Recently on 16th September 2010 in its mid Quarter Review, the RBI, in order to control inflation, hiked the Repo Rate by 0.25% to 6.0% and the Reverse Repo Rate by 0.50% to 5%. So what are these monetary policy tools that the RBI uses to manage inflation and how do these affect interest rates in the market?

The Reserve Bank of India (RBI) uses various monetary tools to manage economic growth and inflation during times of boom and recession. The RBI uses various tools like CRR, SLR, Repo Rate and Reverse Repo Rate. Let us understand these tools one by one

Cash Reserve Ratio (CRR): This is the amount (as % of their deposits) that banks have to set aside with the RBI. Presently the CRR is 6% (as on 16th Sep 2010). This effectively means that banks have to keep 6% of their Time and Demand Deposits with the RBI. Out of every Rs 100 collected by banks as deposits, Rs 6 will have to be kept aside with the RBI. The RBI does not pay any interest on the CRR money of the banks. In times of high inflation the RBI increases the CRR. When the CRR is increased banks have to set more money aside with the RBI. Due to this banks have less money to lend to borrowers. This sucks out excess liquidity out of the markets. With less money in the financial system, there is less money to lend and less money with people to spend. This brings down the demand for goods and services. Low demand pulls down prices of goods and brings down inflation.

The reverse of this happens during times of recession and deflation. There is less demand or no demand for goods and services in the economy. During such times the RBI reduces the CRR. This injects more money in the financial system. It makes more money available with banks to lend. Banks in turn give more loans. With more money available to spend in the form of easy loans, people demand more goods and services. This kick starts economic activity and results in higher GDP growth.

Statutory Liquidity Ratio (SLR): This is the amount (as % of their deposits) that banks need to keep in the form of cash or invest in gold or government bonds or other approved securities. Presently the SLR is 25%. This effectively means that banks have to keep 25% of their Time and Demand Deposits either in cash or invest it in gold or in government bonds. Out of every Rs 100 collected by banks as deposits, they will have to invest Rs 25 in government bonds. When inflation is high the RBI increases the SLR. Due to this money is removed from the financial system. Banks lend less and the demand for goods and services come down resulting in lower inflation.

When the economy is going through a recession, the RBI lowers the SLR, thereby freeing up more money for banks to lend, which in turns results in higher demand and thereby revives the economy.

Repo Rate: This is the rate at which the RBI lends money to banks. Banks to meet their short term lending requirements borrow from the RBI. Recently the RBI hiked the Repo Rate by 0.25% to 6.0% (as on 16th Sep 2010). This effectively means that banks will have to pay 6.0% to borrow from the RBI. When inflation is high the RBI increases the Repo Rate. Higher Repo Rate results in increase in cost of funds for banks. With their borrowing costs going up, banks in turn increase their lending rates. When loan interest rates go up, the demand for loans goes down. This reduces the money supply in the financial system and results in lower demand for goods and services. This in turn brings down inflation.

During times of recession, the RBI cuts the Repo Rate. This reduces the cost of funds for banks. With borrowing costs going down, the banks reduce their lending rates. When interest rates on loans come down, there is a higher demand for loans. With more money to splurge, people demand more goods and services. This revives demand and results in economic growth.

Reverse Repo Rate: This is the rate at which banks park their surplus funds with the RBI. Recently the RBI hiked the Reverse Repo Rate by 0.50% to 5% (as on 16th Sep 2010). During times of high inflation the RBI increases the Reverse Repo Rate. When this happens banks earn higher return on their funds with the RBI. So instead of lending money to the public, banks park their money with the RBI. This removes excess money supply from the financial system. This leads to banks giving less loans and there by bringing down the demand and thereby reducing inflation.

During times of recession the RBI cuts the Reverse Repo Rate. When this happens banks will earn less return on their surplus funds. So there will be less incentive for banks to deposit their money with the RBI as it will earn less return. So they in turn prefer to lend this money to the public. When more loans are disbursed, people have more money to spend. They demand more goods and services. This leads to economic revival.

Summary
So RBI uses monetary tools and reduces the CRR, SLR, Repo Rate and Reverse Repo Rate during recessionary times to kick start the economy. This increases the demand for goods and services. Increase in demand will lead to increase in the prices of goods and services if there is not enough supply to meet the demand. Increase in prices leads to inflation. This inflation as long as it is at manageable levels is good to keep the economy in good health.

But when inflation starts getting out of control it affects the common man as cost of living increases. Then the RBI again uses monetary tools and increases the CRR, SLR, Repo Rate and the Reverse Repo Rate to bring down inflation. But increasing these rates brings down economic growth also along with bringing down inflation. So RBI has to do the fine balancing act of keeping the economic growth momentum intact and at the same time keep inflation under control. This makes the task of the RBI Governor of balancing growth and inflation more difficult than that of a juggler.

Author: Gopal Gidwani
Website URL: http://bachatkhata.com