Monetary Policy Mechanism

In the previous article we learnt about Central bank controlling money supply to the economy and the instruments at its disposal to achieve this objective. This article elaborates on how Central bank uses these tools to achieve its monetary policy objective.

Suppose a central bank wants to pump in more money into the economy. This is called expansionary monetary policy. Let’s see how this can be achieved using different tools:

CRR: This is the percentage of deposit that the bank is required to retain and maintain as reserve with RBI. Suppose current CRR is 6% and RBI reduces the same to 4%. The differential of 2% (6%- 4%) has now been made available to banks, they can now withdraw this amount and lend the same. Increased lending will lead to flow of money from banks into the economy, thereby accomplishing RBI’s mission.  

SLR: If the objective it to increase money supply then RBI can lower SLR. Suppose the current SLR is 18%, and RBI lowers the same to 15%. Banks can redeem the 3% differential amount and utilise the same for lending purposes. This extra money will flow into the economy.  

Open Market Operations: If the Central bank wants to increase money supply, it can buy back Government securities held by banks. This will put more funds in the hands of banks, which will then lend out the same leading to increased money supply in the economy.

Repo rate and reverse repo rate: Repo rate is the rate at which banks can borrow money from Central banks. If Central bank reduces repo rate, then banks cost of borrowing goes down. Suppose the repo rate drops from 7% to 6%, the 1% differential interest outflow that banks saved on can be utilised to lend to borrowers. Lower interest rates might also encourage banks to borrow more to lend. This will lead to more money flow into the economy.   

Reverse repo rate is the interest rate which Central banks pay other banks for funds parked with it. Lowering reverse repo rate, will lead to lesser interest earnings for banks. Hence instead of parking money with Central bank, banks will lend more to borrowers leading to increased money supply.

In a contrary situation, when central bank wants to take money out of the economy, it will reverse its decisions in all the above cases. So CRR, SLR, repo rate & reverse repo rate will all increase and Central bank will sell Government securities to suck money out of the system. This is called contractionary monetary policy.

Let’s now understand how central banks decide which economic policy, contractionary or expansionary, to pursue.