RBI and Inflation

February 15, 2018

 

RBI - a Brief Introduction

 

The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.
The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937.

It was initially set up in the interest of the foreign goverment to cater their monetory needs and access in conducting the daily business.

 

Preamble

 

The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:

"To regulate the issue of Bank notes and 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; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth."

 

Organisation and Management:


The Reserve Bank”s affairs are governed by a central board of directors. The board is appointed by the Government of India for a period of four years, under the Reserve Bank of India Act.

Full-time officials : Governor and not more than four Deputy Governors.
Nominated by Government:  ten Directors from various fields and two government Officials
Others: four Directors – one each from four local boards

 

Present Board:

 

Dr. Urjit R. Patel -> Governor
Shri N. S. Vishwanathan -> Deputy Governor
Dr. Viral V. Acharya -> Deputy Governor
Shri B.P. Kanungo -> Deputy Governor

 

MPC - Monetary Policy Committee of India


The Monetary Policy Committee of India is a committee of the Reserve Bank of India that is responsible for fixing the benchmark interest rate in India. The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.

 

->The committee comprises six members - three officials of the Reserve Bank of India and three external members nominated by the Government of India.
->The Governor of Reserve Bank of India is the chairperson ex officio of the committee.
->Decisions are taken by majority with the Governor having the casting vote in case of a tie.


Members of MPC

 

The Governor of the Bank—Chairperson, ex officio;
Deputy Governor of the Bank, in charge of Monetary Policy—Member, ex officio;
One officer of the Bank to be nominated by the Central Board—Member, ex officio;
Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) — Member
Professor Pami Dua, Director, Delhi School of Economics (DSE) — Member        
Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management (IIM) - Member
 

RBI and Inflation


In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. Accordingly, the Central Government has notified in the Official Gazette 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021.
Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India.

* As the role of RBI is to control the money flow in the economy, it becomes an underlying duty of RBI to check and control inflation.
* It is well known that money surplus and deficit causes variation in the rate of inflation.

 

Memory Map


If one can recall the Inflation Notes Link:

 

https://www.pursuitias.org/single-post/2018/02/12/Inflation
 

It was mentioned there that when the supply of money increases keeping the produce same it causes a general rise in the price of goods.


*There can be many ways in which excess supply of money can enter into the market like Parallel economy (e.g., fake currency circulation), Foreign investments in the market, Govt spendings (e.g., excess subsidies)
*Once there is excess money keeping the supply constant (this is real life situation as supply side cannot be boosted overnight, it takes time to reflect thus supply enhancement is necessarily a long term process, but we can increase it in short term by increasing imports which will increase Current account deficit).
*So proactive steps are required by RBI to absorb this surplus, which it does by following tight money policy.
*Also this might encourage a doubt that what happens if the money supply reduces.
*In that case the rate of inflation will reduce or in other words deflation will occur, which will slow down the growth rate.
*Here the RBI will inject money into the economy and we will say easy money policy is followed.

Try and visualise (Room-Rice example, I will use this name "Room-Rice" example whenever I require you to recall this)
there is a room 3 person are present Say Vaibhav, Jyoti and Vivek and there is 2kg on rice present in the room.
Vaibhav initially had Rs 10 and so did Jyoti, so its a room with 2kg of rice and Rs20 in total, so the price of each Kg of rice is Rs 10.
Everything was fine until Vaibhav thought to borrow money from one of his friend outside this room and increase his share in rice, now Vaibhav got 10 Rs more from outside equating his total amount to 20Rs.
So here comes the case where now the amount in room is Rs30 and Rice is still 2kg, so the price of rice will rise to 15Rs per kg.
Now if this thing had to be tackled up then what should be done, here Vivek is the authority who is senior to rest two, He will ask Vaibhav to lend him his extra Rs10 in assurance that he will pay him back 11Rs after 1 year.
For Vaibhav this was a profitable deal as it will fetch him interest, so he gives his money to Vivek, who will not be buying rice so this way Rs10 are out of the market of rice now this leads to initial senario where both Jyoti and Vaibhav had Rs10 each and 2kg of rice was present. So, per kg rice Costs Rs 10 gain.

Scenario-2
 In previous Example lets suppose a friend of Vaibhav needs money and he is outside the room, so Vaibhav lends him Rs5 and left with Rs5
Now if you calculate total money in the room is Rs15 with 2 kg rice to spend upon, price per Kg will fall now to Rs7.5 per Kg, which is nothing but deflation.
So now what Vivek has to do is that He lends Vaibhav Rs5(Vivek can print money or he has a reserve of money from which he can provide).
Again Market in the room comes back to same point.

 

Now that You all have understood, simply replace Vivek with RBI and multiple goods are there instead of rice alone, so this is what RBI does to control the flow of money supply in the market it either borrows or lends and this is done using various tools which will be explained further.

 

Quantitative Tools


1: Reserve Ratios (SLR and CRR)


Cash Reserve Ratio (CRR): The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such per cent of its Net demand and time liabilities (NDTL) that the Reserve Bank may notify from time to time in the Gazette of India.

Statutory Liquidity Ratio (SLR): The share of NDTL that a bank is required to maintain in safe and liquid assets, such as, unencumbered government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector.

 

*For any individual or firm sitting on the money is never a profitable affair.
*Banks earn their profits by collecting money from people into various types of accounts (Portfolios more formal term) and then later on giving other people/firms loan at an interest rate higher than what was provided to depositors.
*Now suppose one day some natural calamity occurs and people rush to their banks for withdrawing money in that case bank won't be having sufficient money to repay all depositors as maximum input would be circulating in loans, so for that case as an assurance for this calamity control RBI maintains certain amounts as a gurantee which can be provided to bank in time of need.
*its of two types first most liquid cash form called CRR and secound security form SLR.
*now if Inflation is high so naturally RBI is required to cut down the money that is present with the Banks, for this they will increase the CRR and SLR so that more money stays in RBI reserve and Banks will have less to lend.

 

2: Open Market Operation (OMO)


Open Market Operations (OMOs): These include both, outright purchase and sale of government securities, for injection and absorption of durable liquidity, respectively.

Market Stabilisation Scheme (MSS): This instrument for monetary management was introduced in 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilised is held in a separate government account with the Reserve Bank.

 

*If you recall the Room-Rice example in case of borrowing from outside the room or lending to outside the room, there was a liquidity change in the market.
* To control this excess liquidity must be soaked in case of surplus liquidity and extra liquidity must be injected in case of low liquidity.
* This can be done if RBI issues bonds in exchange of money so that they can get the extra money flowing in the market and in return the depsitor will get a bond with interest.
*In case of low liquidity RBI will purchase the bonds issued earlier and provide people with money in exchange of bonds.

 

3: Policy Rates

 

i) Bank Rate: It is the rate at which the Reserve Bank is ready to buy or rediscount bills of exchange or other commercial papers. The Bank Rate is published under Section 49 of the Reserve Bank of India Act, 1934. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes.

ii) Liquidity Adjustment Facility (LAF): The LAF consists of overnight as well as term repo auctions. Progressively, the Reserve Bank has increased the proportion of liquidity injected under fine-tuning variable rate repo auctions of range of tenors. The aim of term repo is to help develop the inter-bank term money market, which in turn can set market based benchmarks for pricing of loans and deposits, and hence improve transmission of monetary policy. The Reserve Bank also conducts variable interest rate reverse repo auctions, as necessitated under the market conditions.

iii) Repo Rate: The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).

iv) Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF.

v) Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest. This provides a safety valve against unanticipated liquidity shocks to the banking system.

 

*If a bank needs money for long term, they are given loan by RBI at the interest rate known as Bank Rate
*No collateral is required on long term loan by RBI from Bank
* If inflation is needed to be controlled then this rate is increased, to cut short the money supply to the banks, As banks will borrow less from RBI and thus will have less money to lend.

*Repo (repurchase agreement) rate short term loan
Securities as collateral

*Most important tool to control markets in Repo Rate that is why its always emphasized.
*If a Bank needs to borrow money from RBI for short term, they will pay an interest to RBI in return, and this rate of interest is called Repo Rate and bank will keep Government Securities(Bonds) as a collateral for such borrowings.
*Reverse of this is RBI borrows from Banks it will pay interest to Banks at a rate called Reverse Repo rate.

--Imp Mapping
 -> Repo Rates = Banks Borrows from RBI keeping G-secs as collateral.
-> Reverse Repo Rates = RBI Borrows from Banks (Basically reverse of Repo), Goverment is the security (nothing is more secure than the Government run institution).

*Now if Inflation is High, RBI needs to cut down money in the Banks, So it will increase Repo Rate and as the rate will be higher the banks will borrow less and thus will lend less and at a higher rate than before to people/firms further.
*Reverse Repo Rate will be low so that banks can invest money with RBI and thus extra money will flow to RBI.

*If low rate of inflation is flowing than RBI needs to inject money to system, in this case Repo Rate will be low so that banks can borrow affordably from RBI and lend to others, thus increasing the net money in flow in the markets.
*Reverse Repo Rate will be high so that banks will hesitate to invest with RBI and will invest it somewhere else leading to flow in the system only and less money returning to RBI.

 

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