Monetary Policy Instruments
The previous article details Central bank’s functions and it’s importance in the financial system. In today’s world, inflation targeting and control of money flow in order to ensure price stability takes precedence over all other tasks of the Central bank. The bank uses different processes and adopts various instruments to achieve this objective. Some of the important ones are explained below:
Cash Reserve Ratio (CRR): Let’s again go back to the example where we understood how more money is created in the economy and how money multiplier works. As soon as a deposit was made, the bank was required to retain a certain portion of the deposit and was free to lend the balance amount. The percentage of deposit that the bank is required to retain is called “cash reserve ratio”. So if an individual deposits Rs 100 with the bank and CRR is 5%, banks need to retain Rs 5 in reserve and can lend rest of the money to borrowers. The main objective of CRR is to ensure that banks have sufficient cash, in order to meet withdrawal requirements of their customers. It works on the assumption that all depositors do not demand their money back on the same day and only a small percentage of the total population do so. In India, Reserve Bank of India (RBI) sets the CRR ratio and banks are required to deposit the same with RBI.
Statutory Liquidity Ratio (SLR): It can be thought of as an addition requirement like CRR where banks are required to retain certain percentage of total deposits in cash and cash equivalents. The main objective of this exercise is to ensure that banks have sufficient liquid balance to meet customer’s demand for cash. Suppose funds are invested in real estate property or used to buy stake in a company, then it cannot be easily liquified. It will take time to sell stake in a company or sell land/real estate. However investing in gold or Government securities is prudent as these instruments can be readily converted to cash. Gold has a standard price and can be easily converted to cash by exchanging with other banks or selling in the market. Read more about Government securities below.
Open Market Operations: When individuals need funds, they can borrow the same from banks. This transaction involves promise of payback within a certain time period and payment of interest on the borrowed amount. Similarly when Government wants to borrow money, it does so by issuing securities called treasury bill/bond. Suppose Government wants to borrow Rs 1000, it can issue a treasury bond which promises pay back of Rs 1000 in 5 years and an interest rate of 8%. RBI handles Government’s borrowing activities. In open market operations, RBI either buys these securities from financial institutions like banks or sells it to them. If RBI is buying from banks, it means RBI is paying money to banks, which will then be loaned out thereby pumping more money into the system. If RBI is selling to banks, then banks are paying money and buying these securities thereby reducing the cash available to provide loans.This has the effect of sucking money out of the system.
Repo and Reverse Repo Rate: Just like individuals and governments, sometimes banks also need money to fulfil their cash requirements. In such cases they can borrow money from RBI. The interest rate at which banks borrow money from RBI is called repo rate. Sometimes banks also have excess cash and like to earn interest on it. In such cases they can park the money with RBI and earn interest on it. Interest rate received by banks for parking excess cash with RBI is called reverse repo rate.