1. CREDIT CREATION &
MONETARY POLICY

2. 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.

3. 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.

4. 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.

5. 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)

6. Monetary Aggregates
After 1998
Weekly Compilation
M0 = Currency in Circulation + Bankers' Deposits with
the RBI + 'Other' Deposits with the RBI

7. 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

8. 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

9. 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 Aggregates
Broad and Narrow Money

10. How the banks create money?
Glen Echo Bank Balance Sheet (1)
Initial Balance
Assets
Liabilites
Loans
Outstanding
Rs. 80.0
million
Government
debt
13.0 million
Required
Reserves
10.0 million
Total
103.0
million
Deposits
Net Worth
Total
Rs. 100.0
million
3.0 million
103.0
million

11. 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
Government
debt
13.0 million
Required
Reserves
10.1 million
Total
104.0 million
Deposits
Net Worth
Total
Rs. 101.0
million
3.0 million
104.0 million

12. How the banks create money?
Glen Echo Bank Balance Sheet
(Add Rs. 0.9 million deposit)
After Rs. 0.9 million deposit
Assets
Loans Outstanding
Liabilites
Rs. 81.71 millionDeposits
Government debt
13.00 millionNet Worth
Required Reserves
Rs. 101.9 million
10.19 million
Total
104.90 million Total
3.0 million
104.9 million

13. 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)

14. Table Sources:
Individual
Bank
Amount
Deposited
A
B
C
D
E
F
G
H
I
J
K
100
80
64
51.2
40.96
32.77
26.21
20.97
16.78
13.42
10.74
Lent Out
Reserves
80
64
51.2
40.96
32.77
26.21
20.97
16.78
13.42
10.74
20
16
12.8
10.24
8.19
6.55
5.24
4.19
3.36
2.68
Total Reserves:
89.26
Total Amount
of Deposits:
Total Amount Lent
Out:
Total Reserves +
Last Amount
Deposited:

15. 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

16. 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

19. Tools of Monetary Policy
Three monetary policy tools—
open market operations,
reserve requirements and
discount window lending.

20. 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.

21. 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

22. Open Market Operations
When the RBI Eases
When the RBI Tightens
RBI buys government securities from a firm that RBI sells government securities to a firm that
deals in them.
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.

23. 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.

24. 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 Check inflation
activity
Lowered
Stimulates
economic
activity
Economic
growth

25. 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

26. 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.

27. 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.

28. 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.

29. 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.

31. 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).

32. 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

33. 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

34. 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%

35. Expansionary Monetary Policy

36. Contractionary Monetary Policy

37. 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.

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