CREDIT CREATION &

MONETARY POLICY
Main Functions of RBI

Monetary Authority:
Formulates implements and monitors the monetary policy.
Objective: maintaining price stability and ensuring adequate
flow of credit to productive sectors.

Regulator and supervisor of the financial system:

Prescribes broad parameters of banking operations within
which the country's banking and financial system functions.
Objective: maintain public confidence in the system, protect
depositors' interest and provide cost-effective banking services
to the public.
Main Functions of RBI

Manager of Foreign Exchange

Manages the Foreign Exchange Management Act, 1999.
Objective: to facilitate external trade and payment and promote
orderly development and maintenance of foreign exchange
market in India.

Issuer of currency:
Issues and exchanges or destroys currency and coins not fit for
circulation.
Objective: to give the public adequate quantity of supplies of
currency notes and coins and in good quality.
Main Functions of RBI

Developmental role
Performs a wide range of promotional functions to
support national objectives.

Banker to the Government: performs merchant banking

function for the central and the state governments; also
acts as their banker.

Banker to banks: maintains banking accounts of all

scheduled banks.
Earlier Aggregates: From 1970
 M0 = Currency in Circulation + Bankers' Deposits with
the RBI + 'Other' Deposits with the RBI
 M1 = Currency with the Public + Demand Deposits with
the Banking System + 'Other' Deposits with the RBI
 M2 = M1 + Post offices savings deposits
 M3 = M1  + Time Deposits with the Banking System
 M = M3 + Total Post office deposits (excluding
4  
National Savings Certificates)
Monetary Aggregates
After 1998
Weekly Compilation
 
M0 = Currency in Circulation + Bankers' Deposits
with the RBI + 'Other' Deposits with the RBI
Monetary Aggregates
M1 = Currency with the Public + Demand Deposits
with the Banking System + 'Other' Deposits with
the RBI
 
  = Currency with the Public + Current Deposits with the Banking System
+ Demand Liabilities Portion of Savings Deposits with the Banking
System + 'Other' Deposits with the RBI

 
Monetary Aggregates
M2 = M1 + Time Liabilities Portion of Savings Deposits with the
Banking System + Certificates of Deposit issued by Banks +
Term Deposits of residents with a contractual maturity of up to
and including one year with the Banking System (excluding
CDs)
 
 
  = Currency with the Public + Current Deposits with the Banking
System + Savings Deposits with the Banking System + Certificates of
Deposit issued by Banks + Term Deposits of residents with a
contractual maturity up to and including one year with the Banking
System (excluding CDs) + 'Other‘ Deposits with the RBI
Monetary Aggregates
 
 
 

M3 = M2 + Term Deposits of residents with a

contractual maturity of over one year with
the Banking System + Call/Term borrowings
from 'Non-depository‘ Financial
Corporations by the Banking System
 
 Monetary Aggregates
Broad and Narrow Money
How the banks create money?

Glen Echo Bank Balance Sheet (1)

Initial Balance
Assets Liabilites

Loans $ 80.0 $100.0

Deposits
Outstanding million million

Government
13.0 million Net Worth 3.0 million
debt

Required
10.0 million
Reserves

103.0 103.0
Total Total
million million
How the banks create money?

Glen Echo Bank Balance Sheet (Add $1.0 million deposit from you)

Assets Liabilities

Loans
$ 80.9 million Deposits $101.0 million
Outstanding

Government
13.0 million Net Worth 3.0 million
debt

Required
10.1 million
Reserves

Total 104.0 million Total 104.0 million

How the banks create money?

Glen Echo Bank Balance Sheet

(Add $0.9 million deposit)
After $0.9 million deposit

Assets Liabilites

Loans Outstanding $81.71 millionDeposits $101.9 million

Government debt 13.00 millionNet Worth 3.0 million

Required Reserves 10.19 million

Total 104.90 millionTotal 104.9 million

How the banks create money?

Several things have occurred due to deposit of

$900,000 in the Glen Echo Bank.

 Total deposits increased from $101 million to $101.9 million.

 Required reserves increased by $90,000 (= $900,000 x .10).
 Total required reserves increased from $10.1 million to $10.19
million.
 The bank was able to lend out the difference between the deposit
($900,000) and required reserves ($90,000), an amount equal to
$810,000.
 Outstanding loans increased from $80.9 million to $81.71 million
($80.9 + 0.810)
 Table Sources:

Individual Amount
Lent Out Reserves
Bank Deposited

A 100 80 20
B 80 64 16
C 64 51.2 12.8
D 51.2 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
H 20.97 16.78 4.19
I 16.78 13.42 3.36
J 13.42 10.74 2.68
K 10.74    

      Total Reserves:
      89.26

Total Reserves +
Total Amount Total Amount Lent Last Amount
  of Deposits: Out: Deposited:
  457.05 357.05 100
Money Multiplier
The money multiplier as equal to

= 1/r.r.
This formula stems from the fact that the sum of the "amount loaned out" column above can be
expressed mathematically as a geometric series with a common ratio of 1 − R

In reality there are a number of leakages from the above scenario that will reduce the value of the
multiplier:
 People may not deposit all of their cash into the banking system. Besides the money we keep in our
wallets, we may save some of our money outside the depository banking system.

 Banks may not loan out all potential reserves, choosing to keep excess reserves.
 Balance sheet of RBI
 Monetary aggregates
Monetary Liabilities of RBI
 High Powered Money: Monetary Liabilities of RBI
+ Government Money
 Monetary Liabilities of RBI = Currency with the
Public + Reserves + ‘Other’ Deposits with RBI
 Reserves = Vault cash + Deposits with RBI +
Excess Reserves
Tools of Monetary Policy
Three monetary policy tools—
open market operations,
reserve requirements and
discount window lending.
Open Market Operations
The most effective tool the RBI has is the buying
and selling of government securities in its open
market operations. Government securities include
gilt edged bonds, notes, and bills.
Open Market Operations
Open market operations serve:
 to steer short-term interest rates,

 to manage the liquidity situation in the money

market, and
 to signal the stance of monetary policy
Open Market Operations
When the RBI Eases When the RBI Tightens

RBI buys government securities from a firm that RBI sells government securities to a firm that
deals in them. deals in them.

It pays by crediting the account that the dealer’s It pays by debiting the account that the
bank has at the RBI. dealer’s bank has at the RBI.

The bank in turn credits the dealer’s account. The bank in turn debits the dealer’s account.

The banking system has more funds to lend. The banking system has fewer funds to lend.

Downward pressure on the RBI funds rate—the Upward pressure on the RBI funds rate.

interest rate banks charge each other for  
overnight loans.

Influences other interest rates in the economy— Other interest rates in the economy also
which also go down. rise as a result.

Gives the economy a boost. Slows the economy and curbs inflation.

Open Market Operations
 The RBI buys bonds from banks.
 Bank reserves and the monetary base increase.
 Banks don't want money sitting in their vaults, earning zero return, so they
attempt to loan out the money.
 To attract borrowers, banks lower the interest rates that they charge.
 The businesses and individuals who borrow the money from the banks spend
it on goods and services.
 These expenditures create incomes that are deposited into the banking system.
 The money supply increases by a greater amount than the original RBI
purchase of bonds because of the money multiplier.
 Increases in investment activity by businesses will increase aggregate demand
and the growth rate of GDP.
Discount Window Lending
Discount rate is the interest rate that the RBI charges banks for
short-term loans. Changes in the discount rate typically occur in
conjunction with changes in the Bank rate.

Discount Rate Impact on Policy

Economic
Activity

Raised Slows Check

economic inflation
activity

Lowered Stimulates Economic

economic growth
activity
Reserve Requirements
Reserve requirements are the percentages of certain
types of deposits that banks must keep on hand in
their own vaults or on deposit at a Reserve Bank of
India. 

Reserve Impact on
requirement bank lending

Raised Reduce lending

Lowered Increase
lending
Cash Reserve Ratio
 The Reserve Bank, having regard to the needs of securing the monetary
stability in the country, can prescribe Cash Reserve Ratio (CRR) for
scheduled banks without any floor rate or ceiling rate. 
[Earlier, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per
cent of total of their demand and time liabilities].

 RBI uses CRR either to drain excess liquidity or to release funds

needed for the economy from time to time. Increase in CRR means that
banks have less funds available and money is sucked out of circulation. 

 Thus we can say that this serves duel purposes i.e. it not only ensures
that a portion of bank deposits is totally risk-free, but also enables RBI
to  control liquidity in the system, and thereby, inflation by tying the 
hands of the banks in lending money.
Statutory Liquidity Ratio
Statutory Liquidity Ratio (SLR) is a term used in
the regulation of banking in India. It is the amount
which a bank has to maintain in the form:
 Cash
 Gold valued at a price not exceeding the current market price,
 Unencumbered approved securities (Government securities or Gilts come under
this) valued at a price as specified by the RBI from time to time.
Statutory Liquidity Ratio
The objectives of SLR are:
 To restrict the expansion of bank credit.

 To augment the investment of the banks in

Government securities.
 To ensure solvency of banks. A reduction of SLR

rates looks eminent to support the credit growth in

India.
Difference between SLR & CRR

 SLR restricts the bank’s leverage in pumping more money into the
economy. On the other hand, CRR, , is the portion of deposits that the
banks have to maintain with the Central Bank.

 The other difference is that to meet SLR, banks can use cash, gold or
approved securities whereas with CRR it has to be only cash. CRR is
maintained in cash form with RBI, whereas SLR is maintained in liquid
form with banks themselves.
Liquidity Adjustment Facility
Liquidity Adjustment Facility (LAF) was introduced by RBI
during June, 2000 in phases, to ensure smooth transition and
keeping pace with technological up gradation.

Objective : The funds under LAF are used by the banks for
their day-to-day mismatches in liquidity. 

Tenor :Under the scheme, Reverse Repo auctions (for

absorption of liquidity) and Repo auctions (for injection of
liquidity) are conducted on a daily basis (except Saturdays).
Repo and Reverse Repo

 Repo (Repurchase) rate is the rate at which the RBI lends shot-term money to the banks.
When the repo rate increases borrowing from RBI becomes more expensive.  Therefore,
we can say that in case,  RBI wants to make it more expensive for the banks to borrow
money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to
borrow money, it reduces the repo rate.

 Reverse Repo rate is the rate at which banks park their short-term excess liquidity with
the RBI.  The RBI uses this tool when it feels there is too much money floating in the
banking system.  An increase in the reverse repo rate  means that the RBI will borrow
money from the banks at a higher rate  of interest. As a result, banks would prefer to keep
their money with the RBI

Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in
the banking system by RBI, whereas Reverse repo rate signifies the rate at which the
central bank absorbs liquidity from the banks
Market Stabilization Scheme (MSS)

 Reserve Bank has proposed to the Government of India to authorize issuance

of existing debt instruments, viz., Treasury Bills and dated securities up to a
specified ceiling to be mutually agreed upon between the Government and
the Reserve Bank.

 The bills/bonds issued under MSS would have all the attributes of the
existing Treasury Bills and dated securities.

 The Reserve Bank will decide and notify the amount, tenure and timing of
issuance of such treasury bills and dated securities. Whenever such securities
are issued by the Reserve Bank for the purpose of market stabilization and
sterilization, a press release at the time of issue would indicate such purpose.
 Monetary Policy Stance
Latest Important Banking  Sector  Data

 Bank Rate
6.00%
 
 Cash Reserve Ratio (CRR) 6.00

 Statutory Liquidity Ratio (SLR)

25%(w.e.f. 07/11/2009)Increased from 24% which was continuing since.
08/11/2008

 Reverse Repo Rate

6.25%

 Repo Rate under LAF

5.25%
Expansionary Monetary Policy
Contractionary Monetary Policy
Policy Lags
Time lags that occur between the onset of an economic problem and the
full impact of the policy intended to correct the problem.
Policy lags come in two broad categories:
 inside lag (getting the policy activated)
* recognition lag,
* decision lag, and
* implementation lag.
 outside lag (the subsequent impact of the policy).
* impact lag.
Policy lags can reduce the effectiveness of business-cycle stabilization
policies and can even destabilize the economy. Policy lags, especially
inside lags, are often different for monetary policy than for fiscal policy.
Monetary Policy
Can be made ineffective:
 In times of recession

 Increase in velocity of money

 Volatile currency – deposit ratio

 Demand for Credit