Understanding Basic Economic Terms of RBI's Policies

You must have read the words "CRR" "repo rate" & SLR in newspapers. Do you want to know the basics about it and interested in its effect on various things like Inflation and bank Interest rate?

Let's start with the meanings of CRR, Repo rate, reverse repo rate and SLR.

CRR (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 reduces the CRR then available amount with Banks increased and they are able to lend more.

Repo Rate: Repo rate is the rate at which our banks borrow rupees from RBI. This facility is for short term measure and to fill gaps between demand and supply of money in a bank .when a bank is short of funds they borrow from bank at repo rate and if bank has a surplus fund then the deposit the funds with RBI and earn at Reverse repo rate.

Reverse Repo rate is the rate which is paid by RBI to banks on Deposit of funds with 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. To borrow from RBI bank have to submit liquid bonds/Government Bonds as collateral security ,so this facility is a short term gap filling facility and bank does not use this facility to Lend more to their customers.

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 Government bonds.

SLR and Cash reserve ratio is maintained for bank solvency and higher ratio of SLR and CRR makes bank relatively safe as higher ratio means they have more of their funds deposited in liquid securities and can fulfill the demand on redemption of deposit from the Bank.

Let’s take an example: Imagine a Bank has taken a deposit of 100 from public and CRR is 10 and SLR is 25 then available funds to lend from deposits with the bank will be 100-10-25=65 so there is direct relation between CRR, SLR and Funds available with bank to lend to public out of deposit received from public.

Impact on Interest rates of these ratios:

Now take point what will be the impact on Interest rates of this ratios: Interest rate are fixed on the Demand supply situation of the amount available with person who want to lend and person who want to borrow and interest rate is fixed on demand supply of the funds if demand is more and supply is less then interest rate rises up and if demand is less and supply is excessive then interest rate comes down .this relation is based on many assumption as said above.

So RBI is controlling the supply side of the Funds and by changes in CRR and SLR, Bank control the supply side of the money. So when RBI increase these ratio then available funds with the banks will go down and as demand remain the same then people will have to pay more as interest and interest rate will go up. On the reverse if RBI reduces these rates, then amount available with bank for lending will be increased and they have to reduce rates to lend more. In this situation bank also reduce the rate of short term deposit from public as they have surplus money already to lend. So these rates have double impact the first direct effect is, bank reduce rate of lending so more money is available with people and second is interest on Deposit will be reduced so more money will be available with the people.

But other side of interest rate i.e. demand/off take of loan is also important to set the interest rate .This may be some time region wise and seasonal or other factor also effect the decision of Interest rate.

Impact on inflation :

As from the above paragraphs we have understood that how these ratio reduce or increase the money supply in the system and we know if more person is demanding few goods then price of goods tends to increase and it’s called inflation so when RBI reduce these ratios then money supply in market increases and inflation is rises further but in present case this is not the correct and right relation. The Increase in CRR will squeeze 36000 crore from market, so less money will chase few things means less demand so it will reduce Inflation.

At the time of depression the reduction of this ratio is to maintain liquidity without disturbing inflation much. While marked is falling and each and every commodity rate going downwards. In this situation after increasing of money supply inflation rate does not goes up as the demand is slow and reduction in commodity prices will nullify the impact of increase in money supply and have less inflationary effects.

But sometimes in few cases Inflation is due to supply side, like in case of pulses and sugar the demand is somewhat the same but production has been reduced and rate has been doubled .In these types of cases Ever increase in CRR will not have much impact as the problem is from supply side .