EASTERN INSTITUTE OF MANAGEMENT

Group Project on Managerial Economics

[Sub: Find out the meaning of the following terms: bank rate, repo rate, reverse repo rate,
CRR, SLR, PLR, basis points, open market operations.
Trace their current values.
In what purpose are these values used?
Find the objectives and implications of monetary policy.]

BANK RATE: Bank rate, also referred to as the discount rate, is the rate of interest
which a central bank [Reserve Bank of India (RBI) in case of India]
charges on the loans and advances that it extends to commercial banks and other financial
intermediaries. Bank rate is a long-term measure and is governed by the long-term
monetary policies of the governing banks concerned.

Purpose of using bank rate: Changes in the bank rate are often used by central banks to
control the money supply. At the time of inflation, the
central bank may increase bank rate while providing financial assistance to commercial
banks. As a result, commercial banks also charge high rates from the borrowers. As
interest on loan increases, people will prefer to borrow smaller amounts from the
commercial banks. Smaller amount of loan reduces purchasing power of people, which in
turn contracts aggregate demand and reduces inflationary pressure.

REPO RATE: Whenever the banks have any shortage of funds they can borrow it
either from RBI or from other banks. The repo rate is the rate at which
the banks borrow these excess funds. The borrowing bank mortgages its government
securities to carry out this loan transaction. Repo is a short-term measure, i.e. applicable
to short-term loans and comes from the repurchasing agreement.

Purpose of using repo rate: The main purpose of repos is to finance the purchase of
Securities by government bond dealers until they can be
sold to customers. These are private traders for which there are no public quotes. Since
most dealers can sell most of their inventory quickly, they only need 2 borrow money for
a day or a few days at most, which is why the terms of most repos is very short.

REVERSE REPO RATE: Reverse Repo rate is the rate at which the central bank
borrows money from banks. Banks are always happy to
lend money to the central bank since their money are in safe hand with good interest.
Purpose of using reverse repo rate: The bank that makes the loan for a repo, usually
reverse repo position, which is simply the opposite
side of a repo. Hence for every repo, some part has the reverse repo. An increase in
reverse repo rate can cause the banks to transfer more funds to the central bank due to the
attractive interest rates. It can cause the money to be drawn out of the banking system.

CASH RESERVE RATIO (CRR): Cash Reserve Ratio (CRR) is the fraction of total
demand and time deposits that a bank has to keep
with the central bank of a country. The value of CRR is not fixed; central bank can
announce any value of CRR. In India, CRR generally lies between 3% to 15%, depending
on the condition of the economy.

Purpose of using CRR: Increase in the value of CRR reduces the amount of money
available with the commercial banks which again reduces the
amount of money to be given as loans. At the time of inflation, central bank may increase
CRR to reduce lending capacity of commercial banks anticipating that reduced lending
capacity reduces aggregate demand which in turn will help in curbing inflationary
pressure.

STATUTORY LIQUIDITY RATIO (SLR): Banks are bound to set aside a part of
their demand and time deposits either in
form of cash or in the form of central and state government securities. This kind of
deposit is known as SLR.

Purpose of using SLR: SLR not only increases solvency of banks, but also contracts
banks’ ability to provide loans because of banks, augmented
investment in government securities, compulsory cash balance etc. If SLR is increased,
inflationary pressure may be reduced as it reduces lending capacity of banks leading to
fall in private purchasing power.

PRIME LENDING RATE (PLR): Prime Lending Rate is a term applied in many
countries to a reference interest rate used by banks.
The term originally indicated the rate of interest at which banks lend to favoured
customers, i.e. those with high credibility, though this is no longer always the case. Some
variable interest rates may be expressed as a percentage above or below prime rate.

Purpose of using PLR: PLR is often used as an index in calculating rate changes to
adjustable rate mortgages (ARM) and other variable rate short
term loans. It is used in the calculation of some private student loans. Many credit cards
and home equity lines of credit with variable interest rates have their rate specified as the
prime rate (index) plus a fixed value commonly called the spread or margin.
BASIS POINT: Basis point (bp) is a unit that is equal to 1/100th of a percentage point.
It is frequently used to express percentage point changes of less than
1%. It avoids the ambiguity between relative and absolute discussions about rates. For
example, a “1% increase” from a 10% interest rate could refer to an increase either from
10% to 10.1% (relative), or from 10% to 11% (absolute).

Purpose of using basis point: It is common practice in the financial industry to use basis
points to denote a rate change in a financial instrument, or
the difference (spread) between two interest rates. This is partially due to the large effect
of small changes to financial instruments. The basis point is also used to calculate
changes in equity indexes and the yield of a fixed-income security.

OPEN MARKET OPERATIONS: The term open market operations is used in two
senses. In the narrow sense open market operations
mean purchase and sale of government securities by the central bank in the open market.
But in the broad sense the term implies purchase and sale of not only government
securities but also other eligible papers by the central bank in the open market.

Purpose of open market operations: At the time of inflation, central bank sells
government securities and consequently the cash
reserves of all the buyers, specially the commercial banks, reduce. Reduced cash
available to commercial banks makes credit scarce, and this leads to increase in price of
credit, i.e. interest on loans. High interest on loans discourages people to take loans. As a
result, total expenditure of the economy falls causing decline in inflation.

CURRENT VALUES AS SPECIFIED BY RBI

Terms Current Values

Bank rate 6%

Repo rate 9%

Reverse repo rate 6%

Cash Reserve Ratio 9%

Statutory Liquidity Ratio 25%

Prime lending rate 12.75%

 OBJECTIVES OF MONETARY POLICY

Monetary policy refers to the policy adopted by the central bank of the country. The
objectives of monetary policy are as follows:-

• To regulate monetary growth so as to maintain a reasonable degree of price

stability
• To ensure adequate expansion in credit to assist economic growth
• To encourage the flow of credit into certain desired channels including priority
and the hitherto neglected sectors, and,
• To introduce measures for strengthening the banking system and creating
institutions for filling credit gaps.

IMPLICATIONS OF MONETARY POLICY

• The point of implementing policy through raising or lowering interest rates is to

affect people's and firms' demand for goods and services. Monetary policy actions
affect real interest rates, which in turn affect demand and ultimately output,
employment, and inflation.

• For the most part, the demand for goods and services is not related to the market
interest rates quoted in the financial pages of newspapers, known as nominal
rates. Instead, it is related to real interest rates—that is, nominal interest rates
minus the expected rate of inflation.
•
Changes in real interest rates affect the public's demand for goods and services
mainly by altering borrowing costs, the availability of bank loans, the wealth of
households, and foreign exchange rates.

For example, a decrease in real interest rates lowers the cost of

borrowing; that leads businesses to increase investment spending, and it leads households
to buy durable goods, such as autos and new homes.

• In addition, lower real rates and a healthy economy may increase banks'
willingness to lend to businesses and households. This may increase spending,
especially by smaller borrowers who have few sources of credit other than banks.

• Lower real rates also make common stocks and other such investments more
attractive than bonds and other debt instruments; as a result, common stock prices
tend to rise. Households with stocks in their portfolios find that the value of their
holdings is higher, and this increase in wealth makes them willing to spend more.
 Higher stock prices also make it more attractive for businesses to invest in plant
and equipment by issuing stock.

• The increase in aggregate demand for the economy's output through these
different channels leads firms to raise production and employment, which in turn
increases business spending on capital goods even further by making greater
demands on existing factory capacity. It also boosts consumption further because
of the income gains that result from the higher level of economic output.

• Wages and prices will begin to rise at faster rates if monetary policy stimulates
aggregate demand enough to push labor and capital markets beyond their long-run
capacities. In fact, a monetary policy that persistently attempts to keep short-term
real rates low will lead eventually to higher inflation and higher nominal interest
rates, with no permanent increases in the growth of output or decreases in
unemployment. As noted earlier, in the long run, output and employment cannot
be set by monetary policy. In other words, while there is a trade-off between
higher inflation and lower unemployment in the short run, the trade-off disappears
in the long run.

• Policy also affects inflation directly through people's expectations about future
inflation. For example, suppose the RBI eases monetary policy. If consumers and
business people figure that will mean higher inflation in the future, they'll ask for
bigger increases in wages and prices. That in itself will raise inflation without big
changes in employment and output.

These are some of the implications of monetary policy.