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Direct regulation:
Cash Reserve Ratio (CRR): Commercial Banks are required to hold a certain proportion of their deposits in
the form of cash with RBI. CRR is the minimum amount of cash that commercial banks have to keep with the
RBI at any given point in time. RBI uses CRR either to drain excess liquidity from the economy or to release
additional funds needed for the growth of the economy.
For example, if the RBI reduces the CRR from 5% to 4%, it means that commercial banks will now have to keep
a lesser proportion of their total deposits with the RBI making more money available for business. Similarly, if
RBI decides to increase the CRR, the amount available with the banks goes down.
Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the
form of gold or government approved securities before providing credit to the customers. SLR is stated in terms
of a percentage of total deposits available with a commercial bank and is determined and maintained by the
RBI in order to control the expansion of bank credit. For example, currently, commercial banks have to keep
gold or government approved securities of a value equal to 23% of their total deposits.
Indirect regulation:
Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate. Whenever
commercial banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI
increases the Repo Rate, it makes borrowing expensive for commercial banks and vice versa. As a tool to
control inflation, RBI increases the Repo Rate, making it more expensive for the banks to borrow from the RBI
with a view to restrict the availability of money. The RBI will do the exact opposite in a deflationary environment
when it wants to encourage growth.
Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse
repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest
rate to commercial banks to park their money with the RBI. This results in a reduction in the amount of money
available for the banks customers as banks prefer to park their money with the RBI as it involves higher safety.
This naturally leads to a higher rate of interest which the banks will demand from their customers for lending
money to them.
The RBI issues annual and quarterly policy review statements to control the availability and the supply of
money in the economy. The Repo Rate has traditionally been the keyinstrument of monetary policy used by
the RBI to fight inflation and to stimulate growth.
1. The value of currency is allowed to fluctuate freely according to changes in demand and
supply of foreign exchange.
2. There is no official (Government) intervention in the foreign exchange market.
3. Flexible exchange rate is also known as Floating Exchange Rate.
4. The exchange rate is determined by the market, i.e. through interactions of thousands of
banks, firms and other institutions seeking to buy and sell currency for purposes of making
transactions in foreign exchange.
For, Merits and demerits of flexible exchange rate system, refer Power Booster.
Fixed Exchange Rate System Vs Flexible Exchange Rate System:
Fixed
Basis
Flexible
It is officially
It is determined
fixed in terms
by forces of
Rate:
by government. exchange.
There is
There is no
complete
government
government
intervention and
according to
Government
Control:
to change it.
conditions.
The exchange
rate generally
remains stable
Stability in
and only a
The exchange
Exchange
Rate:
is possible.
changing.