Saturday, September 17, 2011

Monetary Tools used by RBI to control Inflation

What is Inflation?

Inflation simply refers to  "an increase in the price you pay for goods." In other words, a decline in the purchasing power of your money".

So Inflation is nothing but a rise in the level of prices of goods and/or services in an economy over a certain period of time.

Inflation can have positive and/or negative effects on an economy. Negative effects of inflation could be a decrease in the real value of money and other monetary items over time; uncertainty about future inflation cal also discourage investment and savings, and high inflation might lead to shortages of goods if the consumers begin hoarding out of concern that the prices will increase in the future. Positive effects of inflation include a mitigation of economic recessions and debt relief by way of reducing the real level of debt.

How Inflation is measured in India?

In India, inflation is calculated on a weekly basis. India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy.

WPI was first published in 1902, and was one of the more economic indicators available to policy makers until it was replaced by most developed countries by the Consumer Price Index in the 1970s.

WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. It is also the price index which is available on a weekly basis with the shortest possible time lag only two weeks. The Indian government has taken WPI as an indicator of the rate of inflation in the economy

Present Rate of Inflation in India:9.8% as on Aug 2011

Monetary Policy of RBI to control Inflation and Various Monetary tools:

The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy.

These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.

Besides, the RBI also announces norms for the banking and financial sector and the institutions which are governed by it. These would be banks, financial institutions, non-banking financial institutions, Nidhis and primary dealers (money markets) and dealers in the foreign exchange (forex) market.

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year.

Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy.

However, with the share of credit to agriculture coming down and credit towards the industry being granted whole year around, the RBI since 1998-99 has moved in for just one policy in April-end. However a review of the policy does take place later in the year

The different rates/tools used  in monetary policy to control Inflation  used by RBI are explained below:

1.  CRR(Cash Reserve Ratio):Cash reserve Ratio (CRR) is the amount of Cash(liquid cash like gold) that    the banks have to keep with RBI. This Ratio is basically to secure solvency of the bank and to drain out the excessive money from the banks. If RBI decides to increase the percent of this, the available amount with the banks comes down and if RBI reduce the CRR then available amount with Banks increased and they are able to lend more.

Present CRR is ( 6% as of Sept 2011    ) .

2.SLR((Statutory Liquidity Ratio) is the amount a commercial bank needs to maintain in the form of cash, or gold or govt. approved securities (Bonds) before providing credit to its customers. SLR rate is determined and maintained by the RBI (Reserve Bank of India) in order to control the expansion of bank credit.Generally this mandatory ration is complied by investing in Govtbonds.

Present  SLR is 24 of Sept2011

3. Repo Rate: 

Whenever the banks have any shortage of funds 
they can borrow it from RBI. 
Repo rate is  the rate at which our banks borrow 
rupees from RBI. A reduction in  the repo rate will 
help banks to get money at a cheaper rate. 

When the repo rate increases borrowing from RBI 
becomes more expensive. 

Present Repo Rate:8.25 % as of September 2011

4. Reverse Repo rate:

Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always ready to lend money to RBI since their money are in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system. 

Present REverse Repo Rate: 7.25% as of September 2011

5. Bank Rate:

Bank Rate is the rate at which  RBI  allows finance to commercial banks. Bank Rate is a tool, which central bank  uses for short-term purposes. Any upward revision in Bank Rate by central bank is an indication that banks should also increase    deposit rates  as well as Base Rate/ Benchmark Prime Lending Rate(BPLR).  Thus any revision in the Bank rate indicates that it is likely that interest rates on your deposits are likely to either go up or go down,  and it can also indicate  an increase or decrease in your EMI.

Present Bank Rate: 6 % as of Sept.2011

You can refer the Website of RBI to know the above rates on any date at:

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