The RBI uses the monetary policy to influence the amount of money supply in the economy. The monetary policy can be expansionary or contractionary. The monetary policy is expansionary when the RBI's objective is to boost economic activity, which becomes increasingly important during a recession. A recession is defined as two consecutive quarters of negative growth in real GDP that puts the economic activity of a country under tremendous stress. The RBI deals with this by increasing the supply of money or lowering the interest rates in the economy. On the other hand, the monetary policy is contractionary when RBI's objective is to slow down economic activity. A high degree of economic activity due to a high rise in aggregate demand without a corresponding increase in the aggregate supply can lead to inflationary pressures in the economy. Imagine this; if tomorrow, RBI drops 2000 rupee notes around the country such that the money supply doubles, it will lead to a fall in the value of money and a rise in the price level in the economy. The quantity theory of money dictates that the quantity of money available in the economy will determine the value of money and the growth in the quantity of money, which is the primary cause of inflation. In the above example, the monetary injection in the economy led to an inflow of excess money in people's pockets. They will try to eliminate the excess cash by buying goods and services, investing in equity and bonds, giving out loans, depositing the money in their bank accounts, etc. The demand for goods should increase. However, the economy's ability to increase the production of goods and services is unchanged and cannot change in the short run. As a result, the price level increases. This example is a dramatic version of a realistic situation facing many global economies today. Many global economies, including the United States of America and India, announced relief packages to battle the pandemic. However, the printing of excess cash with record government found its way into the economy leading to inflationary pressure.
The RBI has a set of quantitative and qualitative tools at its disposal to regulate the money supply in the economy. Quantitative instruments are tools of credit control that focus on the overall money supply in the economy. Qualitative instruments are instruments of credit control that focus on select sectors of the economy. As a result, the money supply is regulated in specific sectors of the economy that might be responsible for the instability in the economy.
Quantitative tools:
1. Bank Rate: The bank rate is the rate at which the RBI lends to commercial banks in India. The RBI offers these loans to commercial banks without collateral and funds short-term and immediate needs of the banks. It uses bank rates to regulate the money supply in the economy, which keeps inflation in check. The current bank rate set by the RBI is 6.5%. The RBI has been aggressive with its monetary policy in recent times. In a recent notification, RBI revised the bank rate upwards by 50 basis points from 5.65% to 6.15%, which was later increased to 6.5%. The bank rate revision affects the general public as well. An increase in the bank rate is followed by a hike in the market interest rate, making it expensive for the general public to borrow from the bank. As a result, banks lower their borrowing from the RBI, and the general public cuts down on borrowing from commercial banks. This lowers the demand for credit in the economy, which in turn lowers the money supply. This is useful in slowing down economic activity and battling inflation. On the flip side, the RBI lowers the bank rate when it intends to increase the money supply in the economy and boost economic activity. A fall in the bank rate increases the demand for credit in the economy. RBI ensures that inflation is kept stable, as deflation is also undesirable.
2. Open Market Operations: Open market operations refer to the sale and purchase of securities such as government bonds and national saving certificates (NCS) in the open market to commercial banks and other organizations. By selling the aforementioned securities in the open market, the RBI soaks up liquidity in the economy. As a result, the buyers of the securities are left with a less liquid instrument. Commercial banks are left with lower cash reserves when they buy the securities, reducing their credit creation capacity. In turn, the money supply in the economy is lowered, and inflation is kept in check. On the other hand, RBI purchases open-market securities, and money is transferred back to the buyer. This increases liquidity in the economy. Even commercial banks are left with higher cash reserves which increase their credit creation capacity. This increases the money supply and boosts economic activity during a recession. There are two types of open market operations: outright and repo. Outright open market operations are permanent in nature. When the RBI sells these securities, it is without any promise to repurchase them. Repo open market operations, there is a promise of repurchasing the securities. The repurchase agreement specifies the date and price of the resale of the security.
3. Repo Rate: This is the rate at which the RBI offers short-period collateral-backed loans to commercial banks. The repurchase agreement or repo is a money market instrument, i.e., a contract to sell an asset at a price P0 and repurchase it on a future date at a higher price P1. The difference between the two prices is the interest. Sometimes, the sale and purchase prices are precisely the same, and the interest is paid out separately. Both parties sign the repurchase agreement, which states that the commercial bank will repurchase the securities on a given date at a predetermined price. It is a collateralized loan since if the commercial bank defaults on its payment to the RBI, the central bank can sell the securities and recover its money. Most of these transactions occur overnight. Transactions of longer duration are known as term repo. Institutions in need of cash go for a repo, while those in need of securities go for a reverse repo. The RBI changes the repo rate to control the money supply in the economy. If the RBI raises the repo rate, the loans to the banks get expensive, and it reduces the demand for credit. This, in turn, reduces the money supply and controls inflation in the economy. If the RBI lowers the repo rate, it increases the demand for credit as the loans become cheaper for commercial banks. This, in turn, leads to an increase in the money supply and increases economic activity, which tackles recession. The current repo rate in India is 6.25%. On 7th December 2022, the RBI increased the repo rate by 35 basis points to 6.25%. This decision is in tandem with RBI's current quantitative tightening policy. The chart below shows a spike in the repo rate in 2021-22. We can illustrate the working of a common repo with the help of an example: Consider a commercial bank A Ltd. that wants to borrow money by pledging government securities with a face value of Rs. 20,00,000. The collateral is government securities with a coupon rate of 6% and a market price of Rs. 95 per Rs.100 of face value. The accrued interest is Rs. 2.5 per Rs.100 of face value. Let the haircut and repo rate be 2% and 6%, respectively. The day count convention is 30/360. The repurchase agreement is for 18 days. Note that a haircut is a reduction in value to protect the lender from a sharp decline in the price. The haircut depends on various factors including the credit quality of the collateral, the time to maturity of the collateral, and the term to maturity of the repo. The table below illustrates the example we built. Here, "1-h" specifies how the haircut was applied.
4. Reverse Repo Rate: This is the rate at which the Reserve Bank of India accepts deposits from commercial banks (via government securities). It is a reverse repurchase agreement. Now, RBI is the borrower instead of the lender. Similar, to a repo, the reverse repurchase agreement is signed by both parties stating that the securities will be repurchased on a given date at a pre-decided price. Now, commercial banks have an opportunity to earn interest income. To lower the money supply in the economy, the RBI increases the reverse repo rate. As a result, commercial banks will be inclined to park their surplus funds with the RBI and earn interest income. This lowers the money supply in the economy and controls inflation. On the other hand, the RBI reduces the reverse repo rate to discourage the banks from parking their surplus funds with the RBI. Subsequently, banks have excess cash, which increases their credit creation ability. Thus, the supply of money in the economy increases, which boosts economic activity to tackle recessions. In contrast to the repo rate, the reverse repo rate has remained relatively stable, as shown.
5. Reserve Ratios: Commercial banks must maintain a minimum amount in cash, gold, unencumbered approved securities, and government bonds with the RBI. This amount is calculated as a percentage of the bank's liabilities (including savings account deposits and fixed deposits). The two types of reserve ratios are cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR). The CRR refers to the minimum percentage of the bank's total deposits mandated to be kept with the RBI. The RBI regulates the CRR to control the money supply in the economy. A rise in the CRR mandates commercial banks to park a higher percentage of their deposits with the RBI, which reduces the loan they could give out to their customers. As a result, the money supply in the economy is lowered, and inflation is controlled. On the other hand, a lower CRR allows commercial banks to loan out more money which increases the money supply in the economy and boosts economic activity. The SLR is the minimum percentage of the bank's liquid assets, including cash, gold, and unencumbered approved securities, that it is supposed to maintain with the RBI. SLR is used in a similar way to control the money supply in the economy. The current SLR rate is 18%, while the CRR rate is 4.5%.
Qualitative Tools
1. Selective Credit Control: The RBI follows the selective credit control policy to adjust its lending to select sectors. RBI asks banks to extend credit to specific priority sectors to simulate production in such sectors. On the other hand, the RBI asks banks to reduce credit availability to certain non-priority sectors. For instance, RBI discourages and reduces the availability of credit for speculative activities (like storage of grains) during periods of high inflation.
2. Loan to Value Requirements: It refers to the ratio of the loan's value to the collateral's current value. RBI can alter the credit availability to different sectors of the economy via this tool. For instance, if RBI decreases the LTV from 70% to 60%, one will obtain a lower amount as a loan for the same amount of collateral. As a result, the demand for credit will fall, and thus, the supply of money will fall. This controls inflation. On the other hand, if RBI increases the LTV from 70% to 80%, one can obtain a higher loan amount for the same amount of collateral. This increases the demand for credit and money supply in the economy. This is useful for simulating economic activity.
3. Moral Suasion: This is the act of persuading commercial banks to follow the directives of the RBI. This follows a combination of both persuasion and pressure. During the recession, banks are advised to be liberal in lending to increase the money supply. While during inflation, banks are advised to restrict lending. This is a way of regulating credit in the economy by influencing commercial banks to follow certain directives. However, no penalties are imposed on the banks for not following these directives.
4. Rationing of Credit: Examples of rationing of credit include fixing quotas for different business activities, increasing the minimum down payment amount, etc. This restricts the supply of money in the economy and controls inflation. Such schemes are withdrawn if RBI intends to increase the money supply in the economy.
Finally, as a last resort, the RBI takes direct action where it may levy sanctions and force the commercial bank to move in tandem with its guidelines. It might even derecognize a bank if it fails to comply with these guidelines.
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