Monetary Policy Liquidity Related Tools

Monetary policy is a set of actions taken by a country's central bank or government by using monetary tools to regulate factors such as interest rates, money supply, and credit availability under the control of the central bank to achieve the ultimate goal of economic policy. The Reserve Bank of India (RBI) is responsible for conducting monetary policy in India.

Before learning about various monetary policy tools used by RBI to control the money supply in the economy, let us see with an example how commercial banks do money creation in an economy.

For the sake of simplicity, we assume that:

• There is a single banking system in the economy, and initially, the bank receives deposits of Rs. 1000.
  
• Cash Reserve Ratio is 10%, and it does not change
  

(and so on till all excess reserves are exhausted)

In the above table, you can see that,

• In the first round, the bank receives deposits of Rs. 1,000.
  

• The cash reserve ratio to handle liability of Rs. 1,000 is equal to Rs 100 (because CRR is 10% of the total deposit). Now, banks have excess reserves of Rs. 900 (1000 – 100), which can be used for lending/giving loans.
  

• When the excess reserves (Rs. 900) are loaned out, deposits of the banks are increased by Rs. 900. The banks need to hold cash reserves equal to 10% of Rs. 900 which is Rs. 90. Now, the excess reserve of the bank is Rs. 810 (900 – 90) which can be used for lending/giving loans. This process continues until total deposits are Rs. 10,000, and the cash reserves are Rs. 1,000.
  

• Thus, if the cash reserve ratio is 10%, the initial deposit of Rs 1,000 allows the bank to create demand deposits up to Rs. 10,000.
  

From the above example, we can say that money creation by commercial banks depends on two principal factors as under:

(i) Cash balance with the banks, which they can use for the creation of credit. The Higher the cash balances, the greater the money creation.
(ii) Higher the cash reserve Ratio (CRR) lower the capacity to create money.

Now, let us understand various monetary policy instruments of credit control or to control of the money supply in the economy.

1. Cash Reserve Ratio

From the above example of money creation, you might have an idea of what the cash reserve ratio is!

It refers to the minimum percentage of the bank’s total deposits required to be kept with RBI. The RBI fixes the cash reserve ratio, which can vary from time to time to regulate the supply of money in the economy.

The current CRR (as of 30th July 2024) fixed by RBI is 4.50%.

In an economy, when there is a need to increase the supply of money, the RBI lowers CRR. Whereas when there is a need to decrease the money supply, the RBI raises CRR.

Impact of increase and decrease of CRR in an economy:

To control inflation in an economy, the RBI will increase the Cash Reserve Ratio (CRR). This means that for a given amount of demand deposit, more money will be required to be kept as reserves. For example, if the earlier CRR was 10% and the demand deposit was Rs. 1,000, the amount of CRR was Rs. 100. However, if the CRR is increased to 20%, the amount of CRR will be Rs. 200. This reduction in the amount of money available to banks will lead to a decrease in the money supply, which helps control inflation.

To control deflation in an economy, the RBI will decrease the Cash Reserve Ratio (CRR), which will result in a decrease in the cash reserve for a given amount of demand deposit. For example, if the CRR was 10% and the demand deposit was Rs. 1,000, the amount of CRR was Rs. 100. If the CRR is increased to 20%, the amount of CRR will be Rs. 200. This decrease in CRR will lead to an increase in the money supply, ultimately helping to control deflation.

2. Statutory Liquidity Ratio ( SLR )

The Statutory Liquidity Ratio (SLR) is the minimum percentage of deposits a commercial bank must maintain in the form of liquid cash, gold, or other securities. It represents the reserve requirement that banks are expected to keep before offering credit to customers. The SLR is fixed by the RBI and can vary from time to time to regulate the supply of money in the economy. The government uses the SLR to regulate inflation and fuel growth.

The current SLR (as of 30th July 2024) fixed by RBI is 18.00%.

Impact of increase and decrease of SLR in an economy:

To control inflation in an economy, RBI will increase SLR, which will lead to an increase in liquid assets to be held by commercial banks, leading to a decrease in the money supply of the commercial bank. Thus, inflation is controlled.

To control deflation in an economy, RBI will decrease SLR which will lead to a decrease in liquid assets to be held by commercial banks, leading to an increase in the money supply of the commercial bank. Thus, deflation is controlled.

3. Open Market Operation

Open market operations refer to the sale and purchase of securities in the open market by RBI on behalf of the government. By selling securities (like National Saving Certificates- NSCs) in the open market, the RBI soaks liquidity(cash) from the economy. And, by buying the securities, the RBI releases liquidity.

Impact of Sale and purchase of securities by RBI in an economy:

To control inflation in an economy, RBI will sell securities on behalf of the government, which will lead to the soaking of liquidity and leads to a fall in cash reserves of the commercial banks, leading to a fall in the credit creation capacity of commercial banks that further leads to fall in money supply. Thus, inflation is controlled.

To control deflation in an economy, RBI purchases securities on behalf of the government, which releases liquidity and increases commercial banks' cash reserves. This increases commercial banks' credit creation capacity, which in turn increases the money supply. Thus, inflation is controlled.

CRR, SLR, and Open market operations are the liquidity-related tools of monetary policy as they affect the liquidity or supply of money in an economy. In the next chapter, we will focus on interest rate tools of monetary policy.