Topic of the week for discussion: 6th to 12th February 2012

Topic: How RBI controls money supply

The Reserve Bank of India was established in 1935 as a central bank of

India to supersede the control and regulation of Indian banking sector.
With the passage of time the domain of RBI has increased from mere a
regulator of banking sector to an agent of development of not just banking
sector but of overall development through the manipulation of monetary
policy instruments.
The major objective of monetary policy is to ensure equal growth and
develop of all the sectors, apart from controlling the inflation and creating
employment.

Topic
Introduction

However RBI is often blamed for concentrating more on the inflation and
neglecting the growth factor which may be true also as RBI thorough its
tools can affect the money supply directly which in turns affect the
inflationary pull while the growth depends on many other factors over
which RBI has no say.
For instance if investment rate in the economy is low due to negative
sentiments, decrease in rate of interest many times doesnt transform the
bad sentiments into good sentiments.
RBI manipulates the money supply with the help of following tools:
1. Bank Rate: Bank rate is the rate at which RBI lend money to the
commercial banks if they are short of liquidity. If liquidity in the market is
high, inflationary forces are strengthened. In such a situation RBI increases
the bank rate, making the availability of funds for the banks expensive and
pushes the interest rates upwards. This helps in squeezing the money supply
in the market and thereby curbing the inflationary forces. This instrument is
not often used by the RBI to affect the money supply as it will make
borrowing expensive only when commercial banks are short of cash which
rarely happens in India. However, Banks have been borrowing more than
Rs.1 lakh crore from the RBI since mid-December, 2011, which touched a
peak of Rs.1.5 lakh crore in the recent weeks. The bank rate as on 28
January 2012 is 6 percent.

2. Cash Reserve Ratio (CRR): The cash Reserve ratio is that part of the total
deposits with the commercial banks which banks have to keep with the
Reserve Bank of India. If RBI increases the CRR, it means that commercial
banks had to park more funds with the RBI and are with fewer funds
available to lend further to the customers. On the vice versa, if RBI looks
for increase in the credit growth, it decreases the CRR which increases the
fund availability of funds with the commercial banks for further lending.
This instrument is often used by RBI as it directly affects the credit creation
capacity of the banks. Last time, RBI reduced the CRR by 0.5 per cent to
5.5 per cent on January 25, 2012, signaling the reversal of the rate hike
cycle after nearly two years, and to give a push to growth. The CRR cut by
0.5 basis points releases Rs.32,000 crore of funds from central banks
reserves to the commercial banks, which had been reeling under a shortage
of funds for over a couple of months.
3. Statutory Liquidity Ratio (SLR): SLR is that proportion of deposits that
banks need to invest in cash, gold, government debt and other approved
securities. It also affects the credit creation capacity of commercial banks in
similar manner as that of CRR. This instrument is most seldom used by the
RBI to effect the credit creation. It has not been changed since December
2010 and remained unchanged at 24 percent since then.
4. Liquidity Adjustment Facility (LAF): Liquidity adjustment facilities are
used to aid banks in resolving any short-term cash shortages during periods
of economic instability or from any other form of stress caused by forces
beyond their control. Various banks will use eligible securities as collateral
through a repo agreement and will use the funds to alleviate their short-term
requirements, thus remaining stable.
5. Marginal Standing Facility (MSF): Marginal Standing Facility (MSF):
Marginal Standing Facility (MSF) is a new scheme announced by the
Reserve Bank of India (RBI) in its Monetary Policy (2011-12). It came into
effect from 9th May 2011. MSF scheme is provided by RBI where the
banks can borrow overnight up to 1 per cent of their net demand and time
liabilities (NDTL) i.e. 1 per cent of the aggregate deposits and other
liabilities of the banks. The rate of interest for the amount accessed through
this facility is fixed at 100 basis points (i.e. 1 per cent) above the repo rate
for all scheduled commercial banks. The MSF would be the last resort for
banks once they exhaust all borrowing options including the liquidity
adjustment facility by pledging through government securities, which has
lower rate of interest in comparison with the MSF.

Read further :
http://mbarendezvous.com/topimage.php?id=300
http://www.rbi.org.in/home.aspx#
http://en.wikipedia.org/wiki/Money_supply