MONETARY POLICY- KEY CONCEPTS

 

Concepts at a glance

Reserve Bank of India (RBI) draft and regulate monetary policy to regulate money supply.

Reverse Repo Transaction- Money Supply (MS) ↓ | Repo Transaction- Money Supply (MS) ↑  

Reverse Repo Rate ↑ - Money Supply (MS) ↓ | Repo Rate ↑ - Money Supply (MS) ↓

Please note Repo/Reverse Repo Transaction is different than Repo/Reverse Repo Rate.

Repo Rate is called Policy Rate, why?

-     RBI only announces Repo Rate and this is linked with Reverse Repo Rate. Hence called Policy Rate. Please note following relation:-

o   Reverse Repo = Repo Rate – 25 BPS

o   This is not commonly changed, but it can be changed.

o   This difference, between Repo Rate and Reverse Repo Rate, is called ‘Interest Spread’

  

With increase in Cash Reserve Ratio (CRR), money multiplier will reduce (Because it depend on credit creation capacity of the Bank) not the Reserve money (M₀) as the cash is parked with RBI.

 

Note- BPS (Basis Point) - 100 BPS = 1% Point

Illustration-

 

Repo Rate- Loan is given for short term against G-Securities. (G-Sec pledged to borrow money- Hence high interest rate).

Bank Rate- Loan is given for any duration against corporate securities. (Corporate securities pledges to borrow money- Hence relatively lower interest rate).

Thus Repo rate is always lower.

Repo Rate always lower than Bank Rate (BR).

BR = Repo Rate + 25 bps

Practically both cannot be equal

Common in both the above rate is that RBI give loan to the commercial Banks.

 

Banks will always borrow at Bank Rate (BR), why?

OR

If BR becomes equal to Repo Rate, at which rate Banks will borrow? [Practically both cannot be equal]

Bank will always prefer to pledge corporate securities rather than government securities. Also if they pledge G-sec then it will become encumbered security and will not be counted in SLR and thus their SLR obligation will be affected. (With BR, SLR will not be affected)

Secondly yield/returns on G-sec is relatively better than corporate securities (Commercial Paper/Commercial Bill etc.), hence Banks will try to keep the reserves preferably in G-sec.

If both becomes equal Repo Rate will become ineffective.

RBI always ready to lend at Repo rate. In order to encourage and discourage they change the rate.

RBI may not lend at Bank Rate. It is a discretion of RBI. 2008-12 BR was not operational, RBI did not lend to any Bank at Bank Rate.  (Money supply was already high hence RBI thought not to lend, also demand was high)

 

Reverse Repo is always lower, why? Why it can never be higher?

-          Reverse Repo = Repo Rate – 25 BPS

-          It will be counter-productive.