Monetary policy instruments used by the central banks

Recently the September 16, 2010 in his mid term review, RBI, in order to control inflation, has walked the Repo rate by 0.25% -6.0% and the Reverse Repo rate by 0.50% to 5%. So what are these monetary policy instruments that the RBI uses to manage inflation and how these affect interest rates in the market?

The Reserve Bank of India (RBI) use various monetary tools to control economic growth and inflation in times of boom and recession. The Indian Central Bank uses various tools like CRR, SLR, Repo rate and Reverse Repo Rate. We must understand these tools one by one

The cash reserve ratio (CRR): this is the amount (as a% of their deposits) that banks must set aside with the RBI. Currently the CRR is 6% (on September 16, 2010). This means that banks must hold the 6% of their time and deposits with the RBI. On every 100 Rs collected by banks as deposits, Rs 6 will have to be followed by the RBI. The RBI will not pay any interest on money banks CRR. During periods of high inflation, the RBI increased the CRR. When it increased the CRR banks have more money aside with the RBI to set. Because of this, banks have less money to lend to borrowers. This sucks out excess liquidity in the markets. With less money in the financial system, there is less money to pay and less money to people to spend. This reduces the demand for goods and services. Low demand pulls down commodity prices and inflation port.

The inverse of this happens during periods of recession and deflation. There is less demand or demand for goods and services in the economy. During these periods the RBI reduced the CRR. This injects more money into the financial system. Provides with the banks to lend more money. Banks in turn give more loans. With more money to spend in the form of easy loans, people demand more goods and services. This kick start economic activity and results in higher GDP growth.

Law of liquidity (SLR): this is the amount (as a% of their deposits) that banks must keep as cash or invest in gold or Government bonds or other securities of approved. Currently, the SLR is 25%. This means that banks must retain 25% of their time and deposits or cash or invest in gold or in government bonds. On every 100 Rs collected by banks as deposits, have to invest Rs 25 in government bonds. When inflation is high, the RBI increased the SLR. Because of this money is removed from the financial system. Banks lend less and demand for goods and services fall resulting in low inflation.

When the economy is going through a recession, the RBI lowering SLR, then freeing more money for banks to lend, which makes the results more request and then revives the economy.

Repo rate is the rate at which the RBI lends money to banks. Banks to meet their short-term loan requirements on loan from RBI. Recently the RBI hiked the Repo rate by 0.25%-6.0% (on September 16, 2010). This means that banks will have to pay 6.0% to borrow from RBI. When inflation is high the Repo rate increases RBI. High Repo rate translates into increased cost of funds for banks. With their costs rising, banks in turn increase the lending rates. When interest rates go up, lending loan demand goes down. This reduces the supply of money in the financial system and translates into less demand for goods and services. This in turn leads to inflation.

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

Reverse Repo Rate: This is the rate at which banks Park them further with the RBI. Recently the RBI hiked the Reverse Repo Rate by 0.50% to 5% (on September 16, 2010). During periods of high inflation, the RBI increased the Repo rate Reverse. When this happens the banks earn higher return on their funds with RBI. So instead of lending money, Park banks public money with the RBI. This removes excess money offered by the financial system. This leads to less lending and giving banks there bringing down demand and reducing inflation.