Tools in Indian Economy

1. Symbiosis Institute of Business Management
MBA [Ex. Edu.] Batch 2012-2014
Semester I – Section
Anurag Verma(35413)
Assignment:
Analyze the various tools /instruments of monetary policy.
Also discuss current monetary policy of Indian economy.
Do you think they are able to check inflationary situation. Elaborate?
Description:
Instruments of Indian Monetary Policy
“A policy employing the central banks control of the supply of money as an instrument for achieving the
objectives of general economic policy is a monetary policy.”
Monetary policy, also known as Credit Policy, helps RBI in deciding about the supply of money in an
economy, ratio of interest to be charged for some amount of money. It provides measure to control
inflation and most important of all it helps in deciding how to achieve the economic growth and
development objectives of an economy.
So to attain these objectives various monetary policy instruments are used.
Monetary Policy Instruments
Principal Instruments of monetary policy or credit control are broadly classified as:
 Quantitative Instruments: These tools are related to the Quantity or Volume of the money.
These are the instruments of monetary policy which affect overall supply of money/ credit in the
economy. For example, Bank Rate, Cash Reserve Ratio.
 Qualitative Instruments: These instruments direct or restrict the flow of credit to specified
areas of economic activity. These include instruments like Margin Requirement, Direct Auction
etc. It may be possible that some qualitative instruments may have shades of quantitative
instrument.
We limit our scope to various quantitative instruments for this assignment.
Bank Rate: “The interest rate at which RBI lends money to the commercial banks.”
Managing the bank rate is a preferred method by which central banks can regulate the level of
economic activity. In most of the cases, the increase (or decrease) in bank rate is often followed by
increase (or decrease) in market rate of interest.
With the increase in the bank rate by RBI, commercial banks reduce their volume of borrowings from
RBI as high bank rate increases their cost of borrowing. Thus, they have less availability of credit with
them to lend to public or if they have, it is available at high rate. Therefore, with increase in bank rate

2. there is an increase in market rate of interest also and this ultimately results in reduced borrowing by
public.
On the other hand, if the RBI reduces the bank rate, borrowings for commercial banks will become
cheaper. And banks will also reduce their rates thus resulting in credit expansion.
Open Market Operations (OMO): “The open market operation refers to the purchase and/or sale of
short term and long term securities by the RBI in the open market.” Let’s see how it helps in credit
control.
RBI, especially during inflation, sells government securities in an open market which is purchased by
commercial banks and private individuals. When commercial banks purchases securities, money get
transferred to RBI from commercial bank. Thus, there is fall in money supply in an economy. Now due
to decrease of money supply, purchasing power reduces which helps in controlling inflation.
While, when RBI buys the securities from commercial banks in the open market, commercial banks sell
securities and get back the money. It results in increase in the volume of money in the economy. It is
done mostly during depression or recession.
Variable Reserve Rates (VRR): These basically include Cash Reserve Ratio (CRR) and Statutory Liquidity
Ratio (SLR).
 CRR: “Cash reserve ratio is the cash parked by the banks in their specified current account
maintained with RBI.”
Commercial banks have to keep a certain percentage of their total deposits in the form of cash reserves
with RBI. For example if CRR is 10% and total deposits with a bank are Rs. 100 crore, they will have to
keep Rs. 10 crore with RBI as minimum cash reserves.
 SLR: “Statutory liquidity ratio is in the form of cash (book value), gold (current market value) and
balances in unencumbered approved securities.”
Every bank is required to maintain a fixed percentage of its assets in the form of cash and other liquid
assets with RBI.
“Other liquid assets include cash, balances with RBI, balances in current accounts with banks, money at
call and short notice, inter-bank placements due within 30 days and securities under “held for trading”
and “available for sale” categories excluding securities that do not have ready market.”
By varying VRR commercial banks lending capacity can be affected. Suppose, commercial banks have
total deposits of 100 crore with them. Now if VRR increases from 20% to 30%, than the reserves to be
held by banks would increase from 20 crore to 30 crore.

3. Thus, the availability of money with commercial bank which can be used for credit creation will reduce
by 10 crore. On the contrary any decrease in VRR will make more money available with banks for credit
creation.
Liquidity Adjustment Facility: “A tool used in monetary policy that allows banks to borrow money
through repurchase agreements.”
“Repo or ready forward contact is an instrument for borrowing funds by selling securities with an
agreement to repurchase the said securities on a mutually agreed future date at an agreed price which
includes interest for the funds borrowed.”
Thus, in Repo transaction banks borrow funds from RBI by selling securities with an agreement to
repurchase the said securities on a mutually agreed future date at an agreed price. If the 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.
“The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of
securities with an agreement to resell the said securities on a mutually agreed future date at an agreed
price which includes interest for the funds lent.”
The RBI uses this tool when it feels there is too much money floating in the banking system. With the
increase in reverse repo rate, RBI gives bank a lucrative rate for depositing money. Thus, banks prefer to
deposit money with RBI rather than lending it. It results in reduction of money circulation in an economy
and thus purchasing power.
LAF enables liquidity management on a day to day basis. This arrangement allows banks to respond to
liquidity pressures and is used by governments to assure basic stability in the financial markets.
Marginal Standing Facility Rate: “Banks will be able to borrow up to 1% of their respective Net Demand
and Time Liabilities”. The rate of interest on the amount accessed from this facility is 100 basis points
(i.e. 1%) above the repo rate.
This scheme will reduce volatility in the overnight rates and improve monetary transmission. This
measure has been introduced by RBI to regulate short-term asset liability mismatches more effectively.
Current Monetary Policy of Indian Economy
The monetary policy in India underwent gradual changes concerning both its strategy and its
implementation. Quite some progress has been done in the direction indicated by best practices and the
economic theory. Notwithstanding these changes, the RBI has been until recently unwilling to commit
its monetary policy to a single objective and a clear definition of intermediate targets.
RBI monetary policy strategy is still guided by the multiple objectives of price stability, growth and
financial stability, with relative weights depending upon evolving domestic and global macroeconomic
and financial conditions. Price stability is an important but not the exclusive goal of monetary policy in
India.

4. RBI has released its Monetary Policy Statement for 2012-13 and it has raised the concerns of current
global scenario.
The US economy continues to show signs of modest recovery. Large scale liquidity infusions by the
European Central Bank (ECB) have significantly reduced stress in the global financial markets. However,
recent developments, for example in Spain, indicate that the euro area sovereign debt problem will
continue to weigh on the global economy. Growth risks have emerged in emerging and developing
economies (EDEs). And, amidst all these, crude oil prices have risen by about 10 per cent since January
and show signs of persisting at current levels.
RBI has announced the Monetary Policy measures through its Mid Quarter Monetary Policy Review:
September 12
Monetary and Liquidity Measures: On the basis of an assessment of the current macroeconomic
situation, it has been decided :
 To reduce the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 4.75 percent to
4.5 percent of their net demand and time liabilities (NDTL) effective the fortnight beginning
September 22, 2012. Consequently around INR 170 billion of primary liquidity, will be injected into
the banking system.
 Keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 8.0 percent.
Consequently, the reserve repo rate under the LAF will remain unchanged at 7.0 percent, and the
marginal standing facility (MSF) rate and the Bank Rate at 9.0 percent.
Here is the table which summarizes the current Monetary and Liquidity measures.
Sr No. Monetary Instrument Current Value as on Sep 2012
1 Cash Reserve Ratio (CRR) 4.5 percent
2 Repo Rate 8.0 percent
3 Reverse Repo Rate 7.0 percent
4 Marginal Standing Facility (MSF) 9.0 percent
5 Bank Rate 9.0 percent.
Do you think they are able to check inflationary situation. Elaborate ?

5. Domestic Economy
Growth
1. Economic activity picked up modestly in Q1 of 2012-13 in relation to the preceding quarter; but the
sluggish momentum of value added in Q1 was evident across all sectors of the economy, and
particularly in industry. Lead indicators point to slack activity in Q2 as well. Industrial production rose by
just 0.1 per cent in July. In August, the manufacturing PMI (Purchasing Managers Indices) fell to its
lowest level during 2012 so far, as a result of output disruptions due to power shortages and declining
export orders. The services PMI, however, picked up in August on growth in new orders and
employment. With the progressive reduction in the rainfall deficit, kharif sowing, though still below
normal, has improved. Reassuringly, the late rains have augmented storage in reservoirs which should
improve prospects for the rabi crop, mitigating to some extent the concerns about agricultural
prospects.
Inflation
2. Headline WPI inflation (y-o-y) has remained sticky at around 7.5 per cent throughout the current
financial year so far. At the disaggregated level, within primary food articles, the easing of vegetable
prices in July-August was to a large extent offset by the surge in prices of cereals and pulses. Demand-
supply imbalances in respect of protein-rich items persist. Fuel price inflation picked up in August,
largely reflecting the upward revision in electricity prices. As welcome as the recent hike in diesel
prices/rationalisation of LPG subsidy has been, the pass-through to administered prices remains
incomplete. International crude prices are vulnerable to being driven up further by global liquidity. Core
inflation pressures remained firm with non-food manufactured products inflation inching up from 5.1
per cent in April to 5.6 per cent in August and the momentum indicator remaining elevated. Even as
demand pressures moderate, supply constraints and rupee depreciation are imparting pressures on
prices, rendering them sticky.
3. In terms of the new CPI, inflation (y-o-y) remained broadly unchanged in July from June at close to 10
per cent, held up by rising prices of food items. Notwithstanding some easing in July, core CPI inflation
(CPI excluding food and fuel sub-group) remains elevated.
4. While the recent upward revision in diesel prices and rationalisation of subsidy for LPG is a significant
achievement, in the short-term, there will be pressures on headline inflation. Over the medium-term,
however, it will strengthen macroeconomic fundamentals. It is important to note that these revisions
were anticipated at the time of the April policy when a front-loaded repo rate reduction was
undertaken. Over the longer run, holding down subsidies to under 2 per cent of GDP as indicated in the
Union Budget for 2012-13 is crucial to manage demand-side pressures on inflation. Containing
inflationary pressures and lowering inflation expectations warrant maintaining the momentum of recent
policy actions to step up investment, alleviate supply constraints, and improve productivity.
Liquidity Conditions
5. Money supply (M3), bank credit and deposits have moderated in relation to their indicative
trajectories, reflecting the slowing down of economic activity. Against this backdrop, liquidity conditions
have remained comfortable since the FQR. However, going forward, the wedge between deposit growth

6. and credit growth could widen on the back of the seasonal pick-up in credit demand in the second half
of the year. This, combined with outflows on account of advance tax payments and the onset of festival-
related currency demand, could accentuate pressures on liquidity over the next few weeks. In these
conditions, appropriate liquidity management assumes importance in order to ensure that drawals
under the Liquidity Adjustment Facility (LAF) broadly remain within the indicative target of +/- 1 percent
of NDTL, thereby facilitating monetary policy transmission and enabling adequate flow of credit to the
productive sectors of the economy.
External sector
6. While the trade deficit narrowed in the first five months of 2012-13, the relatively large fall of exports
in July-August is indicative of risks to the current account from the worsening global outlook. As regards
external financing, the moderation in FDI inflows was partly compensated by a surge in non-resident
deposits and a renewal of FIIs flows in recent months. Consequently, the rupee has been trading in a
narrow range since the FQR. Looking ahead, a moderation in the trade deficit combined with increased
inflows in response to domestic policy developments could ease pressures on the balance of payments.
However, risks from global factors, in terms of both capital movements and oil prices will persist. Given
these external risks, holding down the CAD to sustainable levels will depend on durable fiscal
consolidation and, in particular, switching public expenditure from subsidies to capital outlay that
crowds in private investment, thus preparing the ground for a revival of growth.
Guidance
7. Since the FQR, while growth risks have increased, inflation risks remain. Mitigating the growth risks
and taking the economy to a higher sustainable growth trajectory requires concerted policy action
across a range of domains, a process to which last week’s actions made a significant contribution.
Monetary policy also has an important role in supporting the growth revival. However, in the current
situation, persistent inflationary pressures alongside risks emerging from twin deficits – current account
deficit and fiscal deficit - constrain a stronger response of monetary policy to growth risks. Accordingly,
as this process evolves, the stance of monetary policy will be conditioned by careful and continuous
monitoring of the evolving growth-inflation dynamic, management of liquidity conditions to ensure
adequate flows of credit to productive sectors and appropriate responses to shocks emanating from
external developments.