What are the instruments of monetary policy?

INSTRUMENTS OF MONETARY POLICY

1. Bank Repo Rate: The rate at which the Central Bank of a country gives loans to commercial banks in case of a shortage of funds is called repo rate or repurchase rate. The repo rate is used to control inflation. The banks or financial institutions approach the RBI when they face a financial crisis for a loan and the RBI advances the money at a rate of interest which is ‘repo rate’. The banks or financial institutions sell government securities with a legal agreement stating that they will be repurchasing them after a fixed period.

2. Reverse Repo Rate: This is the rate at which RBI borrows money from the commercial banks. It also does this to reduce the excess money supply in the banking system. So, the rate at which RBI borrows money from the commercial banks within the country is called the reverse repo rate. It is used as a monetary policy instrument by increasing or decreasing the rate. The simple implication of altering the reverse repo rate is that an increase in the rate will decrease the money in the banking system and thus the money supply of a country and vice versa, other variables remaining constant.

3. Cash Reserve Ratio: All commercial banks must keep a minimum amount of money in proportion to their deposits with the RBI in cash, called, currency chests. This minimum ratio of cash to be kept with RBI is called the Cash Reserve Ratio (CRR). This acts as another instrument of monetary policy as a higher CRR will leave a lower amount with the commercial banks to be able to use it for loans and investment. The RBI can control the amounts that the banks can give as loans by increasing the CRR. The RBI uses CRR also to control liquidity in the economy.

4. Statutory Liquidity Ratio: It is relevant here to understand two terms before defining Statutory Liquidity Ratio (SLR). They are:

· Net Demand Liabilities: The bank accounts from which one can withdraw sums of money like a savings/current account are called net demand liabilities.

· Time Liabilities: These are those liabilities or sums of money that the banks are liable to pay to the customers after an agreed period. These include fixed, recurring deposits, cash certificates and so on.

The SLR is the ratio of liquid assets to demand and time liabilities which can be increased by 40 % by the RBI. It controls the supply of money into the economy by commercial banks

5. Marginal Standing Facility (MSF): The MSF is a facility which allows the commercial banks to borrow additional overnight money from the RBI by drawing from the SLR at a penal rate of interest. This makes the banks respond to unexpected liquidity shocks.

6. Lending Rate: These are the rates fixed by the RBI based on which money is lent to the customers. Higher the lending rate, more costly shall be the credit given to the customer. In case rates are lower, the customers can take more credit from the bank. 

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