CRR, SLR, Repo and Reverse Repo Rate - 4 Monetary Policy Tools of RBI

The Ministry of Finance and Reserve Bank of India (RBI) are responsible for controlling inflation or deflation in the country. They control inflation or deflation by changing the amount of money circulating in the economy which directly affects demand-pull inflation. 

The RBI controls inflation or deflation by managing money supply in the economy using 4 monetary policy tools:

• Repo Rate
• Reverse Repo Rate
• Cash Reserve Ratio
• Statutory Reserve Ratio

In this article, lets discuss about:

• What is Inflation?
• What is Deflation?
• What are the four Monetary Policy Tools of RBI which are used to control inflation or deflation?

What is Inflation?

Inflation is the rate at which prices of goods and services INCREASES over a period of time.

When the money flow in the economy increases, the cash in the hands of people increases. Thus, people have more money to buy commodities from the market which in turn increases the demand for the products. 

If the demand increases over the same level of supply or supply decreases over the same level of demand, the cost of the product increases.

Hence, now for the same amount of money you have in hand, you will be able to purchase less amount of product when compared to the earlier scenario. Thus, purchasing power of money decreases.

This whole situation leads to DEMAND-PULL inflation.

What is Deflation?

Deflation is the opposite of what inflation is. Thus, deflation is the rate at which prices of goods and services DECREASES over a period of time. 

When the money flow in the economy decreases, the cash in the hands of people decreases. Thus, people have lesser amount money to buy commodities from the market which in turn decreases the demand for the products. 

If the demand decreases over the same level of supply or supply increases over the same level of demand, the cost of the product decreases.

Hence, now for the same amount of money you have in hand, you will be able to purchase more amount of product when compared to the earlier scenario. Thus, purchasing power of money increases.

What are the four Monetary Policy Tools of RBI to control inflation or deflation?

The four Monetary Policy Tools of RBI to control inflation or deflation are:

i) Repo Rate

ii) Reverse Repo Rate

iii) Cash Reserve Ratio

iv) Statutory Reserve Ratio

The Repo Rate and Reverse Repo Rate forms part of Liquidity Adjustment Facility (LAF).

NOTE:

Whenever money goes towards the RBI, the money supply in the economy decreases and it helps to control inflation.

Whenever money goes away from RBI, the money supply in the economy increases and it helps to control deflation.

What is Repo Rate?

Repo Rate is the interest rate at which commercial banks borrow money from the RBI to meet their short-term liquidity needs by selling off the government securities and repurchasing them at a later on date as mentioned in the Repurchase Agreement or Repo Rate is the interest rate at which RBI lends money to the commercial banks whenever there is a shortfall in the funds for a short period of time. Repo Rate is the POLICY RATE.

i) To control inflation, RBI increase the repo rate thereby commercial banks borrow less from RBI and thus loan rates increases which ultimately decreases demand the products.

ii) To control deflation, RBI decreases the repo rate thereby commercial banks borrow more from RBI and loan rates become cheaper which ultimately increases demand the products.

What is Reverse Repo Rate?

Reverse Repo Rate is the interest rate at which RBI borrows money from the commercial banks or Reverse Repo Rate is the interest rate at which commercial banks lends money to the RBI.

Reverse Repo Rate is kept lower than Repo Rate.

i) To control inflation:

Whenever Reverse Repo Rate is increased, the money circulating in the economy decreases as commercial banks prefer to keep more money with RBI rather than lending it on loan to the bank customers. As the money supply decreases in the economy, the money in the hand of people decreases which decreased the demand for the products. Thus, it helps to control inflation.

ii) To control deflation:

Whenever Reverse Repo Rate is decreased, the money circulating in the economy increases which helps to control deflation.

What is Cash Reserve Ratio (CRR)?

Cash Reserve Ratio is the proportion of total deposits of bank customers which commercial banks have to maintain with RBI in the form of hard CASH.

Commercial banks need to maintain CRR to ensure that bank has enough cash to meet the payment demands of the depositors and bank does not run out of cash when depositors demand their money back from the bank.

If CRR is increased, then commercial banks have to keep more cash with RBI as a reserve and will not be able to lend this money to the bank customer which increases interest rates of bank loan. Thus, money supply in the economy decreases which decreases the demand for the product. Hence, controlling the inflation in the country.

If CRR is decreased, then commercial banks have to keep less cash with RBI as a reserve and will be able to lend more money to the bank customer which decreases interest rates of bank loan. Thus, money supply in the economy increases which increases the demand for the product. Hence, controlling the deflation in the country.

What is Statutory Liquidity Ratio (SLR)?

Statutory Liquidity Ratio (SLR) is the proportion of total net deposits and time liabilities (NDTL) which the commercial bank has to maintain with itself at the end of each business day in the form of liquid assets such as cash, gold, government bonds or securities.

SLR is the ratio of liquid assets to the NDTL which commercial bank need to maintain with itself at the end of each business day to meet the liquidity requirements.

If SLR is increased, then commercial banks have to keep more liquid assets with itself as a reserve and will not be able to lend this money to the bank customer which increases interest rates of bank loan. Thus, money supply in the economy decreases which decreases the demand for the product. Hence, controlling the inflation in the country.

If SLR is decreased, then commercial banks have to keep less liquid assets with itself as a reserve and will be able to lend more money to the bank customer which decreases interest rates of bank loan. Thus, money supply in the economy increases which increases the demand for the product. Hence, controlling the deflation in the country.


Further Readings:

• Liquidity Adjustment Facility, Marginal Standing Facility and 4 differences between Repo Rate and MSF