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Heard about the recent reserve requirements changes by RBI? Wondering why the RBI is selling or purchasing securities? Well, these are some of the monetary instruments used by the central bank to control the money supply in the economy. The aim of the monetary policy of a country is to maintain the money supply in the economy to achieve the economic objectives of price stability, full employment, balance of payments and economic development. The major macroeconomic variables of importance in monetary policy are money supply and interest rates. It is the change in the money supply in the economy that governs the availability of credit in the economy.
Tight money policy
In a contractionary monetary policy, the central bank of the country uses its tools to reduce the money supply in the economy. With lesser money supply in the market, the funds become expensive and interest rates rise and the credit lending ability of the banks are reduced. Loans and borrowings become more expensive; investors ability to buy more assets gets reduced due to higher borrowing costs and lower availability of funds and therefor assets depreciate in value which leads to a decrease in aggregate demand. Demand also gets reduced when consumers put off purchases which require funding - vehicles, white goods etc - because interest rates are too high for their comfort. The quantity of credit demanded decreases as the opportunity cost of holding money by the public also becomes high. RBi would typically follow a tight money policy when it wants to control inflation, when it is concerned about too much speculative purchases of assets and when it wants to cool down an overheating economy which is growing too fast on borrowed money.
Easy money or loose money policy
In an expansionary monetary policy, the monetary authority uses its powers to increase the money supply in the economy. With more money circulating in the market, funds become easily accessible and banks lower their interest rates as they have plenty of money for lending. Funds become cheaper and loans and borrowings become cheaper. Assets increase in value as investors are encouraged by easy access to cheap finance to borrow and invest in assets - these could be homes, equities, commodities etc. Overall demand in the economy also increases as consumers are encouraged by availability of cheap finance to buy more - either for consumption or for investment - using borrowed funds. Vehicles, white goods, homes etc are typical purchases that are encouraged by availability of cheap finance.
The central bank uses its monetary tools to indirectly influence the inflation. It does so by bringing in a change in the nominal interest rates so as to change the real interest rates. A change in the real interest rates affects the consumption and investment which ultimately leads to a change in the aggregate demand.
Tools of monetary policy
The monetary authority of a country has both quantitative and qualitative instruments available for controlling the money supply.
Quantitative instruments
1. Reserve Requirements: The commercial banks have to keep a certain percentage of their deposit liabilities as statutory reserves with the central bank of the country. This gives the power to the monetary authority to influence the credit lending availability of the commercial banks. The most popular reserve ratio used by the central bank is the cash reserve ratio. When the central bank increases the reserve requirements, the commercial banks have to maintain more reserves with the central bank and hence have lesser funds available for lending purposes. For example, if RBI stipulates that the CRR should be 10% and SLR should be 25%, it means that for every Rs. 100 that a bank collects as a deposit from an investor, Rs. 10 have to be maintained as balance with RBI and a further Rs. 25 needs to be invested by the bank in approved Government securiies (Statutory Lending Ratio - SLR). This leaves only Rs. 65 available to the bank to lend out either to its corporate clients or retail clients as home loans etc. If CRR is brought down from 10% to 5%, automatically, Rs. 5 out of every Rs. 100 that the bank is holding as deposits are now freed up for commercial lending. Lowering the reserve requirements is typically done when RBI wants to encourage lending activity, while higher reserve requirements are normally stipulated when RBI wishes to curtain lending activity. When reserve requirements increase, funds become scarce and expensive and commercial banks raise their interest rates for lending. Similarly, decreasing the reserve requirements leaves the commercial banks with more funds at their disposal. As a result, interest rates decline and funds become cheaper.
2. Bank rate/Discount rate: Whenever the commercial banks are unable to maintain the reserves at the required level and there is shortage of reserves in the entire system, the commercial banks can directly borrow reserves from the central bank. The central bank lends these reserves at the discount rate or the bank rate. The central bank uses this bank rate as an instrument to alter the money supply. When they want to reduce the money supply, the central bank increases this rate and lends at a higher rate to the commercial banks. The bank rate serves as a basis for the commercial banks to decide their own lending rates. As funds become expensive for them, they pass the higher expense to the borrowers by charging them higher interest rates. Similarly, when the central bank wants to makes easy funds available in the economy, it decreases the bank rate which leads the commercial banks to reduce their own lending rates and make cheaper credit available in the market. This is expansionary monetary policy.
3. Open market operations: In open market operations, the central bank purchases and sells securities in the open market. When the central bank wants to increase the money supply, it holds an open market purchase of securities. On purchasing of securities, the central bank pays to the lenders and makes available the funds in the market to increase the credit creation. This leads to a decrease in the interest rates as the yields fall. Similarly, when the central bank sells the securities, it drains out the funds in the market and decreases the credit creation leading to a rise in the yield and of the interest rates. Thus, the central bank can influence the aggregate demand for credit.
Qualitative instruments
Sometimes, the central bank of the country issues directives to the commercial banks on the type of credit to be extended. This may be in the form of the terms and amount of credit availability. This is done by the central bank to ensure that only desirable and non speculative lending takes place. For example, RBI places a limit of Rs. 20 lakhs that can be granted as a loan against shares and mutual funds - this limit is in place to curb too much of speculative activity on borrowed funds. Likewise, RBI from time to time prescribes additional capital requirements for loans that banks extend to real estate developers. When banks have to set aside additional capital against real estate loans, that automatically serves as a disincentive for banks to lend to that sector, and if they still wish to lend, they will obviously charge a much higher rate of interest, to cover the cost of additional scarce capital that has to be earmarked against such loans. In this way, RBI can reduce the availability and increase cost of loans to a sector that it believes is leading to speculative excesses. On the flip side, RBI has priority sector lending norms in place - where banks must lend a certain minimum percentage of their overall loans to sectors that are of national priority - these could include agri sector, small scale industries etc.
Inside lag and outside lag
Monetary policy has a lesser 'inside lag' than fiscal policy but a greater 'outside lag'. What this means is that monetary policy can be changed anytime by the central bank as and when it deems the changes are fit. However, the effect of these changes on the macroeconomic variables such as output, employment etc takes time to show up. This is because the monetary policy has an indirect effect in changing the credit availability and hence the aggregate demand.
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