CREDIT CREATION & MONETARY POLICY

Main Functions of RBI

Monetary Authority: Formulates implements and monitors the monetary

policy. Objective: maintaining price stability and ensuring

adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system: Prescribes broad parameters of banking operations

within which the country's banking and financial system functions.

Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public.

Main Functions of RBI

Manager of Foreign Exchange Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and

promote orderly development and maintenance of foreign exchange market in India.

Issuer of currency: Issues and exchanges or destroys currency and coins

not fit for circulation. Objective: to give the public adequate quantity of

supplies of currency notes and coins and in good quality.

Main Functions of RBI

Developmental role Performs a wide range of promotional

functions to support national objectives.

Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.

Banker to banks: maintains banking accounts of all scheduled banks.

Earlier Aggregates: From 1970

M0 = Currency in Circulation + Bankers' Deposits with the RBI + 'Other' Deposits with the RBI

M1 = Currency with the Public + Demand Deposits with the Banking System + 'Other' Deposits with the RBI

M2 = M1 + Post offices savings deposits

M3 = M1  + Time Deposits with the Banking System

M4 = M3  + Total Post office deposits (excluding National Savings Certificates)

Monetary Aggregates

After 1998Weekly Compilation M0 = Currency in Circulation + Bankers'

Deposits with the RBI + 'Other' Deposits with the RBI

Monetary Aggregates

M1 = Currency with the Public + Demand Deposits with the Banking System + 'Other' Deposits with the RBI

   = Currency with the Public + Current Deposits with the

Banking System + Demand Liabilities Portion of Savings Deposits with the Banking System + 'Other' Deposits with the RBI

 

Monetary Aggregates

M2 = M1 + Time Liabilities Portion of Savings Deposits with the Banking System + Certificates of Deposit issued by Banks + Term Deposits of residents with a contractual maturity of up to and including one year with the Banking System (excluding CDs)

    = Currency with the Public + Current Deposits with the

Banking System + Savings Deposits with the Banking System + Certificates of Deposit issued by Banks + Term Deposits of residents with a contractual maturity up to and including one year with the Banking System (excluding CDs) + 'Other‘ Deposits with the RBI

Monetary Aggregates

   

M3 = M2 + Term Deposits of residents with a contractual maturity of over one year with the Banking System + Call/Term borrowings from 'Non-depository‘ Financial Corporations by the Banking System

  Monetary AggregatesBroad and Narrow Money

How the banks create money?

Glen Echo Bank Balance Sheet (1) Initial Balance

Assets Liabilites

Loans Outstanding

Rs. 80.0 million Deposits Rs. 100.0

million

Government debt 13.0 million Net Worth 3.0 million

Required Reserves 10.0 million

Total 103.0 million Total 103.0

million

How the banks create money?

Glen Echo Bank Balance Sheet (Add Rs. 1.0 million deposit from you)

Assets Liabilities

Loans Outstanding

Rs. 80.9 million Deposits Rs. 101.0

million

Government debt 13.0 million Net Worth 3.0 million

Required Reserves 10.1 million

Total 104.0 million Total 104.0 million

How the banks create money?

Glen Echo Bank Balance Sheet (Add Rs. 0.9 million deposit)

After Rs. 0.9 million deposit

Assets Liabilites

Loans Outstanding Rs. 81.71 millionDeposits Rs. 101.9 million

Government debt 13.00 millionNet Worth 3.0 million

Required Reserves 10.19 million

Total 104.90 millionTotal 104.9 million

How the banks create money?

Several things have occurred due to deposit of Rs. 900,000 in the Glen Echo Bank.

Total deposits increased from Rs. 101 million to Rs. 101.9 million. Required reserves increased by Rs. 90,000 (= Rs. 900,000 x .10). Total required reserves increased from Rs. 10.1 million to Rs.

10.19 million. The bank was able to lend out the difference between the deposit

(Rs. 900,000) and required reserves (Rs. 90,000), an amount equal to Rs. 810,000.

Outstanding loans increased from Rs. 80.9 million to Rs. 81.71 million (Rs. 80.9 + 0.810)

Table Sources:

Individual Bank

Amount Deposited Lent Out Reserves

A 100 80 20B 80 64 16C 64 51.2 12.8D 51.2 40.96 10.24E 40.96 32.77 8.19F 32.77 26.21 6.55G 26.21 20.97 5.24H 20.97 16.78 4.19I 16.78 13.42 3.36J 13.42 10.74 2.68K 10.74

Total Reserves: 89.26

Total Amount of Deposits:

Total Amount Lent Out:

Total Reserves + Last Amount Deposited:

457.05 357.05 100

Money Multiplier

The money multiplier as equal to

= 1/r.r. This formula stems from the fact that the sum of the "amount loaned out" column above

can be expressed mathematically as a geometric series with a common ratio of 1 − R

In reality there are a number of leakages from the above scenario that will reduce the value of the multiplier:

People may not deposit all of their cash into the banking system. Besides the money we keep in our wallets, we may save some of our money outside the depository banking system.

Banks may not loan out all potential reserves, choosing to keep excess reserves. Balance sheet of RBI Monetary aggregates Multiplier in India

Monetary Liabilities of RBI

High Powered Money: Monetary Liabilities of RBI + Government Money

Monetary Liabilities of RBI = Currency with the Public + Reserves + ‘Other’ Deposits with RBI

Reserves = Vault cash + Deposits with RBI + Excess Reserves

Tools of Monetary Policy

Three monetary policy tools—open market operations, reserve requirements and discount window lending.

Open Market Operations

The most effective tool the RBI has is the buying and selling of government securities in its open market operations. Government securities include gilt edged bonds, notes, and bills.

Open Market Operations

Open market operations serve: to steer short-term interest rates, to manage the liquidity situation in the

money market, and to signal the stance of monetary policy

When the RBI Eases When the RBI Tightens

RBI buys government securities from a firm that deals in them.

RBI sells government securities to a firm that deals in them.

It pays by crediting the account that the dealer’s bank has at the RBI.

It pays by debiting the account that the dealer’s bank has at the RBI.

The bank in turn credits the dealer’s account. The bank in turn debits the dealer’s account.

The banking system has more funds to lend. The banking system has fewer funds to lend.

Downward pressure on the RBI funds rate—the interest rate banks charge each other for

overnight loans.

Upward pressure on the RBI funds rate. 

Influences other interest rates in the economy—which also go down.

Other interest rates in the economy also rise as a result.

Gives the economy a boost. Slows the economy and curbs inflation.

Open Market Operations

Open Market Operations

The RBI buys bonds from banks. Bank reserves and the monetary base increase. Banks don't want money sitting in their vaults, earning zero

return, so they attempt to loan out the money. To attract borrowers, banks lower the interest rates that they

charge. The businesses and individuals who borrow the money from the

banks spend it on goods and services. These expenditures create incomes that are deposited into the

banking system. The money supply increases by a greater amount than the

original RBI purchase of bonds because of the money multiplier. Increases in investment activity by businesses will increase

aggregate demand and the growth rate of GDP.

Discount Window Lending

Discount rate is the interest rate that the RBI charges banks for short-term loans. Changes in the discount rate typically occur in conjunction with changes in the Bank rate.

Discount Rate

Impact on Economic Activity

Policy

Raised Slows economic activity

Check inflation

Lowered Stimulates economic activity

Economic growth

Reserve Requirements

Reserve requirements are the percentages of certain types of deposits that banks must keep on hand in their own vaults or on deposit at a Reserve Bank of India. 

Reserve requirement

Impact on bank lending

Raised Reduce lending

Lowered Increase lending

Cash Reserve Ratio

The Reserve Bank, having regard to the needs of securing the monetary stability in the country, can prescribe Cash Reserve Ratio (CRR) for scheduled banks without any floor rate or ceiling rate. 

[Earlier, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of total of their demand and time liabilities].

RBI uses CRR either to drain excess liquidity or to release funds needed for the economy from time to time. Increase in CRR means that banks have less funds available and money is sucked out of circulation. 

Thus we can say that this serves duel purposes i.e. it not only ensures that a portion of bank deposits is totally risk-free, but also enables RBI to  control liquidity in the system, and thereby, inflation by tying the  hands of the banks in lending money.

Statutory Liquidity Ratio

Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form:

Cash Gold valued at a price not exceeding the current market price, Unencumbered approved securities (Government securities or

Gilts come under this) valued at a price as specified by the RBI from time to time.

Statutory Liquidity Ratio

The objectives of SLR are: To restrict the expansion of bank credit. To augment the investment of the banks

in Government securities. To ensure solvency of banks. A reduction

of SLR rates looks eminent to support the credit growth in India.

Difference between SLR & CRR

SLR restricts the bank’s leverage in pumping more money into the economy. On the other hand, CRR, , is the portion of deposits that the banks have to maintain with the Central Bank.

The other difference is that to meet SLR, banks can use cash, gold or approved securities whereas with CRR it has to be only cash. CRR is maintained in cash form with RBI, whereas SLR is maintained in liquid form with banks themselves.

Liquidity Adjustment Facility

Liquidity Adjustment Facility (LAF) was introduced by RBI during June, 2000 in phases, to ensure smooth transition and keeping pace with technological up gradation.

Objective : The funds under LAF are used by the banks for their day-to-day mismatches in liquidity. 

Tenor :Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo auctions (for injection of liquidity) are conducted on a daily basis (except Saturdays).

Repo and Reverse Repo

Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks. When the repo rate increases borrowing from RBI becomes more expensive.  Therefore, we can say that in case,  RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.

Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI.  The RBI uses this tool when it feels there is too much money floating in the banking system.  An increase in the reverse repo rate  means that the RBI will borrow money from the banks at a higher rate  of interest. As a result, banks would prefer to keep their money with the RBI

Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks

Market Stabilization Scheme (MSS)

Reserve Bank has proposed to the Government of India to authorize issuance of existing debt instruments, viz., Treasury Bills and dated securities up to a specified ceiling to be mutually agreed upon between the Government and the Reserve Bank.

The bills/bonds issued under MSS would have all the attributes of the existing Treasury Bills and dated securities.

The Reserve Bank will decide and notify the amount, tenure and timing of issuance of such treasury bills and dated securities. Whenever such securities are issued by the Reserve Bank for the purpose of market stabilization and sterilization, a press release at the time of issue would indicate such purpose.

Monetary Policy Stance

Latest Important Banking  Sector  Data

Bank Rate 6.00%  Cash Reserve Ratio (CRR) 6.00 %

Statutory Liquidity Ratio (SLR) 24%

Reverse Repo Rate 7.50%

Repo Rate under LAF 8.50%

Expansionary Monetary Policy

Contractionary Monetary Policy

Policy Lags

Time lags that occur between the onset of an economic problem and the full impact of the policy intended to correct the problem.

Policy lags come in two broad categories: inside lag (getting the policy activated) * recognition lag, * decision lag, and * implementation lag. outside lag (the subsequent impact of the policy). * impact lag. Policy lags can reduce the effectiveness of business-cycle

stabilization policies and can even destabilize the economy. Policy lags, especially inside lags, are often different for monetary policy than for fiscal policy.

Monetary Policy

Can be made ineffective: In times of recession Increase in velocity of money Volatile currency – deposit ratio Demand for Credit