26th May 2022 | Money and banking: money supply, Structure of Indian banking and Non-Banking Financial Institutions.

Syllabus- Money and banking: money supply, Structure of Indian banking and    

Non-Banking Financial Institutions.

Number of questions- Mains: 02, Prelims – 10

Mains Questions of the day-

1Q. A. Discuss various instruments used in the Monetary Policy.

Introduction:

Mention the meaning of monetary policy and its importance.

Body:

Mention the various instruments used in monetary policy. – Quantitative and Qualitative tools.

Conclusion:

Monetary policy is now decided by the Monetary Policy committee to achieve the dual goals of price stability and promotion of growth in the economy.  

Content:

Monetary policy:

  • Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments to achieve the goals specified in the RBI Act.
  • The primary objective of the RBI’s monetary policy is to maintain price stability while keeping in mind the objective of growth.
  • Price stability is a necessary and precondition to sustainable growth.
  • The Government amended RBI Act, 1934 by the Finance Act, 2016, to provide for a statutory and institutionalized framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
  • The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
  • It provides for the inflation target (4%, +or-2%) to be set by the Government, in consultation with the Reserve Bank once in every five years.

Various Instruments of Monetary Policy: –

Open Market Operations:

  • An open market operation is an instrument which involves buying/selling of securities like government bond from or to the public and banks.
  •  The RBI sells government securities to control the flow of credit and buys government securities to increase credit flow.

Repo Rate:  

  • The interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral under the liquidity adjustment facility (LAF).

Reverse Repo Rate:

  • The interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis from banks against the collateral under the LAF.

Liquidity Adjustment Facility (LAF):

  • The LAF consists of overnight as well as term repo.
  • The aim of term repo is to help develop the inter-bank operation in terms of money market, that is set market-based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy.

Marginal Standing Facility (MSF):

  • A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by giving their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
  • This provides a safety valve against unanticipated liquidity shocks to the banking system.

Corridor:      

  • The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

Bank Rate:

  • It is the rate at which the RBI is ready to buy or rediscount the
  • bills of exchange or
  • other commercial papers.
  • The Bank Rate is published under Section 49 of the RBI Act, 1934.
  • This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.

Cash Reserve Ratio (CRR):

  • The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.

Statutory Liquidity Ratio (SLR):

  • The share of Net demand and time liabilities (NDTL) that a bank is required to maintain in safe and liquid assets such as government securities, cash and gold.
  • Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.

Open Market Operations (OMOs):

  • These include both purchase and sale of government securities
  • For injection and absorption of liquidity in to or from the system.

Market Stabilisation Scheme (MSS):

  • This instrument for monetary management was introduced in 2004.
  • Surplus liquidity arising from large capital inflows is absorbed through sale of short-term government securities and treasury bills.
  • The cash so mobilised is held in a separate government account with the RBI.

2. What is Monetary Policy Framework? What are Various Policy Stances of RBI?

Introduction:

Mention the Monetary Policy Committee that implements Monetary Policy Framework.

Body:

Mention the Monetary Policy Framework.

Mention the various policy stances of RBI.

Conclusion:

  • The main aim of monetary policy committee is:
  • To maintain the price stability and 
  • Provide for sustainable growth of economy 
  • The above specified goals are accomplished by Monetary Policy committee by using various instruments of monetary policy such as CRR, SLR, repo, Reverse repo, MSS etc…

Content:

Monetary Policy Committee (MPC):

  • Origin:

Under Section 45ZB of the amended (in 2016) RBI Act, 1934, the central government is empowered to constitute a six-member Monetary Policy Committee (MPC).

  • Objective:
  • Under Section 45ZB lays down that “the Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target”.
  • The decision of the Monetary Policy Committee shall be binding on the Bank.
  • Composition:

Section 45ZB says the MPC shall consist of 6 members:

  • RBI Governor as its ex officio chairperson,
  • Deputy Governor in charge of monetary policy,
  • An officer of the Bank to be nominated by the Central Board
  • Three persons to be appointed by the central government. This category of appointments must be from “persons of ability, integrity and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy”.

Monetary Policy Framework:

  • Origin:

In May 2016, the RBI Act was amended to provide a legislative mandate to the central bank to operate the country’s monetary policy framework.

  • Objective:

The framework aims at setting the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation, and modulation of liquidity conditions to anchor money market rates at or around the repo rate.

  • Reason for Repo Rate as Policy Rate:
  • Repo rate changes transmit through the money market to the entire financial system, which, in turn, influences aggregate demand.
  • Thus, it is a key determinant of inflation and growth

Various Policy Stances of RBI:

RBI followed different stances (fixing the rates of various instruments in the Monetary Policy) consider the situation of economy:

Accommodative:  

  • An accommodative stance means the central bank is prepared to expand the money supply to boost economic growth.
  • The central bank, during an accommodative policy period, is willing to cut the interest rates. A rate hike is ruled out.
  • The central bank typically adopts an accommodative policy when growth needs policy support and inflation is not the immediate concern.

Neutral:

  • A ‘neutral stance’ suggests that the central bank can either cut rate or increase rate.
  • This stance is typically adopted when the policy priority is equal on both inflation and growth.
  • The guidance indicates that the market can expect a rate action on either way at any point.

Hawkish Stance

  • A hawkish stance indicates that the central bank’s top priority is to keep the inflation low.
  • During such a phase, the central bank is willing to hike interest rates to curb money supply and thus reduce the demand.
  • A hawkish policy also indicates tight monetary policy.
  • When the central bank increases rates or ‘tightens’ the monetary policy, banks too increase their rate of interest on loans to end borrowers which, in turn, curbs demand in the financial system.

Calibrated Tightening:

  • Calibrated tightening means during the current rate cycle, a cut in the repo rate is off the table.
  • However, the rate hike will happen in a calibrated manner.
  • This means the central bank may not go for a rate increase in every policy meeting but the overall policy stance is tilted towards a rate hike.
  • This can happen outside the policy meetings as well if the situation warrants.

Prelims Questions of the day:

1.Which of the following is the component of Monetary Policy?

  1. Bank rate
  2. Taxation
  3. Public debt
  4. Public revenue

Answer: A

Explanation:

The main instruments of the monetary policy are Cash Reserve Ratio, Statutory Liquidity Ratio, Bank Rate, Repo Rate, Reverse Repo Rate, and Open Market Operations.

2.Which of the following statements is correct regarding the Monetary Policy Committee (MPC)?

  1. It decides the benchmark interest rates.
  2. It is a 12-member body including the Governor of RBI and is reconstituted every year.
  3. It functions under the chairmanship of the Union Finance Minister.
  4. Deputy Governor as its ex officio chairperson.

Answer: A

Explanation:

Monetary Policy Committee (MPC):

  • Origin: Under Section 45ZB of the amended (in 2016) RBI Act, 1934, the central government is empowered to constitute a six-member Monetary Policy Committee (MPC).
  • It decides the RBI’s benchmark interest rates.
  • Objective: Further, Section 45ZB lays down that “the Monetary Policy Committee shall determine the Policy Rate required to achieve the inflation target”.
  • The decision of the Monetary Policy Committee shall be binding on the Bank.
  • Composition: Section 45ZB says the MPC shall consist of 6 members:
  • RBI Governor as its ex officio chairperson,
  • Deputy Governor in charge of monetary policy,
  • An officer of the Bank to be nominated by the Central Board,
  • Three persons to be appointed by the central government.
  • This category of appointments must be from “persons of ability, integrity and standing, having knowledge and experience in the field of economics or banking or finance or monetary policy”.

3. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?

  1. Cut and optimise the Statutory Liquidity Ratio
  2. Increase the Marginal Standing Facility Rate
  3. Cut the Bank Rate and Repo Rate
  4. Cut the CRR

Answer: B

Explanation:

  • An expansionary monetary policy is focused on expanding (increasing) the money supply in an economy. This is also known as Easy Monetary Policy.
  • An expansionary monetary policy is implemented by lowering key interest rates thus increasing market liquidity (money supply). High market liquidity usually encourages more economic activity.
  • When RBI adopt Expansionary Monetary Policy, the central bank
  • decrease Policy Rates (Interest Rates) like Repo, Reverse Repo, MSF, Bank Rate etc.
  • decrease Reserve Ratios like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
  • buys government securities from the market as part of Open Market Operations (OMO) – providing liquidity in the market

4. If the RBI decides to adopt a Contractionary Monetary Policy, which of the following would it do?

  1. Decrease Repo Rate
  2. Decrease Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
  3. Buys government securities from the market as part of Open Market Operations (OMO)
  4. Sells government securities from the market as part of Open Market Operations (OMO).

Answer: D

Explanation:

Contractionary Monetary Policy:

  • A contractionary monetary policy is focused on contracting (decreasing) the money supply in an economy. This is also known as Tight Monetary Policy.
  • A contractionary monetary policy is implemented by increasing key interest rates thus reducing market liquidity (money supply). Low market liquidity usually negatively affects production and consumption. This may also have a negative effect on economic growth.
  • When RBI adopt a contractionary monetary policy, the central bank
  • increase Policy Rates (Interest Rates) like Repo, Reverse Repo, MSF, Bank Rate etc.
  • increase Reserve Ratios like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
  • sells government securities from the market as part of Open Market Operations (OMO) – taking out liquidity from the market

5.When the Cash Reserve Ratio (CRR) is increased by the RBI, which of the following will happen?

  1. Increase the supply of money in the economy
  2. Decrease the supply of money in the economy
  3. No impact on the supply of money in the economy
  4. Initially increase the supply but later on decrease automatically.

Answer: B

Explanation:

  • When RBI increases the CRR, fewer funds are available with banks as they have to keep larger portions of their cash in hand with RBI.
  • Hike CRR leads to an increase of interest rates on loans provided by the Banks. Reduction in CRR sucks money out of the system causing a decrease in the money supply.

 6. Which of the following represents the Open Market Operations?

  1. Sale of agricultural products in the government regulated Mandis.
  2. Sale and purchase of bonds and securities to the commercial banks by the RBI.
  3. Sale and purchase of bonds and securities by the RBI to the government.
  4. Sale and purchase of bonds and securities by the commercial banks to the customers.

Answer: B

Explanation:

  • An open market operation (OMO) for UPSC is a central bank operation.
  • It involves supplying or receiving liquidity in its currency to or from banks.
  • A monetary policy instrument that influences short-term interest rates through regulating the money supply and the liquidity of the banking system.

7.Which of the following is not the monetary tool?

  1. CRR
  2. SLR
  3. Deficit financing
  4. Open market operations

Answer: C

Explanation:

  • Deficit financing means generating funds to finance the deficit which results from an excess of expenditure over revenue.
  • The gap is covered by borrowing from the public by the sale of bonds or by printing new money.

8.Which of the following statement is false regarding the National Payments Corporation of India (NPCI)?

  1. It is an initiative of the Reserve Bank of India (RBI) and the Indian Banks’ Association (IBA).
  2. RuPay card payment scheme was launched by the NPCI.
  3. It is an umbrella organisation for operating retail payments and settlement systems in India
  4. It is formed under Banking Regulation Act 1949

Answer: D

Explanation:

National Payments Corporation of India (NPCI), an umbrella organisation for operating retail payments and settlement systems in India, is an initiative of Reserve Bank of India (RBI) and Indian Banks’ Association (IBA) under the provisions of the Payment and Settlement Systems Act, 2007, for creating a robust Payment & Settlement Infrastructure in India.

9. Which of the following organisation has released the EASE 2.0 Index?

  1. NPCI
  2. RBI
  3. NITI Aayog.
  4. Indian Banking Association (IBA)

Answer: D

Explanation:

  • EASE 2.0 Index Results has been released recently by the Indian Banking Association (IBA).
  • Bank of Baroda, State Bank of India, and erstwhile Oriental Bank of Commerce were felicitated for being the top three (in that order) in the ‘Top Performing Banks’ category according to the EASE 2.0 Index Results.

10. Why RBI is called as the ‘lender of last resort’?

A. If commercial banks refuse to give loan to a poor, he can always turn to RBI for approval.

B. It acts as a guarantor for banks and extends loans to ensure the solvency of the latter.

C. All heavy infrastructure projects that cannot be financed by individual banks are financed by the RBI.

D. It is the last agency to assess the credit worthiness of borrowers.

Answer: B

Explanation-

The total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves.

So, if all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures.

The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter.

This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs.

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