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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
[Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upcoming Urjit Article
1. Prologue 2. What is monetary policy? 3. Quantitative Tools 1. #1: Reserve Ratios (SLR and CRR) 2. #2: Open Market Operation (OMO) 3. #3: Policy Rate 4. Bank Rate 1. Liquidity Adjustment facility (LAF) 2. LAF Repo Rate 3. Marginal Standing facility (MSF) 4. Reverse repo Rate 5. Repo Rate in recent years: 4. Monetary Policy: limitations 5. Qualitative Tools 1. #1: Margin Requirements/ LTV 2. #2: Consumer credit regulation 3. #3: Selective credit control 4. #4: Moral Suasion 6. Monetary policy tools: Quantiative vs Qualitative 7. Appendix 1. #1: Why High SLR and High CRR are bad? 2. #2: Narsimhan (I) Committee 1991 3. #3: Narsimhan (II) Committee 1998 8. Mock Questions
Prologue
Next article is about RBI appointed Urjit Patel Committee on Monetary policy framework. But before dwelling into that, we must recap the basic concepts of what is monetary policy: its tools and limitations. Otherwise Urjit wont make much sense. Hence in a way, this whole article is a prologue to next article.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
households and business firms. There are two types of financial intermediaries: banking institution and non-banking financial institutions. RBI controls (all) banks and (some) non-banking financial institutions. RBIs main job is to control Money supply in this game, and thereby fight inflation and deflation. Inflation = price rise = bad for economy, you know that by common sense. But Deflation = price decrease = we can buy things at a lower price. Isnt that good? Why is deflation bad for economy? Ans. Every business has fixed cost of production say minimum light bill, phone bill, office rent, staff salary etc. So, if prices keep falling and falling (say of Nano car), then car marker will suffer losses. He has no motivation to expand business. He wants to cut down his production costs, by firing some of the employees= less new jobs created= unemployment = social unrest. If prices of everything fall- then custom duty, VAT, excise duty, service tax- their collection will also decrease. Then government has less money to spend on education, healthcare, social sector, defense, law and order = poverty, disease, crime. by the way TERM DEFLATION meaning fall in the prices (and fall IN employment.) Does RBI want it? No. yes (while fighting inflation)
DISINFLATION Fall in the prices but without causing unemployment. stagnation + inflation STAGFLATION prices and wages rise but people cant find jobs, companies cant find customers. policy to stop the fall in price levels, but without causing rise in the price levels (inflation).
No
REFLATION
yes
Quantitative Tools
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
You can see, when Rajan has raised reserve ratio, money with SBI is reduced (from 73 crores to just 45 crores.) What will be its implication? Imagine youre a money lender. Youve 100 crore rupees and you must make Rs.1 crore profit in a year. Obviously, you should lend it @1% interest rate. (because 1% of 100 crore = 1 crore.) But what if youve only 2 crore rupees, and you still want to make Rs.1 croer profit in a year? Now you must lend it @50% interest rate. (because 50% of 2 cores = 1 crore.) Observe that as money decreased (from 100 to 2), loan interest rate increased (from 1% to 50%). Same happens when SBI is left with less money (after RBI increases reserve ratio). Lets prepare a flow chart. Situation: Economy has inflationary trend. Prices of goods and services increasing every day.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Solution: RBI raised reserve ratio (CRR, SLR) Result: SBI is left with less money to lend. Consequences: 1. 2. 3. 4. SBI raises its loan interest rate Businessmen borrow less money from SBI Businessmen donot start new business. Donot expand existing business Result=Less jobs. Even existing employees discharged. If anyone remains in the job, he doesnt get pay raise. He starts cutting down unnecessary expenditure (e.g. buying two newspapers, getting his shirts ironed, drinking tea @4PM in office and so on. Thus even paper-wall, dhobi, chai-walla- everyones income reduced.) 5. Result= Less income (Because of above reasons) 6. Result= Less demand of goods and services (because less income). 7. Ultimately shopkeeper will bring down the prices to attract people into buying more things. Thus inflation is reduced. You may doubt- what about supply side bottlenecks, what about cost push and demand pull inflation : Im not going into all that details at the moment, else this article will become longer than five kilometers. Lets just prepare a summary table: Policy dear money cheap money Tool To fight inflation To fight deflation Reserve Ratio (CRR, SLR) Increase them. Decrease them. Moving to the next (Quantitative) tool. Under monetary policy
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
2. 3. 4. 5. 6. 7. 8.
SBI raises its loan interest rate (to keep profit margin same) Businessmen borrow less money from SBI. Businessmen donot start new business. Donot expand existing business Less jobs Less income Less demand Ultimately shopkeeper will bring down the prices to attract people into buying more things.
Thus inflation is reduced. During deflation, RBI will do the reverse. (i.e. RBI buys Sabzi from SBI). How will it stop deflation? Think in your head. Lets update our table Policy Tool Reserve Ratio (CRR, SLR) Open Market Operation (OMO) dear money To fight inflation Increase them. RBI sell securities cheap money To fight deflation Decrease them. RBI buy securities
Mock Question
In 2013, UPSC walla asked a very chillar question from this topic. In context of Indian Economy, Open Market Operation refers to a. b. c. d. Borrowing by scheduled banks from RBI Lending by commercial banks to industries and trade Purchase and sale of government securities by the RBI None of Above
Whenever you face a GS/GK type MCQ, Youve three choices Skip If you dont know the answer, Just leave it instead of risking negative mark. Attempt Correct answer is Opt C. It means youve unsure of the answer. 50:50. So you mark the question number Mark n (say 45), at the back of your question paper. At the end of exam, if youre left with Review. 10-15 free minutes. You look at the question again, and try to solve it. So, should you put above question in mark n review? No. Because its a definition based question. If you dont know the definition of OMO you might tick a wrong answer and fail. Most of the sincere players fail in prelims because of this reason. They push their luck in negative marking to overcome an imaginary cutoff and thus dig up their own grave. (especially during last 10-15 minutes of the exam.) Moral of the story: never put fact/definition type MCQs in Mark-n-Review.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Lets solve a bit more complicated MCQ from 2012s CSAT paper. Q.Which of the following measures would result in an increase in the money supply in economy? 1. 2. 3. 4. Purchase of government securities from public by central bank Deposit of currency in commercial banks by the public Borrowing by government from the central bank. Sale of government securities to the public by central bank.
Whenever you face such multiple statement type MCQs, always use elimination method. First find a statement that is definitely right or definitely wrong and eliminate choices accordingly. Focus on first statement Purchase of government securities from public by central bank: will it increase money supply in the system? Imagine Rajan puts an ad in newspaper: bring your Sabzi (vegetables), Ill buy it. Junta gives him their own veggies, Rajan gives them money. (a classic buy and sell). Ultimate result: money supply increased in the system- because junta got the money. Meaning #1 definitely correct. If you think it on technical terms. Central bank purchases government securities=OMO (Open market operation), where money shifts hands from RBI to people. Hence money supply increased. (In reality, money doesnt go to aam admi directly, but those bankers and non-banking institutions who participate in OMO). Anyways, #1 is right, Eliminate choices that do not have #1 a. b. c. d. Only 1 2 and 4 1 and 3 2, 3 and 4
Now the final answer depends on whether statement #3 is right or wrong? Statement #3 says Borrowing by government from the central bank. (So, will it increase money supply?) How does Government borrow from Central bank? Does Mohan just callup Rajan and demand 1 lakh crores? No. Mohan will have to give Rajan that much government securities (vegetables) and Rajan will give him cash. Is money supply increased? Yes Mohan sold veggies to Rajan and got Money. Whenever Rajan buys veggies and pays the money supply is increased. (this is similar to Open Market operation) Besides, Mohan can then use money to pay salaries of government staff, pay for railroad-bridges and other infrastructure projects, pay for MNREGA and so on. Therefore Answer C: 1 and 3 correct.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Counter- argument? What if Rajan subsequently sells those (Mohans) securities to bankers. Then bankers money reduced. Hence #3 is wrong. Therefore final answer A only 1. So, whats the final answer: is it A or is it C? Ultimate judge= UPSCs official answer key uploaded on their site. In 2012s Question paper Test series A, this is Q77: and its official answer is C. Therefore, both 1 and 3 are correct. Anyways, what to do in the exam? Skip If you dont know the concept better skip. Attempt This question is attemptable if you dont drag the logic too much in statement #3. Yes, it can be put under mark and review because this is not an absolute fact/ Mark n absolute definition type MCQ. If you apply some concepts, you can eliminate Review. wrong choices. But still if doubt persists in the mind (e.g whether Statement 3 is right or not) then its always safe to skip and avoid negative marking. By the way, What about Statement #2: Deposit of currency in commercial banks by the public. (Will it increase money supply or not?) Viewpoint 1: yes. Because bank can used it to expand loanable credit. (as explained in Money creation topic in Class 12 NCERT Macroeconomics page 39 onwards). Viewpoint 2: no. (Because Bank will have to put some money aside as CRR- so that much money is less in the system.) Either way it doesnt change the answer. Because We know that statement 1 is definitely correct. And there is no option where (1,2) are given simultaneously. Anyways, Moving onSo far, RBI has two tools under monetary policy: 1. reserve ratios (SLR, CRR) 2. Open market operation. Third and the most important quantitative tool is
Bank Rate
When banks borrow long term funds from RBI. Theyve to pay this much interest rate to RBI. [Note: different books give different explanation of Bank Rate. I've used NDTV's definition] At present, Bank rate= 9% Collateral: nothing. (Bank can borrow money without pledging government securities to
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RBI) Bank rate is not the main tool to control money supply these days. Nowadays, RBI uses LAF Repo rate as the main tool, to control money supply. Ok then Whats the use of Bank rate? Penal rates are linked with Bank rate. For example, If a bank doesnt maintain CRR, SLR as per the prescribed limit. Then RBI can impose penalty interest on such notorious bank. At present, Penalty rate = Bank rate + 3% (or 5% in some cases) Meaning if Bank rate = 9% then penalty rate=9+3=12% Anyways, what if RBI wants to fight inflation using bank rate as a tool? Obviously they should increase bank rate. That way it becomes harder (more expensive) for banks to borrow from RBI.=> SBI increases its loan rates (to keep the profit margin same). Result? Less people get home loan, bike loan, business loans. Less business expansion Less jobs Less incomes Less demand Ultimately shopkeeper will bring down the prices to attract people into buying more things. Thus inflation is reduced. Lets update our (stupid) table Policy Tool Reserve Ratio (CRR, SLR) Open Market Operation (OMO) Bank rate dear money To fight inflation Increase them. RBI sell securities Increase cheap money To fight deflation Decrease them. RBI buy securities decrease
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
If client borrows money from RBI (for short term) then client has to pay this much interest rate to RBI. At present Repo is 8%. (article written on 29th Jan 2014) If client lends money to RBI (for short term) then RBI has to pay this much Reverse interest rate to client. RBI doesnt like headache. So they made a simple formula: Repo Reverse repo rate= Repo MINUS 1%=8-1=7%. Repo Collateral: Problem with running a adda/gambling-den = sometimes client drinks too much desi liquor and passes out on floor. Sometimes he even dies because of hooch. Sometimes police raids the den, and clients run away with cash and register. If such things happen, Rajan will be at loss. So, he demands government securities as collataral. So even if client doesnt repay money on time, Rajan can sell those securities (in open market operations) and recover money.
Scenario SBI chairman Arundhati mam wants to borrow Rs.100 crore (for short term). She gives her stash of government securities to Rajan. Rajan gives her Rs.100 crore. Madam Also signs an agreement
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
I, Arundhati Bhattacharya, agree to buy same securities from Rajan, at 108 crores after 14 days. Notice that she has agreed to re-purchase same securities from Rajan. Therefore its called Repo. And how much interest rate did she pay on this loan? [108-100]/100=8%. Thats our repo rate. Important: Recall that SBI also has to keep part of her money in RBI approved securities (under SLR). So Madam cannot USE those government securities to borrow under Repo Rate from Rajan. That leads to a new topic
Sorry. Not all clients welcome here. Only scheduled commercial banks can borrow under this window. SBI, PNB, BoB, ICICI etc. This MSF facility is specially created to help them solve short-term cash mis-match.
Can use securities from SLR quota. Maximum 2% of NTDL. To put this in crude words, if SBI received 100 crores from aam-admi under savings account, current account, fixed deposit etc. then SBI can borrow only upto Rs.2 crores from RBI. MSF = Repo Rate +1% = 8+1=9%. (earlier this margin of 1% used to be higher. But nowadays just 1%!)
for those who still have doubt about Repo vs MSF: for repo borrowing, bank will need to pledge securities to Rajan. But bank cannot use SLRreserved securities for this. so, imagine if a bank is in dire need of cash, but doesnt have spare government securitiesthen they can borrow using MSF by pledging those SLR securities. (and under MSF window, Rajan will demand 1% higher than Repo as one type of punishment for pledging SLR
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
securities.)
increase it decrease it increase it decrease it its value is linked with Repo, hence cannot be increased/decreased independently. its value is linked with Repo, hence cannot be increased/decreased independently. Besides MSF= temporary firefighting, cash mismanagement.
We learned that Rajan doesnt use Bank rate much, to control money supply. We learned that Rajan doesnt decide Reverse repo and MSF. (theyre automatically -1% and +1% of Repo rate). Thus the only thing Rajan has to decide under monetary policy= Repo rate. Therefore, Repo rate is called the policy rate Lets revisit out flow chart: Situation: Economy has inflationary trend. Prices of goods and services increasing every day.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Solution: Rajan increases Repo rate. (say from 7.75% to 8%). Result: it becomes expensive for SBI to borrow from Rajan. Theyll increase their own rates as well. Wait. How? Just like how things roll in Onion biz. If prices of Onion rise in Maharashtras wholesale yard (in Lasangaon), then immediately, retail veggie @Ahmedabad will also raise their onion prices to keep the profit margin same. Whatll be the consequences (if repo rate is hiked / increased)? Consequences: 1. 2. 3. 4. 5. 6. 7. SBI raises its loan interest rate (to keep profit margin same) Businessmen borrow less money from SBI. Businessmen donot start new business. Donot expand existing business. Less jobs Less income Less demand Ultimately shopkeeper will bring down the prices to attract people into buying more things.
Thus inflation is reduced. Policy Tool Reserve Ratio (CRR, SLR) dear money cheap money To fight inflation To fight deflation Increase them. Decrease them.
Open Market Operation (OMO) RBI sell securities RBI buy securities Policy Rate (Repo Rate) Increase it Decrease it
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
From above above graph, you can see RBI has frequently changed its repo rate to combat both inflationary and deflationary trend. But Youd agree that inflation has not been contained. No matter what number juggling or statistical interpretations are given- the hardship of common man has not stopped- be it milk, petrol, onion, LPG anything. Agreed that prices of onion, sugar, pulses and food are subject to vagaries of monsoon and black marketeering. Rajan cannot do anything about it. Agreed that crude oil prices are subject to rupee-Dollar exchange rate, external factors and governments de-regulation of their prices. Rajan doesnt have much control over this. But still even in the non-food, non-fuel type commodities- RBIs monetary policies have failed to curb inflation. WHY? Observe the following image.
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Suppose Vijay Mallay got 100 crore loan from State Bank of India. If you trace the source of that money, itll turnout 60-70 crores came from banks savings account, fixed deposit etc. Rajan lends money in repo rate yes, but that doesnt mean banks depend only on Rajan to arrange the cash for its clients. Suppose Rajan reduces repo rate from 8% to 5%. Banks are not legally required to reduce their loan interest rates. The current system is following: Banks are free to decide their base rate. E.g. SBIs base rate is 10%. It means SBI wont loan money to anyone at an interest rate lower than 10% (except those farmers under Interest subvention scheme.) SBI will link all of its loan products with Base rate. For example SBI Base rate =10% Car loan Two wheeler loan Education loan (upto 4 lakh) Home loan for women (upto 75 lakh) Calculation 0.75% above Base rate 8.25% above base rate 3.5% above base rate 0.10% above base rate Result 10.75% 18.25% 13.5% 10.10%
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Meaning if SBI changes her Base rate then all of above loan interest rates will change automatically. If Rajan changes his repo rate, will SBI change her base rate? Not always. Because those common men are the main suppliers of money to SBI. RBI is not the main supplier of money to SBI. SBI will only change its base rate, when she feels necessary for its own profit / loss compared to its competitors. Does it mean Repo rate system is bogus and ineffective? Not always. In developing countries like India, most people park their money in only four things: savings account, fixed deposit (FD), provident fund and LIC. Weve mutual funds, weve NPS, weve ULIPs, weve Rajiv Gandhi equity savings scheme but most people (particularly the older generation) feels insecure in into such new things. Therefore lot of money flows into Savings accounts and fixed deposits= SBIs main source of money. But, In advanced economies, like USA, people dont invest large portion their income in savings account or FD. Theyve variety of investment options. So, for those American banks, their own Central bank (US Feds) is a significant money supplier. Hence US Feds monetary policy shows faster impact on their American Banks, THAN Rajans monetary policy on Desi banks.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
raised..yes. = this mismatch leads to more inflation. 7. Subsidy leakage, Black money, underground economy. 8. And most importantly, because Rajan uses Multi-indicator approach, he focuses on WPI (minus food and fuel). Thats why Urjit Patel recommends him to target CPI. More on that in next article. So far, we learned that RBI has two sets of tools/instruments under monetary policy: Quantitative tool Qualitative tools
1. Reserve ratios 2. OMO Well see them in a moment 3. Policy rate (Repo Rate)
Qualitative Tools
#1: Margin Requirements/ LTV
Mallya wants to borrow from SBI. He pledges his companys shares worth Rs.100 crores as collateral. For such loans, Rajan can prescribe margin, say 65%. In that case even if Mallya pledges 100 crores worth shares, SBI can give him 10065=only 35 Crore rupees as loan. Using this tool, Rajan can control money supply. e.g. during inflation, he should increase margin requirement, so Mallya can borrow less=> less job=>less income=>less demand=>prices reduced. If Rajan changes repo rate, it is not compulsory for SBI to change her loan interest rates. (we saw how Alok Nath keeps giving money to SBI, so they are not entirely dependent on Rajan.) But if Rajan changes margin requirements, then SBI and all other banks must obey it. In other words, this tool has direct impact on money supply.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
In case #2: some of the lower-middleclass families may postpone their decision to purchase nano car (Because they cant afford higher EMIs.) Result= less demand=>prices reduced. (indirectly- because car mechanics get less work, number-plate painters get less orders etc. so they reduce fees to attract new clients and retain existing clients.) Thus, Rajan can control money supply by changing downpayment and installment (EMI) rules.
Rationing of credit
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Indirect in nature. (Even if Rajan changes repo rate, its Direct in nature. (e.g. those margin not necessary SBI will immediately change its base rate requirements) / loan interest rates.) Selective- can affect money supply General- they affect money supply in entire economyin a specific sector of economy be it housing, automobile, manufacturing- everything. e.g. automobile. Lets solve an Official MCQ from UPSC 2012 Question paper Q. RBI Acts as bankers bank. This would imply which of the following? 1. Other banks retain their deposits with RBI 2. RBI lends funds to commercial banks in the times of need. 3. RBI advises commercial banks on monetary matters. Correct Statement 1. 2. 3. 4. Only 2 and 3 Only 1 and 2 Only 1 and 3 1, 2 and 3
Approach: Whenever you face such 3 statement MCQ or 4 statement MCQ, Always use elimination method. First you find out a statement that is definitely right or definitely wrong. In above case, we can see #2 is definitely right. RBI lends funds to banks in the times of need (Repo, MSF) So lets eliminate choices that dont involve statement #2 1. 2. 3. 4. Only 2 and 3 Only 1 and 2 Only 1 and 3 1, 2 and 3 This did not help much. We still have three choices left. Observe statement #1: Other banks retain their deposits with RBI. That is correct with respect to cash reserve ratio. CRR is one type of deposit that banks make to RBI. (RBI doesnt pay interest on itthats a different story). Meaning #1 is also correct eliminate choices that donot have #1 1. Only 2 and 3 2. Only 1 and 2 3. Only 1 and 3 4. 1, 2 and 3 Only two choices left and the ultimate solution = is statement #3 is correct or not?
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Viewpoint #1 The statement says RBI advises commercial banks on monetary matters.The word advises makes this statement incorrect. Because RBI doesnt Advice they just order the banks- be it SLR, CRR, PSL. RBI doesnt advice, RBI gives orders and direction. Therefore statement #3 is wrong. Even if we accept that RBI advices, still the questions asks what is implied by RBI as Bankers bank. So, RBI advices moral suasion that is a monetary policy tool. RBIs not doing it as a Banker to those banks. Therefore, Statement #3 is definitely wrong. Answer (B)
Viewpoint #2 RBI does advice those banks. We saw it under Moral Suasion. Therefore, Statement #3 is right. Money Banking and finance, E Narayan Nadar (PHI publication). He has specifically listed this Advice function under Bankers bank topic. Answer (D)
So, is it B or is it D? Final judge is UPSC. They had uploaded CSAt-2012 official answer key on their site. This question is Test Series A, Question #75 and its official answer is D = meaning all three statements are correct. If you face such MCQ in exam, what should be your approach? Upto you. But if you start skipping all such question (OMO, Money supply, Bankers bank), because youre completely unaware of those topics=that is not Skip pardonable.it shows youre underprepared for this exam. You should either change your study method or change the game- try for some easier exam. This question is attemptable, if you dont nitpick over the word advises in third Attempt statement. If youve thoroughly prepared the RBIs monetary tools (both qualitative and quantitative), you can solve it by applying concepts/principles- particularly the Mark n moral suasion thing. But if youre still doubtful over whether #3 is right or wrong, Review then better skip. If you skip because youre doubtful = that is pardonable. But if you skip because youre completely unaware of this topic= non-bailable offense.
Appendix
These are the topics I wanted to discuss in the article, but they would break the flow of other topics. Hence writing them @bottom:
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
Deposit type examples Time Deposit Fixed deposit (FD) recurring deposit. Demand Deposit Savings account, current account Using this money, bank has to count its Net Demand and Time liabilities (NDTL), every fortnight. Suppose its 100 crores. Both CRR and SLR are counted on this figure. In the old times, these reserve ratios used to be as high as 15% and 40% respectively. Observe the effect: Net Demand and Time Liabilities (NDTL) Reserve ratios CRR (15%) SLR (40%) Money left with bank +100 cr. (-) 15 [no profit] (-) 40 [some profit] =45 cr.
From 100 crores, barely 45 crores left with the bank. But adding insult to the injury- even here RBI mandates Priority sector lending (PSL). Meaning, at least 40% of the loans has to be given to farmers, small businessmen, students etc. groups. Lets update the table: Net Demand and Time Liabilities (NDTL) Reserve ratios CRR (15%) SLR (40%) Money left with bank PSL (40%) Money left for big borrowers (i.e. big businessmen, upper middleclass) +100 cr. (-) 15 [no profit] (-) 40 [some profit] =45 =45 x 0.4 =18 crore. =45-18=27 crores.
By the way, PSL is counted on annual basis while SLR, CRR counted on fortnight basis so above table is technically incorrect but Ive plugged in those numbers only for the sake of explanation. before the 90s- Government would even interfere and order public sector banks to give PSL-loans @cheap interest rates. The local politicians would coerce the branch manager to give PSL-loans to ineligible people. They default on loans, Branch manager cannot recover money (because defaulter will goto civil court then taarikh pe taarikh.) So, bank would have to forget about most of those 18 crores given in PSL loans. Anyways you can see people deposited 100 crores in the bank yet bank is left with barely 27 crores (over which, bank has Freedom to decide whom they should give the loan.) What are the consequences for businessmen? 1. High cost of credit (because bank will try to make maximum profit from those 27 crores- so bank will charge very high interest rate on the business loans- to pay off for the staff salaries, branch office rents and everything.) 2. Businessman cannot expand his business. 3. Less exports.
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
4. Less tax income for the government. So in a way- that was also one of the factors leading to Balance of Payment crisis (and subsequently LPG reforms.) You can read more about that in NCERT Class 11- chapter 2 and 3.
Mock Questions
1. With open market operations, RBI can a. increase liquidity in the economy, but cannot decrease it b. decrease liquidity in the economy, but cannot increase it c. Can increase or decrease liquidity in the economy to control money supply. d. None of above. 2. By which of the following methods, government can reduce money supply in the economy? a. taxation
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
3.
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b. sale of securities to public c. both A and B d. neither A nor B During the period of deflation a. RBI should use dear money policy to combat it b. Government should reduce its tax rates. c. both A and B d. Neither A nor B. IF prices are lowered without causing unemployment, we call it: a. stagflation b. reflation c. disflaction d. Disinflation. Which of the following contains correct set of quantitative instruments of monetary policy? a. reserve ratio, bank rate, margin requirements b. open market operations, margin requirements, regulation of consumer credit c. cash reserve ratio, bank rate, open market operation d. None of above Which of the following contains correct set of qualitative instruments of monetary policy? a. reserve ratio, bank rate, margin requirements b. credit rationing, margin requirements, regulation of consumer credit c. cash reserve ratio, bank rate, open market operation d. None of above
Q7. To counter the effect of deflation, which of the following steps should RBI initiate? 1. decrease reserve ratios 2. buy government securities through open market operation 3. increase policy rate Answer choices a. b. c. d. only 1 and 2 only 2 and 3 only 1 and 3 1, 2 and 3
Q8. To counter inflation, which of the following steps should RBI initiate? 1. Increase reserve ratios 2. sell government securities through open market operation 3. Increase policy rate Answer choices a. only 1 and 2 b. only 2 and 3 c. only 1 and 3
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
d. 1, 2 and 3 Q9. Which of the following may cause deflation in the economy? 1. RBI raises policy rate 2. RBI raises cash reserve ratio 3. RBI sells securities Choices: a. b. c. d. only 1 and 2 only 2 and 3 only 1 and 3 all 1,2 and 3
Q10. Money supply in the economy, is affected by 1. Cheap money policy and dear money policy. 2. Open market operation and Moral Suasion. 3. Consumer credit regulation and loan to value ratio. Choices: a. b. c. d. only 1 and 2 only 2 and 3 only 1 and 3 all 1, 2 and 3
Q11. An increase in SLR 1. will restrict the expansion of banks credit 2. will increase banks investment in safe securities 3. will ensure solvency of the banks choices: a. b. c. d. only 1 and 2 only 2 and 3 only 1 and 3 all 1,2 and 3
Mains/interview type questions- after we check Urjit Patels recommendations on strengthening monetary policy. Hints 1. can increase by buying, can decrease by selling 2. both [or only B, depending on how UPSC examiner interprets the effect of taxation on money supply. In one of the reputed book on Banking and finance, author Narayan Nadar claimed taxation can affect money supply.] 3. dear money policy during deflation =adds insult to the injury of businessman. If government reduces tax- then its revenue collection will drastically reduce. So both
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Mrunal [Banking] Monetary Policy: Quantitative & Qualitative Tools, applications & limitations MSF, LAF, Repo, OMO, CRR, SLR, Revisited before upco
4. 5. 6. 7. 8. 9. 10. 11.
incorrect. [OR debatable- depending on how UPSC examiner interprets the effect of taxation during deflation.] directly given in the article. see the last table in the article see the last table in the article observe the table before the topic repo rate in recent years same as above same as above All correct. (Unless you nitpick and drag the logic too much.) same as above.
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URL to article: http://mrunal.org/2014/01/banking-monetary-policy-quantitativequalitative-tools-applications-limitations-msf-laf-repo-omo-crr-slr-revisited-beforeupcoming-urjit-article.html Posted By Mrunal On 30/01/2014 @ 19:13 In the category Economy
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