Prof. D. C. Pai

Role played by central bank monetary and

credit policy

Monetary PolicyThe objectives are to maintain price

stability and ensure adequate flow of credit to the productive sectors of the economy.

Monetary policy and fiscal policy are two important tools of macroeconomic policy.

RBI is responsible for formulating and implementing monetary policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operation, control credit and vary the reserve requirement.

RBI controls the money supply, volume of bank credit and also cost of bank credit (via the bank rate) and thereby the overall money supply in the economy.

Money supply change is technique of controlling inflationary or deflationary situation in the economy.

RBI issues monetary and credit policies annually and also reviews quarterly.

Tools of monetary controlRBI uses monetary policy by using one or more

of the following tools of monetary control these are:

CRR (cash reserve ratio)

It refers to the cash that all banks (scheduled & non scheduled) are required to maintain with the RBI as a certain percentage of their demand and time liabilities (DTL).

In order to meet these liabilities in time (that is to keep liquidity ), a bank has to keep a regulatory cash reserve with the RBI.

If bank fails to maintain the prescribed CRR at prescribed intervals it has to pay a penalty.

A cut in the CRR enhances loan able funds with the bank and reduces their on the call and term money market.

An increase in CRR will squeeze the liquidity in the banking system and reduce their lending operations and the call rate will tend to increase.

SLR (statutory liquidity ratio)

It refers to supplementary liquid reserve requirements of banks in addition to CRR.

SLR is maintained by all banks in the form of cash in hand (exclusive of the minimum CRR), current account balances with the SBI and other public sector banks, unencumbered approved securities and gold.

RBI can prescribe SLR from 0% to 40% of banks DTL.

SLR has three objectives:

To restrict expansion of banks credit.

To increase banks investment in approved securities

Ensure solvency of banks

Bank rateBank rate is the standard rate at which RBI is prepared

to by or rediscount bills of exchange or other eligible commercial paper from banks.

It is the basic costs of rediscounting and refinance facility from RBI.

Change in the bank rate by RBI affects the interest rate on loans and deposits in the banking system across the board in the same direction, if not to the same extent.

Thus RBI can affect the interest rates via changes in its bank rate , whenever the situation of the economy warrants it.

Open Market Operations (OMOs)

This refers to sale or purchase of government securities (of central or state governments or both) by RBI in the open market.

This is with a view to increase or decrease the liquidity in the banking system and thereby affect the loan able funds with the banks.

RBI can also alter the interest rate structure through its pricing policy for open market sale/ purchase.

Selective Credit Control (SCC)The RBI issues directives, under section 21 and 35A

of banking regulation act, stipulating certain restrictions on bank advances against specified sensitive commodities.

Commodities – pulses, oil seeds, oils incl. vanspati, all imported oil seeds, sugar mills, gur and khandsari, cotton and kapas, paddy/rice and wheat.

RBIs objective in issuing selective credit control (SCC) directives to prevent speculative holding of essential commodities and the resultant rise in their prices.

RBIs general guidelines on SCC are:

Banks should not allow customers dealing in SCC commodities any credit facilities that would directly or in directly defeat the purpose of SCC directives.

Credit limits against each commodities covered by SCC directives should be segregated and SCC restrictions be applied to each of such segregated limits.