Direct and Indirect Instruments of Monetary Policy

Instruments of monetary policy are the tools with the RBI that can be used to realise its set targets and objectives. The instruments are divided into direct and indirect depending upon the way they work to influence the targets set by the RBI. So, instruments are divided into:

(A) Direct Instruments

Direct instruments are those instruments of monetary policy which enable the RBI to hit the monetary policy target (money supply, liquidity) without significant policy action by others. The direct instruments are:

(a) Cash Reserve Ratio (CRR)

The cash reserve ratio is the proportion of demand and time deposits (Net Demand and Time Liabilities) that every scheduled commercial bank has to keep with the RBI as cash reserves.

(b) Statutory Liquidity Ratio (SLR)

Statutory Liquidity Ratio (SLR) is a requirement that commercial banks have to keep a certain proportion of their demand and time deposits as liquid assets in their vault. In the context of SLR, liquid assets mean assets in the form of cash, gold and approved securities (government securities).

(c) Refinance Facilities

Refinance facilities are sector-specific refinance facilities given by the RBI to banks. The main types of refinance facilities are those given to the export sector through banks. Export refinance facilities include foreign exchange, swap facility etc., offered by the RBI.

(B) Indirect Instruments of Monetary Policy

Indirect instruments are the instruments of the RBI where policy actions/responses from institutions like commercial banks are also necessary for hitting the targets and objectives set by the RBI.

Indirect instruments are:

  1. Repo rate: Repo rate is the interest rate charged by the RBI on overnight loans given to the commercial banks under the Liquidity Adjustment Facility. Repo rate is the most important, most powerful and the most preferred monetary policy instrument for the RBI.
  2. Reverse repo rate: Reverse repo rate is the rate (interest) at which the Reserve Bank absorbs liquidity, on an overnight basis, from banks. Or in other words, it is the interest rate that the RBI gives to banks while accepting one-day funds from them.
  3. Liquidity Adjustment Facility (LAF)

Liquidity Adjustment Facility (LAF) is a collective arrangement that includes several liquidity tools by the RBI to manage liquidity in the financial system. Both liquidity injection and liquidity absorption are made by the RBI through various instruments of the LAF.

Open Market Operations refer to buying and selling of government securities by the RBI. Buying securities (by the RBI) in the open market increases the liquidity in the market. On the other hand, selling securities reduces the liquidity in the system. When securities are sold into the market, the financial institutions buy them, and the RBI gets an equivalent volume of money. In this way, money supply or liquidity comes down in the financial system.

  1. Market Stabilisation Scheme (MSS)

Market Stabilization Scheme (MSS) is an open market operation by the RBI, aimed to sterilize or withdraw the excess money supply created out of the foreign exchange market intervention by the RBI.

MSF is an overnight loan facility provided by the RBI to banks when the latter does not have a sufficient level of eligible securities to get loans under repo. It is basically an emergency liquidity facility. MSF permits banks to borrow overnight from the RBI by submitting a prescribed amount of securities to the RBI when the banks do not have any eligible securities (recognized securities above SLR requirements).

Term repo is a liquidity injection instrument by the RBI where it auctions a given amount of funds of a specified tenure (for one day to 13 days) to the entire banking system.

  1. Long Term Repo Operations (LTROs)

LTROs are repo operations conducted by the RBI for long-term like one year and three years, offering funds to banks at the prevailing repo rate.

  1. Targeted Long-Term Repo Operations (TLTROs)

Targeted Long-Term Repo Operations are Long term repo operations (LTROs) conducted by the RBI to ensure adequate liquidity at the longer period for specific sectors. Under this programme, the RBI will be providing funds to banks so that the latter can invest in securities of entities in the specific sectors (targeted) like corporate, NBFCs, HFCs etc.

The Dollar-Rupee swap facility is a liquidity facility by the RBI where the central bank provides either dollar liquidity or rupee liquidity by accepting the opposite currency.

Bank Rate (BR) is the rate at which the RBI rediscounts the first-class bills of exchange provided by banks to the RBI. Effectively, it was the rate at which the central bank gave loans to the commercial banks.

The Corridor in the monetary policy of the RBI refers to the area between the Marginal Facility Rate and the Reverse Repo rate. Ideally, the call rate should travel between the corridor and this shows a comfortable liquidity situation in the system.

Marginal Standing Facility is the upper ceiling of the Corridor, reverse repo rate is the lower ceiling. The call rate should move within the corridor. The repo rate is usually placed in the middle of the corridor.