The tools of monetary policy refer to the tools used by the RBI to meet the set objectives of price stability and growth of economy.The tools used by RBI for the above purposes are;
- Cash Reserve Ratio (CRR),
- Statutory Liquidity Reserve (SLR)
- Directed credit and administered interest
- Bank rate,
- Selective Credit Control,
- Open Market Operations (OMO),
- Liquidity Adjustment Facility (LAF),
Of the above the first three instruments viz. Cash Reserve Ratio, Statutory Liquidity ratios (SLR), Directed credit and administered interest rate are known as direct instruments and the other instruments are known as indirect instruments.
SLR & CRR are the reserves to be maintained by commercial banks in India under statutory provisioning norms .The impact of changes in SLR and CRR is that it either increases or decreases the money supply to commercial banks. This in turn affects lendable resource of banks. The ups and downs of money supply to market by the banks have direct effect on economy of the country.
The Credit and administered interest rate directives take the form of prescribed targets for allocation of credit to preferred sectors or industries and interest rate fixed by the RBI from time to time which fetches lower interest to banks than could be earned by deploying them for other lending purposes. This tool is used by the RBI to meet the set objectives of adequate flow of credit to the productive sectors of the economy. The Credit and administered interest rate directives set to boost the growth of SMEs (Small and Medium Enterprises), exports and other priority sector credits especially those which are currently facing credit crunch.
Bank rate is the re-discounting rate that RBI extends to banks against securities such as bills of exchange, commercial papers and any other approved securities. The bank rates used to be acting as guidelines for banks to set their interest rates. However, in recent years, banks have been following repo rather than the bank rate that has acted as a guideline for banks to set their interest rates.
Selective credit control means control over bank finance against the security of sensitive commodities. In exercise of powers conferred by Section 21 & 35A of the Banking Regulation Act, 1949, the Reserve Bank of India issues directives to commercial banks from time to time, stipulating specific restrictions on bank advances against specified sensitive commodities. They are sensitive because of their substantial weights in the index of wholesale consumer price. RBI’s objective in issuing SCC is to curb the use of bank credit for speculative holding of essential commodities like food grains (cereals and pulses), oil seeds and oils of indigenously grown, and the resultant rise in their prices. Banks are required to segregate each commodity covered by SCC and fix the credit limits against each such commodity.
The Liquidity Adjustment Facility (LAF) is the primary instrument for modulating liquidity and transmitting interest signals to the market. LAF includes both repos and reverse repos. Banks borrow money from RBI for their short term daily liquidity requirement. The interest rate at which banks borrow from RBI is known as Repo rate. In contrast, when banks are flush with funds, they park surplus liquidity with RBI through reverse repo mechanism where RBI pays interest to the bank at reverse repo rate.
Open market operations (OMO) refer to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. While the prime target of Monetary Policy continues to be banks’ reserves, the use of the same is sought to be de-emphasized and the liquidity management in the system is being increasingly undertaken through open market operations (OMO). When RBI wants to induce liquidity or more funds into the system, it would buy Government securities so that more funds are released to the system. Similarly when it wants to curb the excessive money supply from the system it will sell those securities to the bank which would obviously reduce the amount of cash held by the bank.