Excerpts of the Study Materials on Indian Economics: Monetary Policy in India

Traditional and New Tools of Monetary Policy

Bank Rate Policy: Bank rate is the rate at which the central bank of a country provides loan to the commercial banks. If the bank rate is low, the banks are encouraged to borrow reserves against which they can advance loans. This facilitates credit creation. An upward revision of this rate discourages borrowing and exerts a contractionary effect on money stock. When central bank raises the bank rate, the commercial bank raises their lending rates, and it results in less borrowings and reduces money supply in the economy.

Open Market Operations: Open market operation consists of purchase and sale of securities by the central bank of the country. The sale of security by the central bank leads to contraction of credit and purchase thereof leads to credit expansion.

Cash Reserve Ratio: Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep with RBI in the form of reserves or balances. When CRR is increased, the loanable funds at the disposable of commercial banks get reduced and the money supply contracts. The opposite effect occurs if the CRR is reduced. This increases the ability of the banks to create deposit money. Since it is rather a drastic way to change the money supply, the variation in CRR is not used very frequently.

Selective Credit Control: Selective Credit Controls  are aimed at regulating  the distribution of credit amongst sectors or purposes. RBI uses this measure to prevent speculative hoarding of essential commodities and chech undue rises in prices. Selective credit control measures include fixing the margin requirements for loans, fixing the maximum limit for advances and charging discriminatory interest rates on selective advances. RBI may also instruct banks not to provide loans for a specific purpose.

Repo Rate:  Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks against securities. 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: Reverse Repo rate is the rate at which banks park their short-term excess liquidity with the RBI.  The banks use this tool when they feel that they are stuck with excess funds and are not able to invest anywhere for reasonable returns.  An increase in the reverse repo rate  means that the RBI is ready to borrow money from the banks at a higher rate  of interest. As a result, banks would prefer to keep more and more surplus funds with 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

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(From my forthcoming book on IAS General Studies Manual being published by Access Publishing India Pvt. Ltd., New Delhi).