Policy Interest Rates - Reserve Bank of India

Authors

• Narayana Rao

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Version 6

Last edited: 25 May 2011

Exported: 26 Nov 2011

Original URL: http://knol.google.com/k/-/-/2utb2lsm2k7a/617

The Reserve Bank of India (RBI)  India's central bank .

 

It is in charge of monetary policy which has a big impact on liquidity and interest rates in the financial system.

 

The RBI has several goals of which controlling inflation is one of the most important.

 

The RBI has several tools for conducting monetary policy: two of the most important are the cash reserve ratio (CRR) and the liquidity adjustment facility (LAF).

 

The CRR is the proportion of their deposits which banks have to keep with the RBI. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system which reduces demand in the economy and therefore helps curb inflation.

 

The LAF can be thought of as a way for the RBI to lend and borrow to banks for very short periods, typically just a day. The repo rate is the RBI's lending rate and reverse repo rate is the RBI's borrowing rate. These two rates help the RBI influence short-term interest rates in the rest of the financial system.

 

What impact does monetary policy (policy interest rates) have on the different interest rates charged (by say banks)  in the economy ? In general a tighter monetary policy (higher policy interest rates)  leads to higher interest rates.

 

 

Impact on demand in the economy

 

Higher interest rates depress the demand for goods, services and capital goods in the economy

 

Impact on exchange rates

The RBI's monetary policy will have an impact on exchange rates. In particular if Indian interest rates rise because of tighter policy, the demand for Indian interest-paying assets will also rise, leading to an increase in the value of the rupee.

 

The  rising rupee will have a negative impact on export-oriented companies. For example,  IT companies which have a large amount of export earnings will have less profits in rupee terms.

 

Statuory Liquid Ratio

 

Banks have to buy presently government bonds with 24 per cent of their deposits. This provides liquidity to banks as they can pledge these securities to RBI and take loans on them. When depositors withdraw their money, they can easily liquidate government securities but they cannot liquidate loans easily.

 

If policy rates are decreasing, it means economy has a soft interest policy. Economy will pick up in a year or so. If policy rates are increasing, it means economy has a tight interest policy and economy is likely to cool down with a lag effect.

As economies are weakening all over the world, central banks including RBI are reducing policy rates.

 

More reading

 

rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/72255.pdf

www.keralabanking.com/html/what_is_a_repo_rate_.html

http://www.rediff.com/getahead/2008/may/30rbi.htm

 

 

 

Policy Interest Rates in India

 

17th March 2011

Repo rate raised to 6.75%

Reverse repo rate raised to 5.75% 

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Narayana Rao - 14 May 2011