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Role of RBI in Indian Economy

HomeRole of RBI in Indian Economy

RBI RoleDo you read a finance newspaper? Have you flipped through news channels and heard things like “RBI cuts the lending rate” or “RBI slashes the CRR”? I am sure that you have heard or read about such jargon more than once. In case you understand how all this impacts your life, you can skip this article from this point on. If you want to make a little (or a lot) more sense of finance news then you will find this page helpful. You need not memorize anything here. Just a casual reading will help you put a lot more meaning to finance news.

                                  The Reserve Bank of India (RBI) – India’s central banking institution.

RBI through printing new money and through monetary policy monitors and influences the movement of a number of macro economic indicators including interest rates, inflation rate, money supply and Gross Domestic Product (GDP).                

Role of RBIIssuer of Currency

The RBI controls the nation’s money supply and is the only authority empowered to print new currency notes. As the production and consumption in the economy rises because of a rise in population or for any other reason, more money is needed to support this growth. RBI prints money primarily based on this growth in the economy (i.e. GDP) and for replacing old and soiled notes.

Monetary Policy

Monetary policy refers to the use of certain regulatory tools under the control of the RBI in order to regulate the availability, cost and use of money and credit. There are several direct and indirect tools which RBI can use to regulate the financial markets and maintain stability. Important ones are discussed below:

Direct regulation:

Cash Reserve Ratio (CRR): CRR is the minimum amount of cash that commercial banks have to keep with the RBI at any given point in time. Banks are required to hold a certain proportion of their deposits in the form of cash with RBI. RBI uses CRR either to drain excess liquidity from the economy or to release additional funds needed for the growth of the economy.

For example, if the RBI reduces the CRR from 5% to 4%, it means that banks will now have to keep a lesser proportion of their deposits with the RBI making more money available for business. Similarly, if RBI decides to increase the CRR, the amount available with the banks goes down.

Statutory Liquidity Ratio (SLR): SLR is the amount that commercial banks are required to maintain in the form of gold or government approved securities before providing credit to the customers. SLR is stated in terms of a percentage of total deposits available with the bank and is determined and maintained by the Reserve Bank of India in order to control the expansion of bank credit. For example, currently, commercial banks have to keep gold or government approved securities for a value equal to 23% of their total deposits.

Indirect regulation:

Repo Rate: The rate at which the RBI is willing to lend to commercial banks is called Repo Rate. Whenever banks have any shortage of funds they can borrow from the RBI, against securities. If the RBI increases the Repo Rate, it makes borrowing expensive for banks and vice versa. As a tool to control inflation, RBI increases the Repo Rate, making it more expensive for the banks to borrow from the RBI with a view to restrict the availability of money. Similarly, the RBI will do the exact opposite in a deflationary environment.

Reverse Repo Rate: The rate at which the RBI is willing to borrow from the commercial banks is called reverse repo rate. If the RBI increases the reverse repo rate, it means that the RBI is willing to offer lucrative interest rate to banks to park their money with the RBI. This results in a decrease in the amount of money available for banks customers as banks prefer to park their money with the RBI as it involves higher safety.  This naturally leads to a higher rate of interest which the banks will demand from their customers for lending money to them.

The Repo Rate and the Reverse Repo Rate are important tools with which the RBI can control the availability and the supply of money in the economy. 

Also Read:  Relationship between Inflation Interest Rate and Growth

About the Author

Rajat Sharma pictureRajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.