Banking & Monetary Policy

As it was discovered, the money supply in India has been moderated by the Reserve Bank of India, the central bank. They employ a set of core monetary instruments in order to stabilize the economy, bring inflation and other factors into check, and foster growth.

1. Repo and Reverse Repo Rates: The RBI also changes the repurchasing rate at which banks can borrow from the RBI and the redeeming rate at which the RBI can borrow from the banks. Variation of these rates is employed by the RBI to control credit creation in the economy leading to impacted money availability in the economy.

2. Cash Reserve Ratio (CRR): CRR is the proportion of the deposit, which banks are required to maintain with the RBI. CRR uplifting makes the credit available for lending to be scarce and therefore constrict money supply, while its trimming, has the reverse effect.

3. Statutory Liquidity Ratio (SLR): Net demand and time liabilities are also specified as a minimum percentage to be reserved on approved securities. SLR change influences the banking liquidity and ability to approve loans.

4. Open Market Operations (OMOs): To control the money supply, RBI also buys or offers government securities on the market. The sale of securities absorb funds from the market, on the other hand, purchase returns funds into the market.

5. Market Stabilization Scheme (MSS): This tool was introduced to remove excess in the money supply; whereby its work is done through issuing government securities available for absorption of extra money.

Collectively, these tools help make a certain that RBI runs a steady economy in relations to inflation, currency value and availably of credit.

Monetary policy can be defined as the available tools that a country’s central bank uses to direct the money supply of its economy and increase economic growth and employment through such operations as altering interest rates or changing bank reserve requirements.

Tools of Monetary Policy
Monetary policy is employed by central banks in practice through various tools and devices. Some of the very common tools include:

Open Market Operations
The central bank buys or sells government securities, like bonds, in the open market. When the central bank purchases securities, it adds money in the economy; hence, there is more money. When it sells securities, it takes off some money in the economy, hence less money.

Reserve Requirements
Imagine the central banks as the headmaster of all banks. Central banks have rules for how small an amount of money each commercial bank should reserve in their vaults. A teacher might say, You should always carry at least 5 pencils in your bag. Changing such conditions influences the central bank on how much money commercial banks can lend and the quantity of money that they may produce.

Discount Rate
This discount rate is a special interest rate that allows commercial banks to borrow money from the central bank. It can be thought of as the special rate the central bank gives to commercial banks. If the central bank changes this discount rate, then how much it costs to borrow money for commercial banks changes. This affects how much they lend out to people and businesses, which in turn can affect the economy in general.

Interest Rate
Another tool that the central banks use is the interest rate to increase borrowing costs as well as curtail or boost economic activities. For example, by changing the benchmark interest rate of the central bank-overnight lending rate-the central bank can influence market interest rates that are used to calculate borrowing costs for everybody and for all businesses.

The most important negative effects of inflation arise from reduction in purchasing power. Inflation can reduce the value of our money by a huge amount, making it even more difficult to purchase the things we want and need. Knowing how inflationary prices affect our purchasing power is an aspect of financial knowledge, and this skill will help us perform better in managing our money.
An influx of money into the economy from the macroeconomic point of view leads to inflation. Since there will be more money, it reduces the value of each and every unit of currency. This in turn increases the prices of the commodities and services by the reduced value of the money. Therefore, the money can purchase fewer goods and services than it could in the past.

Inflation and purchasing power-At the level of the individual, experiences vary from one person to another with the variables like income, expenses, and lifestyle.

Here’s how inflation may affect your purchasing power:

1. Savings: Because of time, inflation can gradually reduce the value of your savings. For example, imagine having $1,000 worth of savings, and the inflation rate is 3%. After one year, the value of your savings will have shrunk to $970.

2. It is more expensive to maintain living standards due to higher costs of living: With rising prices of goods and services, it becomes harder to achieve the same standard of living, thus reducing the quality of life.

3. Low returns: Inflation will also affect the return on investment. Let’s assume you invest in a bond yielding 2%, and you have a rate of inflation of 3%. This means you are losing money on your investment.

Understanding how inflation affects the purchasing power is extremely important in financial decision-making. In other words, having an understanding of inflation will enable people to think ahead and adjust their strategies because they will be able to realize early if the cost of living will continue to rise or not.

It indeed heavily impacted Indian banks’ capital adequacy and risk management after introducing Basel III norms. These new standards arising out of the global financial crisis of 2008 require higher capital requirements and improved liquidity standards in terms of building up resilience for the banking sector.

The above factor forced Indian banks to raise their capital adequacy ratios: there is an increasing equity or, more often, retained earnings, which can afford shocks much better now. Nevertheless, this has brought along certain challenges that cannot be managed by smaller banks in attracting sufficient capital.

The stricter norms for capital affected the lending practices, as the banks became more risk averse, particularly in the riskier sectors. To an extent, Basel III has permitted sustaining a higher proportion of Tier-1 capital and thus encouraged banks to be quality-specific rather than quantity-specific in lending, that is, secured loans instead of unsecured ones. Hence, though improving the quality of assets, credit growth has become slow-affecting the sectors highly bank-financed most.

On these lines, profitability has also been dealt with because larger capital is required to be deployed reduce leverage and hence the return on equity of banks. The increased focus on liquidity and risk management have also seen operational costs increase. Although, Basel III had the benign effect of stability in the Indian banking sector, it involved the cost of restricted profitability and a more conservative approach towards lending.

The money supply in the making of inflation and deflation as well. Of course such factors are used to determine the level of prices in an economy.

With this money supply there is more liquidity in the consumption and the production processes. As is evident from the Quantity Theory of Money MV = PQ an increase in the stock of money ‘M’, at a constant velocity ‘V’, the resultant will be an increase in the price level ‘P’ with ‘Q’ constant. In a nutshell, yet more money is thrown after the same quantity of goods and services and demand goes further up and up goes the prices and inflation. 

But with most instruments, a central bank also increases money stock through open market operations, reducing interest rates to encourage even higher consumption and investment to bring in easy, demand-led inflation.

This is because when money supply is reduced more money is left in the central bank than circulating in the economic market reducing the consumers’ expenditure and businesses investment thereby lowering the aggregate demand hence deflation. Because price level has a tendency to go down as time goes on; low demand consequently reduces the price level hence deflation.

Aggressive deflation would be a bane to the corporate revenues and also send the economy into stagnation because the consumers wait for cheaper products to be released

Corev, more central banks monitor this money supply and adjustment to a middle position is done to control inflation and avoid both deflationism and inflationism for economy steadiness.