
rate stays within the targeted value.