Explained: Tools of monetary policy

The tools of monetary policy refer to the tools used by the Central Bank (RBI  in India) to meet the set objectives of price stability and growth of the economy. The tools used by the Central Bank for the above purposes are;

1. Cash Reserve Ratio (CRR),
2. Statutory Liquidity Reserve (SLR)
3. Directed credit and administered interest
4. Bank rate,
5. Selective Credit Control,
6. Open Market Operations (OMO),
7. 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 the lendable resources of banks. The ups and downs of the money supply to the market by the banks have a direct effect on the economy of the country.

The Credit and administered interest rate directives take the form of prescribed targets for the allocation of credit to preferred sectors or industries and interest rates 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 are set to boost the growth of SMEs (Small and Medium Enterprises), exports, and other priority sector credits especially those that are currently facing a credit crunch.

The 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 the exercise of powers conferred by Sections 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 weight in the index of wholesale consumer prices. RBI’s objective in issuing SCC is to curb the use of bank credit for the speculative holding of essential commodities like food grains (cereals and pulses), oil seeds, and oils 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 SDF/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 the Repo rate. In contrast, when banks are flush with funds, they park surplus liquidity with RBI through a reverse repo mechanism where RBI pays interest to the bank at a reverse repo rate (*SDF is the new floor for policy rates introduced by RBI in April 2022, as a mechanism to curb inflation by absorbing liquidity. The SDF rate is applied for which banks park their excess funds with the RBI without any collateral. However, the earlier system of reverse repo rate will remain as part of RBI’s toolkit and its operation will be at the discretion of the RBI for purposes specified from time to time, according to RBI’s announcement. This move of RBI makes the reverse repo rate redundant for now).
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Open market operations (OMO) refer to the buying and selling of government securities in the open market 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 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 reduce the amount of cash held by the bank.

Originally posted on 02.01.2019, edited, and reposted on 31.05.2024.

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