1

SL.No Topics PAGE

NO.

1

Introduction
About RBI
History of RBI
Structure of RBI


2
3
4
7


2

Monetary policy in State of economy
Global Economic
Domestic Economic


9
9
9

3

Monetary Policy
Meaning
Objectives
Tools of monetary policy
New methods adopted by RBI

13
14
14
15
25

4

Affect of monetary policy
Change in CRR,SLR and Bank Rate
View by Ex-PM
Thought of Ex governor of RBI


28
29
29

5

Challenges To Monetary Policy

30

6

Monetary Policy in different countries

31

7

Bibliography

36

2


INTRODUCTION

The Annual Policy for 2013-14 is formulated in an environment of incipient signs of stabilisation
in the global economy and prospects of a turnaround, albeit modest, in the domestic economy.


In the advanced economies (AEs), near-term risks have receded, aided by improving financial
conditions and supportive macroeconomic policies. But this improvement is yet to fully transmit
to economic activity which remains sluggish. Policy implementation risks and uncertainty about
outcomes continue to threaten the prospects of a sustained recovery. Emerging and developing
economies (EDEs) are in the process of a multi-speed recovery. However, weak external demand
and domestic bottlenecks continue to restrain investment in some of the major emerging
economies. Inflation risks appear contained, reflecting negative output gaps and the recent
softening of international crude and food prices.

Domestically, growth slowed much more than anticipated, with both manufacturing and services
activity hamstrung by supply bottlenecks and sluggish external demand. Most lead indicators
suggest a slow recovery through 2013-14. Inflation eased significantly in Q4 of 2012-13
although upside pressures remain, both at wholesale and retail levels, stemming from elevated
food inflation and ongoing administered fuel price revisions. The main risks to the outlook are
the still high twin deficits accentuated by the vulnerability to sudden stop and reversal of capital
flows, inhibited investment sentiment and tightening supply constraints, particularly in the food
and infrastructure sectors.













3



ABOUT RBI

The Reserve Bank of India (RBI) is India's central banking institution, which controls
the monetary policy of the Indian rupee. It was established on 1 April 1935 during the British
Raj in accordance with the provisions of the Reserve Bank of India Act, 1934. The share capital
was divided into shares of 100 each fully paid, which were initially owned entirely by private
shareholders. Following India's independence in 1947, the RBI was nationalised in the year
1949.
The RBI plays an important part in the development strategy of theGovernment of India. It is a
member bank of the Asian Clearing Union. The general superintendence and direction of the
RBI is entrusted with the 21-member Central Board of Directors: the Governor (currently Dr.
Raghuram Rajan), four Deputy Governors, two Finance Ministry representative, ten government-
nominated directors to represent important elements from India's economy, and four directors to
represent local boards headquartered at Mumbai, Kolkata, Chennai and New Delhi. Each of these
local boards consists of five members who represent regional interests, as well as the interests of
co-operative and indigenous banks.
The bank is also active in promoting financial inclusion policy and is a leading member of
the Alliance for Financial Inclusion (AFI).












4











CD Deshmukh Raghuram Rajan
(1
st
Indian governor of rbi) (present governor rbi)


HISTORY

19351950


The Reserve Bank of India was founded on 1 April 1935 to respond to economic troubles after
the First World War. RBI was conceptualized as per the guidelines, working style and outlook
presented by Dr Ambedkar as written in his book The Problem of the Rupee Its origin and its
solution. in front of the Hilton Young Commission.The bank was set up based on the
recommendations of the 1926 Royal Commission on Indian Currency and Finance, also known as
the HiltonYoung Commission. The original choice for the seal of RBI was The west india Company
Double Mohur, with the sketch of the Lion and Palm Tree. However it was decided to replace the lion
with the tiger, the national animal of India. The Preamble of the RBI describes its basic functions to
regulate the issue of bank notes, keep reserves to secure monetary stability in India, and generally
to operate the currency and credit system in the best interests of the country. The Central Office of
the RBI initially established in Calcutta (now Kolkata), but was permanently moved to Bombay (now
Mumbai) in 1937. The RBI also acted as Burma's central bank, except during the years of
the Japanese occupation of Burma (194245), until April 1947, even though Burma seceded from
the Indian Union in 1937. After the Partition of India in 1947, the Bank served as the central bank
for Pakistan until June 1948 when the State Bank of Pakistan commenced operations. Though

5


originally set up as a shareholders bank, the RBI has been fully owned by the Government of India
since its nationalization in 1949.

19501960
In the 1950s the Indian government, under its first Prime Minister Jawaharlal Nehru, developed a
centrally planned economic policy that focused on the agricultural sector. The administration
nationalized commercial banks and established, based on the Banking Companies Act of 1949
(later called the Banking Regulation Act), a central bank regulation as part of the RBI.
Furthermore, the central bank was ordered to support the economic plan with loans.

19601969
As a result of bank crashes, the RBI was requested to establish and monitor a deposit insurance
system. It should restore the trust in the national bank system and was initialized on 7 December
1961. The Indian government founded funds to promote the economy and used the slogan
"Developing Banking". The government of India restructured the national bank market and
nationalized a lot of institutes. As a result, the RBI had to play the central part of control and
support of this public banking sector.

19691985
In 1969, the Indira Gandhi-headed government nationalized 14 major commercial banks. Upon
Gandhi's return to power in 1980, a further six banks were nationalized. The regulation of the
economy and especially the financial sector was reinforced by the Government of India in the
1970s and 1980s.The central bank became the central player and increased its policies for a lot of
tasks like interests, reserve ratio and visible deposits. These measures aimed at better economic
development and had a huge effect on the company policy of the institutes. The banks lent
money in selected sectors, like agri-business and small trade companies.

The branch was forced to establish two new offices in the country for every newly established
office in a town. The oil crises in 1973 resulted in increasing inflation, and the RBI restricted
monetary policy to reduce the effects.


19851991
A lot of committees analysed the Indian economy between 1985 and 1991. Their results had an
effect on the RBI. TheBoard for Industrial and Financial Reconstruction, the Indira Gandhi
Institute of Development Research and the Security & Exchange Board of India investigated the

6


national economy as a whole, and the security and exchange board proposed better methods for
more effective markets and the protection of investor interests. The Indian financial market was a
leading example for so-called "financial repression" (Mackinnon and Shaw). The Discount and
Finance House of India began its operations on the monetary market in April 1988; the National
Housing Bank, founded in July 1988, was forced to invest in the property market and a new
financial law improved the versatility of direct deposit by more security measures and
liberalization.


19912000
The national economy came down in July 1991 and the Indian rupee was devalued. The currency
lost 18% relative to the US dollar, and the Narsimham Committee advised restructuring the
financial sector by a temporal reduced reserve ratio as well as the statutory liquidity ratio. New
guidelines were published in 1993 to establish a private banking sector. This turning point should
reinforce the market and was often called neo-liberal. The central bank deregulated bank
interests and some sectors of the financial market like the trust and property markets.

This first
phase was a success and the central government forced a diversity liberalisation to diversify
owner structures in 1998. The National Stock Exchange of India took the trade on in June 1994
and the RBI allowed nationalized banks in July to interact with the capital market to reinforce
their capital base. The central bank founded a subsidiary companytheBharatiya Reserve Bank
Note Mudran Limitedin February 1995 to produce banknotes.


Since 2000
The Foreign Exchange Management Act from 1999 came into force in June 2000. It should
improve the item in 20042005 (National Electronic Fund Transfer).The Security Printing &
Minting Corporation of India Ltd., a merger of nine institutions, was founded in 2006 and
produces banknotes and coins.
The national economy's growth rate came down to 5.8% in the last quarter of 20082009

and the
central bank promotes the economic development.





7


Structure

Central Board of Directors
The Central Board of Directors is the main committee of the Central Bank. TheGovernment of
India appoints the directors for a 4-year term. The Board consists of a Governor, and not more
than 4 Deputy Governors, 15 Directors to represent the regional boards, 2 from the Ministry of
Finance and 10 other directors from various fields..


Governors
The current Governor of RBI is Raghuram Raja. There are 3 Deputy Governors, Deputy
Governor H R Khan, Dr Urjit Patel and R Gandhi. Dr. Urjit Patel became Deputy Governor in
January 2013. Two of the Deputy Governors are traditionally from RBI ranks, and are selected
from the Bank's Executive Directors. As for the rest, one is nominated from among the
Chairpersons of Public Sector Bank, and the other is an economist of repute.



Supportive bodies
The Reserve Bank of India has four regional representations: North in New Delhi, South in
Chennai, East in Kolkata and West in Mumbai. The representations are formed by five members,
appointed for four years by the central government and servebeside the advice of the Central
Board of Directorsas a forum for regional banks and to deal with delegated tasks from the
central board. The institution has 22 regional offices.
The Board of Financial Supervision (BFS), formed in November 1994, serves as a CCBD
committee to control the financial institutions. It has four members, appointed for two years, and
takes measures to strength the role of statutory auditors in the financial sector, external
monitoring and internal controlling systems.
The Tarapore committee was set up by the Reserve Bank of India under the chairmanship of
former RBI deputy governor S. S. Tarapore to "lay the road map" to capital account
convertibility. The five-member committee recommended a three-year time frame for complete
convertibility by 19992000.

8


On 1 July 2007, in an attempt to enhance the quality of customer service and strengthen the
grievance redressal mechanism, the Reserve Bank of India created a new customer service
department.


Offices and branches
The Reserve Bank of India has four zonal offices. It has 19 regional offices at most state capitals
and at a few major cities in India. Few of them are located
in Ahmedabad,Bangalore, Bhopal,Bhubaneswar, Chandigarh, Chennai, Delhi, Guwahati,Hydera
bad, Jaipur, Jammu, Kanpur, Kolkata, Lucknow, Mumbai, Nagpur, Patna
and Thiruvananthapuram. It also has 9 sub-offices located
in Agartala, Dehradun, Gangtok, Kochi, Panaji, Raipur, Ranchi, Shillong, Shimla and Srinagar.
The bank has also two training colleges for its officers, viz. Reserve Bank Staff College at
Chennai and College of Agricultural Banking at Pune. There are also four Zonal Training
Centres at Mumbai, Chennai, Kolkata and New Delhi.






9


Monetary policy at the state of Economic

Global economic

Global economic activity remains subdued amidst signs of diverging growth paths across major
economies. In the US, a slow recovery is taking hold, driven by improvements in the housing
sector and employment conditions. However, the pace of recovery remains vulnerable to the
adverse impact of the budget sequestration which will gradually gain pace in the months ahead.
Japans economy stopped contracting in Q4 of 2012. There has been some improvement in
consumer confidence on account of monetary and fiscal stimulus along with a pick-up in
external demand on the back of a weakening yen. In the euro area, recessionary conditions,
characterised by deterioration in industrial production, weak exports and low domestic demand,
continued into Q1 of 2013. High unemployment, fiscal drag and hesitant progress on financial
sector repair have eroded consumer confidence.

Growth in several EDEs rebounded from the moderation in 2012 as domestic demand rose on a
turnaround in the inventory cycle and some pick-up in investment. Among BRICS countries,
growth accelerated in Brazil and South Africa, while it persisted below trend in China, Russia
and India.
Inflation has remained benign in the AEs in the absence of demand pressures, and inflation
expectations remain well-anchored. The EDEs, on the other hand, present a mixed picture. While
inflation has picked up in Brazil, Russia and Turkey, it has eased in China, Korea, Thailand and
Chile.

Reflecting a pessimistic demand outlook, crude oil prices eased in March-April 2013 from the
elevated levels prevailing through 2012. Non-energy commodity prices have been easing
through Q1 of 2013 on softening metal prices and decline in food prices.



Domestic Economic

With the expansion of only 4.5 percent in Q3 of 2012-2013, the lowest in 15qudters, cumulative
GDP growth for 2 the period April-December 2012 declined to 5.0 per cent from 6.6 per cent a
year ago. This was mainly due to the protracted weakness in industrial activity aggravated by
domestic supply bottlenecks, and slowdown in the services sector reflecting weak external

10


demand. The Central Statistics Office (CSO)s advance estimate of GDP growth for 2012-13 of
5.0 per cent implies that the economy would have expanded by 4.7 per cent in Q4.


The growth of industrial production slid to 0.6 per cent in February 2013 from 2.4 per cent a
month ago, mainly due to contraction in mining and electricity generation and slowing growth in
manufacturing. Consequently, on a cumulative basis, growth in industrial production decelerated
to 0.9 per cent during 2012-13 (April-February) from 3.5 per cent in the corresponding period of
the previous year. The Reserve Banks order books, inventories and capacity utilisation survey
(OBICUS) suggest that capacity utilization remained flat. Rabi production, particularly of pulses,
is expected to be better than a year ago. However, it may not fully offset the decline in kharif
output. Consequently, the second advance estimates of crop production (kharif and rabi) for
2012-13 indicate a decline of 3.5 per cent in relation to the final estimates of the previous year.
The composite purchasing managers index ( P M I ) , Which encompasses manufacturing and
services, fell to a 17-month low in March 2013. Thus, most recent indicators suggest that growth
in Q4 of 2012-13 would have remained low.


On the demand side, the persisting decline in capital goods production during April 2012
February 2013 reflects depressed investment conditions. The moderation in corporate sales and
weakening consumer confidence suggest that the slowdown could be spreading to consumption
spending.


Headline inflation, as measured by the wholesale price index (WPI), moderated to an average of
7.3 per cent in 2012-13 from 8.9 per cent in the previous year. The easing was particularly
significant in Q4 of 2012-13, with the year-end inflation recording at 6.0 per cent.
Notwithstanding the moderation in overall inflation, elevated food price inflation was a source of
upside pressure through the year owing to the unusual spike in vegetable prices in April 2012
followed by rise in cereal prices on account of the delayed monsoon and the sharp increase in the
minimum support price (MSP) for paddy. Fuel inflation averaged in double digits during 2012-
2013 largely reflecting upward revision in administered price and the pass through high
international crude price to freely priced items. Non food manufactured products inflation ruled
above the comfort level in the first half of 2012-13 but declined in the second half to come down to 3.5
per cent by March, reflecting easing of input price pressures and erosion of pricing power.

Largely driven by food inflation, retail inflation, as measured by the new combined (rural and
urban) consumer price index (CPI) (Base: 2010=100), averaged 10.2 per cent during 2012-13.
Even after excluding food and fuel groups, CPI inflation remained sticky, averaging 8.7 per cent.
Other CPIs also posted double digit inflation.
Significantly , inflation expectations polled by the Reserve Banks urban households survey,

11


showed slight moderation in Q4 of 2012-13, even as they remained in double digits, reflecting
high food prices. Wage inflation in rural areas, which rose by an average of close to 20 per cent
over the period April 2009 to October 2012, declined modestly to 17.4 per cent in January 2013.
House price inflation, as measured by the Reserve Banks quarterly house price index, continued
to rise on a y-o-y basis.

An analysis of corporate performance during Q3 of 2012-13, based on a common sample of
2,473 non - government non - financial companies, indicates that growth of sales as well as
profits decelerated significantly.Early results of corporate performance in Q4 indicate continuing
moderation in sales though profit margins increased slightly.

Money supply (M
3
) growth was around 14.0 per cent during Q1 of 2012-13 but decelerated
thereafter to 11.2 percent by end-December as time deposit growth slowed down. There was
some pick up in deposit mobilisation in Q4, taking deposit growth to 14.3 per cent by end-
March. Consequently, M
3
growth reached 13.3 per cent by end-March 2013, slightly above the
revised indicative trajectory of 13.0 per cent.

Non food credit growth decelerated from 18.2 per cent at the beginning of 2012-13 and
remained close to 16.0 per cent for the major part of the year. By March 2013, non-food credit
growth dropped to 14.0 per cent, lower than the indicative projection of 16.0 per cent, reflecting
some risk aversion and muted demand. While the Reserve Banks credit conditions survey
showed easing of overall credit conditions, there was some tightening for sectors such as metals,
construction, infrastructure, commercial real estate, chemicals and finance in Q4 of 2012-13.


The total flow of resources to the commercial sector from banks, non-banks and external sources
was higher at `12.8 trillion in 2012-13 as compared with `11.6 trillion in the previous year. This
increase was accounted for by higher non-SLR investment by scheduled commercial banks
(SCBs), increase in credit flow from NBFCs, gross private placement and public issues by non-
financial entities, and higher recourse to short-term credit from abroad and external commercial
borrowings.

In consonance with the cuts in the policy repo rate and the cash reserve ratio (CRR) during 2012-
13, the modal term deposit rate declined by 11 basis points (bps) and the modal base rate by 50
bps. While the decline in the term deposit rate occurred mostly during the first half, the modal
base rate softened by 50 bps to 10.25 per cent in two steps of 25 bps each during Q1 and Q4 of
2012-13. During Q4, 39 banks reduced their base rates in the range of 5-75 bps. The weighted
average lending rate of banks declined by 36 bps to 12.17 per cent during 2012- 13(up to
February).

12



Liquidity remained under pressure throughout the year because of persistently high government
cash balances with the Reserve Bank and elevated incremental credit to deposit ratio for much of
the year. The net average liquidity injection under the daily liquidity adjustment facility (LAF),
at `730 billion during the first half of the year, increased significantly to `1,012 billion during the
second half. In order to alleviate liquidity pressures, the Reserve Bank lowered the CRR of SCBs
cumulatively by 75 bps on three occasions and the statutory liquidity ratio (SLR) by 100 bps
during the year. Additionally, the Reserve Bank injected liquidity to the tune of `1,546 billion
through open market operation (OMO) purchase auctions. The net injection of liquidity under
the LAF, which peaked at `1,808 billion on March 28, 2013 reflecting the year-end demand,
reversed sharply to `842 billion by end-April 2013.

The revised estimates (RE) of central government finances for 2012-13 show that the gross fiscal
deficit-GDP ratio at 5.2 per cent was around the budgeted level and within the target set out in
the revised roadmap. Budget estimates (BE) for 2013-14 place the gross fiscal deficit-GDP ratio
at 4.8 per cent. The envisaged correction is expected to be achieved through a reduction of
0.6percentage points in the revenue deficit-GDP ratio.


On the back of the policy rate reduction and the announcement of a slew of reform measures by
the Government and a firm commitment to fiscal consolidation, the 10-year benchmark yield
eased from 8.79 per cent on April 3, 2012 to 7.79 per cent on April 30, 2013.


The current account deficit (CAD) came in at an all-time high of 6.7 per cent of GDP in Q3 of
2012-13. There are indications that it may have narrowed in Q4. The narrowing was largely on
account of the trade deficit declining, with exports returning to positive growth after contracting
in the first three quarters and non-oil non-gold imports and gold imports declining. Even as the
CAD expanded, the surge in capital inflows in the second half of the year ensured that it could be
fully financed.







13



Monetary policy
Monetary policy is the process by which monetary authority of a country, generally a central
bank controls the supply of money in the economy by exercising its control over interest rates in
order to maintain price stability and achieve high economic growth. In India, the central
monetary authority is the Reserve Bank of India (RBI). is so designed as to maintain the price
stability in the economy.

1. Slack season policy April September
2. Busy season policy October march






Role of RBI

One of the most important functions of central banks is formulation and execution of monetary
policy. In the Indian context, the basic functions of the Reserve Bank of India as enunciated in
the Preamble to the RBI Act, 1934 are:to regulate the issue of Bank notes and the keeping of
reserves with a view to securing monetary stability in India and generally to operate the currency
and credit system of the country to its advantage.

Thus, the Reserve Banks mandate for monetary policy flows from its monetary stability
objective. Essentially, monetary policy deals with the use of various policy instruments for
influencing the cost and availability of money in the economy. As macroeconomic conditions
change, a central bank may change the choice of instruments in its monetary policy. The overall
goal is to promote economic growth and ensure price stability.











14





Monetary Policy Meaning.

Monetary policy is the macroeconomic policy laid down by
the central bank. It involves management of money supply
and interest rate and is the demand side economic policy
used by the government of a country to achieve
macroeconomic objectives like inflation, consumption,
growth and liquidity.

Reserve Bank of India states that

Monetary policy refers to the use of instruments under the
control of the central bank to regulate the availability, cost
and use of money and credit







Objectives

Price Stability
Price Stability implies promoting economic development with considerable emphasis on price
stability. The centre of focus is to facilitate the environment which is favourable to the
architecture that enables the developmental projects to run swiftly while also maintaining
reasonable price stability.

Controlled Expansion Of Bank Credit
One of the important functions of RBI is the controlled expansion of bank credit and money
supply with special attention to seasonal requirement for credit without affecting the output.

Promotion of Fixed Investment
The aim here is to increase the productivity of investment by restraining non essential fixed
investment.

Restriction of Inventories

15


Overfilling of stocks and products becoming outdated due to excess of stock often results is
sickness of the unit. To avoid this problem the central monetary authority carries out this
essential function of restricting the inventories. The main objective of this policy is to avoid
over-stocking and idle money in the organization

Promotion of Exports and Food Procurement Operations
Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an
independent objective of monetary policy.

Desired Distribution of Credit
Monetary authority has control over the decisions regarding the allocation of credit to priority
sector and small borrowers. This policy decides over the specified percentage of credit that is to
be allocated to priority sector and small borrowers.

Equitable Distribution of Credit
The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all
social and economic class of people

To Promote Efficiency
It is another essential aspect where the central banks pay a lot of attention. It tries to increase the
efficiency in the financial system and tries to incorporate structural changes such as deregulating
interest rates, ease operational constraints in the credit delivery system, to introduce new money
market instruments etc.

Reducing the Rigidity
RBI tries to bring about the flexibilities in the operations which provide a considerable
autonomy. It encourages more competitive environment and diversification. It maintains its
control over financial system whenever and wherever necessary to maintain the discipline and
prudence in operations of the financial system.



Element of monetary policy
Quantitative measure:-
1. bank rate
2. open market operations
3. cash reserve ratio
4. statuary reserve ratio
Qualitative measures

16


1. rationing of credit
2. moral suasion
3. direct action
4. regulation in consumer credit
5. change in margin requirement

Quantitative measure


Open Market Operations
An open market operation is an instrument of monetary policy which involves buying or selling
of government securities from or to the public and banks. This mechanism influences the reserve
position of the banks, yield on government securities and cost of bank credit. The RBI
sells government securities to contract the flow of credit and buys government securities to
increase credit flow. Open market operation makes bank rate policy effective and maintains
stability in government securities market.


OMOs is an actively used technique of monetary control in the US, the UK and many other
countries. Through the open market sales and purchases of government securities, the RBI can
affect the reserve position of banks, yields on government securities, and volume and cost of
bank credit. However, it is the technique least used by the bank, through it has wide powers to it.
There is no reaction the quality or maturity of government securities which it can buy or sell or
hold. Technically, the bank can conduct OMOs in treasury bill, state government, central
government securities; but, in practice they are conducted only in central government securities
of all maturities.

Process of open market
Since most money now exists in the form of electronic records rather than in the form of paper,
open market operations are conducted simply by electronically increasing or decreasing
(crediting or debiting) the amount of base money that a bank has in its reserve account at the
central bank. Thus, the process does not literally require new currency. However, this will
increase the central bank's requirement to print currency when the member bank demands
banknotes, in exchange for a decrease in its electronic balance.

17


When there is an increased demand for base money, the central bank must act if it wishes to
maintain the short-term interest rate. It does this by increasing the supply of base money. The
central bank goes to the open market to buy a financial asset, such as government bonds. To pay
for these assets, bank reserves in the form of new base money (for example newly printed cash)
are transferred to the seller's bank and the seller's account is credited. Thus, the total amount of
base money in the economy is increased. Conversely, if the central bank sells these assets in the
open market, the amount of base money held by the buyer's bank is decreased, effectively
reducing base money.
The process works because the central bank has the authority to bring money in and out of
existence. They are the only point in the whole system with the unlimited ability to produce
money. Another organization may be able to influence the open market for a period time, but the
central bank will always be able to overpower their influence with an infinite supply of money.


How open market operation are conducted
Indias Open Market Operation is much influenced by the fact that it is a developing country and
that the capital flows are very different from those in developed countries. Thus Reserve Bank
Of India, being the Central Bank of the country, has to make policies and use instruments
accordingly. Prior to the 1991 financial reforms, RBIs major source of funding and control over
credit and interest rates was the CRR (Cash reserve ratio) and the SLR (Statutory Liquidity
Ratio). But after the reforms, the use of CRR as an effective tool was de-emphasized and the use
of open market operations increased. OMOs are more effective in adjusting market liquidity.

The two traditional type of OMOs used by RBI:
1. Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
2. Repurchase agreement (REPO): Is short term, and are subject to repurchase. However, even after
sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And
thus, on the recommendations of the Narsimham Committee Report (1998), The RBI brought
together a Liquidity Adjustment Facility (LAF). It commenced in June, 2000, and it was set up to
oversee liquidity on a daily basis and to monitor market interest rates. For the LAF, two rates are
set by the RBI: repo rate and reverse repo rate. The repo rate is applicable while selling securities
to RBI (daily injection of liquidity), while the reverse repo rate is applicable when banks buy
back those securities (daily absorption of liquidity). Also, these interest rates fixed by the RBI
also help in determining other market interest rates.

18


India experiences large capital inflows every day, and even though the OMO and the LAF
policies were able to withhold the inflows, another instrument was needed to keep the liquidity
intact. Thus, on the recommendations of the Working Group of RBI on instruments of
Sterilization (December, 2003), a new scheme known as the Market stabilization scheme (MSS)
was set up. The LAF and the OMOs were dealing with day to day liquidity management,
whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring.
According to this scheme, the RBI issues additional T-bills and securities to absorb the liquidity.
And the money goes into the Market Stabilization scheme Account (MSSA). The RBI cannot use
this account for paying any interest or discounts and cannot credit any premiums to this account.
The Government, in collaboration with the RBI, fixes a ceiling amount on the issue of these
instruments.
[12]

But for an open market operation instrument to be effective, there has to be an active securities
market for RBI to make any kind of effect on the liquidity and rates of interest.




Cash Reserve Ratio

Cash Reserve Ratio is a certain percentage of bank deposits which banks are required to keep
with RBI in the form of reserves or balances .Higher the CRR with the RBI lower will be
the liquidity in the system and vice-versa.RBI is empowered to vary CRR between 15 percent
and 3 percent. But as per the suggestion by the Narsimham committee Report the CRR was
reduced from 15% in the 1990 to 5 percent in 2002. As of October 2013, the CRR is 4.00
percent.

Every commercial bank has to keep certain minimum cash reserves with RBI. Consequent upon
amendment to sub-Section 42(1), the Reserve Bank, having regard to the needs of securing the
monetary stability in the country, RBI can prescribe Cash Reserve Ratio (CRR) for scheduled
banks without any floor rate or ceiling rate, [Before the enactment of this amendment, in terms
of Section 42(1) of the RBI Act, the Reserve Bank could prescribe CRR for scheduled banks
between 5% and 20% of total of their demand and time liabilities]. RBI uses this tool to increase
or decrease the reserve requirement depending on whether it wants to effect a decrease or an
increase in the money supply. An increase in Cash Reserve Ratio (CRR) will make it mandatory
on the part of the banks to hold a large proportion of their deposits in the form of deposits with
the RBI. This will reduce the size of their deposits and they will lend less. This will in turn

19


decrease the money supply. The current rate is 4.00%.. -25 basis points cut in Cash Reserve
Ratio(CRR) on 17 September 2012, It will release Rs 17,000 crore into the system/Market. The
RBI lowered the CRR by 25 basis points to 4.25% on 30 October 2012, a move it said would
inject about 175 billion rupees into the banking system in order to pre-empt potentially
tightening liquidity. The latest CRR is 4%

Statutory Liquidity Ratio
Every financial institution has to maintain a certain quantity of liquid assets with themselves at
any point of time of their total time and demand liabilities. These assets can be cash, precious
metals, approved securities like bonds etc. The ratio of the liquid assets to time and demand
liabilities is termed as the Statutory liquidity ratio.There was a reduction of SLR from 38.5% to
25% because of the suggestion by Narshimam Committee. The current SLR is 23%.


Apart from the CRR, banks are required to maintain liquid assets in the form of gold, cash and
approved securities. Higher liquidity ratio forces commercial banks to maintain a larger
proportion of their resources in liquid form and thus reduces their capacity to grant loans and
advances, thus it is an anti-inflationary impact. A higher liquidity ratio diverts the bank funds
from loans and advances to investment in government and approved securities.The latest SLR as
on 14/12/13 is 22.50% In well-developed economies, central banks use open market
operationsbuying and selling of eligible securities by central bank in the money marketto
influence the volume of cash reserves with commercial banks and thus influence the volume of
loans and advances they can make to the commercial and industrial sectors. In the open money
market, government securities are traded at market related rates of interest. The RBI is resorting
more to open market operations in the more recent years. Generally RBI uses three kinds of
selective credit controls:
1. Minimum margins for lending against specific securities.
2. Ceiling on the amounts of credit for certain purposes.
3. Discriminatory rate of interest charged on certain types of advances.
Direct credit controls in India are of three types:
1. Part of the interest rate structure i.e. on small savings and provident funds, are administratively
set.
2. Banks are mandatory required to keep 23% of their deposits in the form of government
securities.
3. Banks are required to lend to the priority sectors to the extent of 40% of their advances.


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Bank Rate Policy
The bank rate, also known as the discount rate, is the rate of interest charged by the RBI for
providing funds or loans to the banking system. This banking system involves commercial and
co-operative banks, Industrial Development Bank of India, IFC, EXIM Bank, and other approved
financial institutes. Funds are provided either through lending directly or rediscounting or buying
money market instruments like commercial bills and treasury bills. Increase in Bank Rate
increases the cost of borrowing by commercial banks which results into the reduction in credit
volume to the banks and hence declines the supply of money. Increase in the bank rate is the
symbol of tightening of RBI monetary policy. As of 1 January 2013, the bank rate was 8.75%
and as on 21 June 2014 bank rate is 9%.

In India, the bank rate is the rate at which the Reserve Bank of India lends to commercial banks
and other financial institutions for meeting shortfalls in their reserve requirements, for long-term
purposes. The current Bank rate is overnight rate + 200 basis points.




Qualitative measures

Credit Ceiling

In this operation RBI issues prior information or direction that loans to the commercial banks
will be given up to a certain limit. In this case commercial bank will be tight in advancing loans
to the public. They will allocate loans to limited sectors. Few example of ceiling are agriculture
sector advances, priority sector lending.

Credit Authorization Scheme

Credit Authorization Scheme was introduced in November, 1965 when P C Bhattacharya was the
chairman of RBI. Under this instrument of credit regulation RBI as per the guideline authorizes
the banks to advance loans to desired sectors.

Moral Suasion
Moral Suasion is just as a request by the RBI to the commercial banks to take so and so action
and measures in so and so trend of the economy. RBI may request commercial banks not to give
loans for unproductive purpose which does not add to economic growth but increases inflation.


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Repo Rate and Reverse Repo Rate
Repo rate is the rate at which RBI lends to commercial banks generally against government
securities. Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and
increase in Repo rate discourages the commercial banks to get money as the rate increases and
becomes expensive. Reverse Repo rate is the rate at which RBI borrows money from the
commercial banks. The increase in the Repo rate will increase the cost of borrowing and lending
of the banks which will discourage the public to borrow money and will encourage them to
deposit. As the rates are high the availability of credit and demand decreases resulting to
decrease in inflation. This increase in Repo Rate and Reverse Repo Rate is a symbol of
tightening of the policy. As of October 2013, the repo rate was 7.75 % and reverse repo rate was
6.75%. On January 28, 2014, RBI raised repo rate by 25 basis points to 8.00 % and reverse repo
rate by 25 basis points to 7.00%.

Characteristic of repo

1. Overnight repos are 1 day loans;
2. Term repos have terms of greater than 1 dayusually weeks to months.
3. The firm that makes the loan for a repo, usually a bank, has a reverse repo position
which is simply the opposite side of a repo.
4. An open repo is a contractual relationship that allows the borrower to borrow funds up to
a certain limit, without signing a new contractsomewhat like an open credit
arrangement.



Determinates of Repo rate

The repo rate for a particular transaction depends on the following factors:

a) Credit quality: like most other securities, the interest rate varies inversely with the credit
quality of the issuerthe higher the credit quality, the lower the repo rate.

b) Liquidity: greater liquidity lowers trading costs and, therefore, the repo rate.


c) Delivery: if the collateral must be physically delivered, the lender will charge a higher
repo rate to cover its cost.

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d) Collateral availability: if the collateral is a special issue that is hard to get, the seller of
the collateral will be able to obtain a lower repo rate from a lender that needs the
collateral.

Advantages of repo

1. Repos can provide a variety of advantages to the financial market in general & in debt
markets in particular; significantly:

2. Repo is a tool for funding transactions.


3. For institutions and corporate entities, repos provide a source of relatively inexpensive
finance.

4. Central banks can use repo and reverse repo as an integral part of their open market
operations with the objective of injecting/withdrawing liquidity into and from the market
and also to reduce volatility in short term in particular in call money rates.


Impact of REPO

Inflation :
1. The interest rate channel affects the demand for goods and services.

2. Higher interest rates normally lead to a reduction in household consumption. This
happens for several reasons.


3. Higher interest rates make it more attractive to save, in other words to postpone
consumption, thus lowering present consumption.

4. Consumption also falls because existing loans now cost more in terms of interest
payments.

Credit channel:

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1. The credit channel describes the way in which monetary policy affects demand via banks
and other financial institutions.

2. If the interest rate rises, banks choose to decrease their lending and instead buy bonds.


3. This means that households and companies find it more difficult to borrow money.

4. Companies that are either unable or unwilling to borrow must cut back their activities,
postpone investment and so on, and this dampens activity in the economy.


Exchange rate:

1. The exchange rate channel describes how monetary policy affects the value of the
currency.
2. Normally, an increase in the repo rate leads to a strengthening of the currency.

3. In the short term, this is because higher interest rates make Swedish assets more
attractive than investments denominated in other currencies.
4. The result is a capital inflow and increased demand for kronor, which strengthens the
exchange rate.
5. Monetary policy also plays an important part for the exchange rate in the long term.

Inflation:-

1. The way in which changes in the repo rate affect inflation and the rest of the economy is
known as the transmission mechanism.

2. The transmission mechanism is actually not one but several different mechanisms that
interact.


3. Some of these have a more or less direct impact on inflation while others take longer to
have an effect.

4. It is generally held that a change in the repo rate has its greatest impact on inflation

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25


New method adopted By RBI

Liquidity adjustment facility :-
Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow
money through repurchase agreements.
LAF is used to aid banks in adjusting the day to day mismatches in liquidity. LAF consists of
repo and reverse repo operations. Repo or repurchase option is a collaterised lending i.e. banks
borrow money from Reserve bank of India to meet short term needs by selling securities to RBI
with an agreement to repurchase the same at predetermined rate and date. The rate charged by
RBI for this transaction is called the repo rate. Repo operations therefore inject liquidity into the
system. Reverse repo operation is when RBI borrows money from banks by lending securities.
The interest rate paid by RBI is in this case is called the reverse repo rate. Reverse repo operation
therefore absorbs the liquidity in the system. The collateral used for repo and reverse repo
operations are Government of India securities. Oil bonds have been also suggested to be included
as collateral for Liquidity adjustment facility.
Liquidity adjustment facility has emerged as the principal operating instrument for modulating
short term liquidity in the economy. Repo rate has become the key policy rate which signals the
monetary policy stance of the economy.
The origin of repo rates, one of the component of liquidity adjustment facility, can be traced to as
early as 1917 in U.S financial market when war time taxes made other sources of lending
unattractive . The introduction of Liquidity adjustment facility in India was on the basis of the
recommendations of Narsimham committee on banking sector reforms. In April 1999, an interim
LAF was introduced to provide a ceiling and the fixed rate repos were continued to provide a
floor for money market rates. As per the policy measures announced in 2000, the Liquidity
Adjustment Facility was introduced with the first stage starting from June 2000 onwards.
Subsequent revisions were made in 2001 and 2004. When the scheme was introduced, repo
auctions were described for operations which absorbed liquidity from the system and reverse
repo actions for operations which injected liquidity into the system. However in international
nomenclature, repo and reverse repo implied the reverse. Hence in October 2004 when revised
scheme of LAF was announced, the decision to follow the international usage of terms was
adopted.
Repo and reverse repo rates were announced separately till the monetary policy statement in
3.5.2011. In this monetary policy statement, it has been decided that the reverse repo rate would
not be announced separately but will be linked to repo rate. The reverse repo rate will be 100
basis points below repo rate. The liquidity adjustment facility corridor, that is the excess of repo
rate over reverse repo, has varied between 100 to 300 basis points. The period between April

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2001 to March 2004 and June 2008 to early November 2008 saw a broader corridor ranging from
150-250 and 200-300 basis points respectively. During March 2004 to June 2008 the corridor
was narrow with the rates ranging from 100-175 basis points. A narrow LAF corridor is reflected
from November 2008 onwards. At present the width of the corridor is 100 basis points. This
corridor is used to contain any volatility in short term interest rates.


Market stabilization Scheme

This scheme came into existence following a MoU between the Reserve Bank of India (RBI) and
the Government of India (GoI) with the primary aim of aiding the sterilization operations of the
RBI.
Historically, the RBI had been sterilizing the effects of significant capital inflows on domestic
liquidity by offloading parts of the stock of Government Securities held by it. It is pertinent to
recall, in this context, that the assets side of the RBIs Balance Sheet (July 1 to June 30) includes
Foreign Exchange Reserves and Government Securities while liabilities are primarily in the form
of High Powered Money (consisting of Currency with the public and Reserves held in the RBI
by the Banking System). Thus, any rise in Foreign Exchange Reserves resulting from the
intervention of the RBI in the Foreign Exchange Markets (with the intention, say, to maintain the
exchange rate on the face of huge capital inflows) entails a corresponding rise in High Powered
Money. The Money Supply in the economy is linked to High Powered Money via the money
multiplier. Therefore, on the face of large capital inflows, to keep the liabilities side constant so
as to not raise the Supply of Money, corresponding reduction in the stock of Government
Securities by the RBI is necessary.
The MSS was devised since continuous resort to sterilization by the RBI depleted its limited
stock of Government Securities and impaired the scope for similar interventions in the future.
Under this scheme, the GoI borrows from the RBI (such borrowing being additional to its normal
borrowing requirements) and issues Treasury-Bills/Dated Securities that are utilized for
absorbing excess liquidity from the market. Therefore, the MSS constitutes an arrangement
aiding in liquidity absorption, in keeping with the overall monetary policy stance of the RBI,
alongside tools like the Liquidity Adjustment Facility (LAF) and Open Market Operations
(OMO).
The securities issued under MSS, termed as Market Stabilization Scheme (MSS)
Securities/Bonds, are issued by way of auctions conducted by the RBI and are done according to
a specified ceiling mutually agreed upon by the GoI and the RBI. They possess all the attributes
of existing Treasury-Bills/Dated Securities and are included as a part of the countrys internal
Central Government debt.

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The amount raised under the MSS does not get credited to the Government Account but is
maintained in a separate cash account with the RBI and are used only for the purpose of
redemption/buy back of Treasury-Bills/Dated Securities issued under the scheme.
However, following the global financial crisis of 2008, that necessitated fiscal stimulus
measures, an amendment to the original MoU between the RBI and the GoI in February 2009
allowed the Government to convert a portion of the MSS funds into normal government
borrowing for financing its stimulus expenditure requirements.
Treasury-Bills/Securities issued under MSS are matched by equivalent cash balances that are
held by the Government with the RBI. Such payments are not made from the MSS account just
as receipts due to premium or accrued interest on these Securities are not credited to it.
As and when MSS securities are issued by the RBI as well as the annual ceiling, when decided,
is notified through a press release. For the fiscal year 2010-11 the annual ceiling for such
securities outstanding stand at Rs. 50,000 crore, with a review due when the outstanding reaches
the threshold of Rs. 35,000 crore.





















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Affect of Monetary Policy


Bank Rate:
Lending capacity of commercial bank reduces.
Thus loan becomes EXPENSIVE.
Contraction of credit.




CRR/SLR:
Reduces reserve for lending.
Contacting credit.




Bank Rate:
Bank gets loans at cheaper rate.
Thus even they lend at low interests.
Expansion of credit.





CRR/SLR:
More funds with bank.
So more credit to public.







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EX-PMs view at the Monetary Policy

I think we expect the Governor to evolve a policy with
the help of professional persons for a national consensus
if we have to carry on with implementing social and
economic changes in a complex economy, The remarks
assume significance in the context of the raging debate
over RBI's hawkish policy stance on checking inflation
vis a vis government priority on growth.

"The time has come to look at the possibilities and
limitations of the monetary policy in a globalised economy and dealing with the constraints of
the macro economic problems


Thoughts from the ex-Governor
The debate on growth-inflation balance has been clouded by some "oversimplifications".
One such oversimplification is to say that governments are for growth and central banks are for
price stability.
Another oversimplification is to assert that there is a
tension between growth and inflation, and that one
necessarily has to play the trade-off between growth
and inflation in policy making"





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Challenges to monetary policy
1. The growing importance of assets and assets price in a globally integration economy
complicates the conduct of monetary policy when it is a focused on and equipped to
address price stability issues.

2. With the growing integration of financial markets domestically, these is greater activism
in liquidity management with special focus on short end of the market spectrum. As
liquidity management acquires overriding importance, the evolving solvency conditions
of financial intermediaries may get obscured in the short-run.


3. There is considerably difficulty faced by monetary authorities in detecting and
measuring inflation especially inflation expectations. Recent experience in regard to
impact, if increases in oil prices show that ignoring the structural or permanent elements
of shocks may slow down appropriate monetary policy responses ,especially if the focuse
is on CORE INFALTION.

4. Reserve bank faces the dilemma of grappling with the inherently volatile increasing
capital flows relative to domestic absorptive capacity.

5. In the emerging scenario of large and uncertain capital flows, the choices of the
instrument for sterilization and othe policy response have been constrained.

6. In the liberalization process, aligning the operation of large financial conglomerates and
foreign institution with local public policy priorities remains a challenge for domestic
financial regulation.

7. Domestic of all big financial intermediaries increases the concentration risk.








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Monetary policy in other countries
The period since the 1990 has witnesses some convergence in the conduct of monetary policy,
worldwide. The objectives, targets and operating procedures of monetary policy worldwide have
witnessed considerable shifts in tune with the evaluation of monetary theory, central banking
regimes and the changing macroeconomic conditions over time. By 1970s, most central bank
accepted price stability as key objective of monetary policy. In recent year, beyond the
traditional growth inflation trade-off, financial stability has emerged as another key objective in
the wake of growing financial markets integration as\d associated uncertainty and volatility
arising out of contagion. Although a number of central bank is developed countries such as the
Reserve Bank of New Zealand, Reserve Bank of Australia and the Bank of England have
adopted price stability as their sole objective by adopting an inflation targeting framework,
several other countries, US and Japan continue to pursue dual objective of price stability and
growth. Similarly, while some emerging markets economics (EMEs) such as South Africa,
Thailand, Korea and Mexico have emphasized solely price stability by adopting an inflation
targeting framework, some other tends to follow multiple objectives.
As central bank throughout the world could not always directly target the ultimate objectives,
monetary policy focused on intermediates targets that bear close relationship with the final
objective. The selection of intermediates targets is conditional on the channel of monetary policy
transmission that operates in the economy. Although countries differ in terms of the choice of
instruments, they could be broadly classified on the basis of their key operating i.e. Interest rate.
In the first category are countries such as the US, Japan, Canada, and Australia, where the key
operating targets is the overnight inter-bank rate through the signaling strategies differ. In the
case of other developed countries such as the ECB, the key policy rate is tender rate that is
applicable to regular operations, mainly the refinancing operations. Some central banks, however
in countries such as the UK, select overnight markets interest as their operating targets consistent
with official Bank rate decided by the MPC. In general, the maturity of such interest rate varies
from 1 to 2 weeks but could range between 1 or 2 days to 1 month.
The operating targets in the case of several EMEs also are the overnight rate determined in the
interbank markets for settlement balances (Korea and Malaysia). In order to promote financial
stability, central banks, being the monopolistic suppliers of primary liquidity, have endeavored to
Smoothen the movements in the overnight rate with a high degree of precision through calibrated
modulation of bank reserves. Central banks have generally refrained from strict control of
interest rate as it deters the development of money markets. Allowing the volatility in other rate
to absorbed temporary pressure could enable central bank to preserve stability in other money
market policy.
The operating procedures of monetary policy and liquidity management have also changed in
response to the change in the policy environment amidst financial liberalization. The literature

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and the central bank own accounts attribute five main reasons reforms in their operating
procedures in the industrial countries during 1980s and the 1990s(Mehran et al., 1996).
1. Monetary policy instruments were changed to adapt to the new operational frameworks
of respective monetary policy authorities.
2. With Financial deepening occurring more or less entirely outside the central bank
balance sheets, the share of the financial systems over which monetary authorities had
direct control was reduced, warranting indirect ( price oriented as opposed to quality-
oriented instruments) ways to control the non-financial monetary components of
liquidity in the financial systems.

3. In the wake of expansion, diversification and integration of financial markets all over the
world, greater interest rate flexibility and narrowing of differential between rates of
returns in different currencies warranted instruments that can impart flexibility to
liquidity management in terms of the timing, magnitude and accuracy.

4. The growing important of expectations in financial markets favored the adoption of
instruments that are better suited for signaling monetary policy

5. There was a growing urge on the part of central bank to stimulate money market activity
and improved monetary policy transmission while emphasizing the separation of
monetary and government debt management objectives.


As a result of the changes in the policy environment, the following trends could be observed at
the international level, particularly during the 1990s.
1. There has been a continuous reduction in reserve requirements. The marked
international trend towards reduction reserve requirements over the last decade
reflect the conscious policy effort to reduce the tax on intermediation with a view to
reduce the burden of institutions and generate a level of playing field for both
between different types of domestic institution and increasingly those across national
borders.

2. There has been growing emphasis on active liquidity management driven partly by
the pressure of increasingly mobile international capital and decline in reserve
requirements. The main instruments for liquidity management by the central banks
are discretionary market operation. Standing facilities have become safety valves
rather than the key mechanisms for setting the interest rate.


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3. Among wide array of monetary policy instruments repos have almost become the
main policy tool, which could be consider a major milestone in the development of
money market. It is widely believed that the growth of the collateralized repo market
has played an important role in enhancing the overall stability of the financial
systems is removing counterparty risk through funded traded credit protection against
risky transaction in unsecured wholesale financial markets.

4. Greater flexibility in the liquidity management has been accompanied by a greater
transparency in the policy signals relating to desired interest rate levels, driven by the
broader changes in the economic and political environment, including the decline I
inflation to relatively low level, growing emphasis on inflation targeting, greater
autonomy and accountability of central bank and growing influence of market forces
and expectations in the formation of interest rates.


















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Operating procedure of liquidity management in developing countries
Country objective Intermediari
es/
Operating
Targets
Key instrument of discretionary liquidity Frequency of
market
operations
CRR OMO REPO Standing
Facilitie
s
others
USA To promote
maximum
sustainable output,
employment and
stable price
Federal Funds yes yes yes yes Daily
UK Price stability Overnight
market,
interest rate,
consistent
with bank rate
yes yes yes yes One per week
plus one per
month (long
term repo)
Japan Price stability & to
contribute to the
development of
national eco.
Overnight call
money market
yes yes yes yes More than one
per day
Australia Mainly price
stability,
maintenance of full
employment,
economic prosperity
& welfare
cash rate yes yes yes daily
Canada Low & stable
inflation
Overnight rate yes yes Twice a day
Mexico Price stability Bank reserve yes yes yes yes Daily
China Stability of the
currency & promote
economic growth
Money supply
& excess
reserves
yes yes yes yes Policy
oriented
financial
bonds
&central
bonds
1 or 2 per
week

35










India Growth, price &
financial stability
Overnight rate yes Yes yes Yes Market
stabiliza
tion
schemes
Twice a day
repo
Malaysia Monetary
&financial stability
for growth
Overnight call
rate
yes yes yes yes Bank
Negara
bills
Twice a day
Singapor
e
Price stability Weighted
exchange rate
yes yes yes yes Forex
swaps &
reserve
swaps
Twice a day

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Bibliography
Website:-
1. www.RBI.org.in/

2. www.wikipeda.org

3. www.airticlebusiness.com



4. www.indianpolicy.org.in

5. www.vipanronam.com

6. www.kbharti.in

7. www.crunchslideshare.com



Books:-
1. Financial institution and markets Mr. Jitendra Mahakuad

2. Monetary policy and financial stability- Mr. C. Rangrajan

3. Macroeconomic Mr. D. N. Dwivedi





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