C.3] Monetary Policy and Influencing Factors

1. Introduction of Monetary Policy

• Definition: Monetary policy refers to the actions taken by a central bank to manage the supply of money and interest rates to influence the economy.
• Objective: To maintain price stability, promote economic growth, and ensure financial stability.
• Key Players:
  • Central Bank: In India, the Reserve Bank of India (RBI).
  • Government: Influences monetary policy through fiscal policy and legislative measures.
• Tools of Monetary Policy:
  • Repo Rate
  • Reverse Repo Rate
  • Cash Reserve Ratio (CRR)
  • Statutory Liquidity Ratio (SLR)
  • Liquidity Adjustment Facility (LAF)
• Importance in Competitive Exams:
  • Frequently asked in SSC, RRB, and banking exams.
  • Focus on tools, their impact, and recent changes.

2. Repo Rate

• Definition: The rate at which the RBI lends short-term funds to commercial banks.
• Purpose: To control inflation and manage liquidity in the economy.
• Impact:
  • Lower Repo Rate: Encourages borrowing and investment, increases money supply.
  • Higher Repo Rate: Discourages borrowing, reduces money supply, controls inflation.
• Key Dates:
  • Introduced in 1999 as part of the LAF framework.
• Example:
  • If Repo Rate is 5%, banks can borrow from RBI at 5%.
• Exam Fact:
  • Repo Rate is a key tool for monetary policy and is often tested in detail.

3. Reverse Repo Rate

• Definition: The rate at which the RBI absorbs excess liquidity from commercial banks.
• Purpose: To reduce inflation and manage surplus liquidity.
• Impact:
  • Lower Reverse Repo Rate: Banks prefer to invest in the market, increasing liquidity.
  • Higher Reverse Repo Rate: Banks deposit more with RBI, reducing liquidity.
• Key Dates:
  • Introduced in 1999 as part of the LAF framework.
• Example:
  • If Reverse Repo Rate is 4.25%, banks can park their surplus funds with RBI at 4.25%.
• Exam Fact:
  • Reverse Repo Rate is often paired with Repo Rate in questions and exams.

4. Cash Reserve Ratio (CRR)

• Definition: The percentage of total deposits that commercial banks must keep with the RBI in the form of cash.
• Purpose: To control liquidity and ensure banks have enough liquid assets.
• Impact:
  • Higher CRR: Reduces money supply, controls inflation.
  • Lower CRR: Increases money supply, stimulates economic activity.
• Key Dates:
  • Introduced in 1949.
• Example:
  • If CRR is 4%, a bank with Rs. 100 crore in deposits must keep Rs. 4 crore with RBI.
• Exam Fact:
  • CRR is a key tool and is frequently asked in SSC and RRB exams.

5. Statutory Liquidity Ratio (SLR)

• Definition: The minimum percentage of total deposits that commercial banks must maintain in the form of liquid assets (like government securities, cash, etc.).
• Purpose: To ensure banks have enough liquid assets to meet withdrawal demands and to control credit expansion.
• Impact:
  • Higher SLR: Reduces credit availability, increases liquidity in the banking system.
  • Lower SLR: Increases credit availability, reduces liquidity in the banking system.
• Key Dates:
  • Introduced in 1949.
• Example:
  • If SLR is 18%, a bank with Rs. 100 crore in deposits must keep Rs. 18 crore in liquid assets.
• Exam Fact:
  • SLR is a core concept in monetary policy and is often tested in banking exams.

6. Liquidity Adjustment Facility (LAF)

• Definition: A framework used by the RBI to manage short-term liquidity in the banking system through Repo Rate and Reverse Repo Rate.
• Components:
  • Repo Rate: Lending window.
  • Reverse Repo Rate: Borrowing window.
• Purpose:
  • To inject or absorb liquidity in the economy.
  • To stabilize interest rates and manage inflation.
• Key Dates:
  • Introduced in 1999.
• Example:
  • During shortfall of liquidity, RBI may lower Repo Rate to encourage banks to borrow.
  • During surplus liquidity, RBI may raise Reverse Repo Rate to encourage banks to deposit.
• Exam Fact:
  • LAF is a key framework and is often linked with Repo and Reverse Repo Rates in exams.

7. Comparison Table: Key Monetary Policy Tools

8. Important Dates and Facts

• Repo Rate Introduced: 1999
• Reverse Repo Rate Introduced: 1999
• CRR Introduced: 1949
• SLR Introduced: 1949
• LAF Introduced: 1999
• RBI’s Role: Central Bank of India, responsible for monetary policy.
• Key Exams: SSC, RRB, IBPS, SBI, and other banking exams.
• Common Questions: Differences between Repo and Reverse Repo, impact of CRR and SLR, role of LAF.

9. Summary of Key Concepts

• Monetary Policy Tools: Repo Rate, Reverse Repo Rate, CRR, SLR, LAF.
• RBI’s Role: Central Bank, manages liquidity, controls inflation.
• Impact of Tools:
  • Repo Rate: Influences borrowing and investment.
  • Reverse Repo Rate: Influences surplus liquidity.
  • CRR: Controls liquidity and credit.
  • SLR: Ensures liquidity and credit control.
  • LAF: Framework for managing short-term liquidity.
• Exam Focus: Tools, their impact, and recent changes.