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Structure And Role Of The Central Bank: Monetary Policy Tools

A central bank, sometimes known as a monetary authority or a reserve bank, is an organisation that regulates the production of currency in an economy, as well as the interest rate and exchange rates. Furthermore, central banks also regulate their own country's corporate banking sector. Central banks include the European Central Bank (ECB) and the Federal Reserve Bank of the United States.

Reserve Bank of India is the Central Bank of our country. It is empowered with the regulation and production of our currenecy.

The Reserve Bank of India (RBI) was formed on April 1, 1935, during the British Raj, in accordance with the criteria of the Reserve Bank of India Act, 1934. Following India's independence in 1947, the RBI was nationalised in 1949.

The RBI is an important aspect of the Government of India's development agenda. It is a bank that is a member of the Asian Clearing Union.

The RBI's general supervision and direction is delegated to the 21-member Central Board of Directors.

Main Functions
Traditional Functions Of RBI:
Traditional functions are those that any central bank would have to do out. These tasks are essentially in line with the goals for which the RBI was established.

They include the following responsibilities:
  1. Currency Notes:
    Except for one rupee note and coins of smaller denominations, the RBI has the absolute rights, autonomy, or monopoly of issuing currency notes. The RBI issues legal tender currency notes in denominations of Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000. The RBI has controls in place to issue and withdraw money notes, as well as trade them between divisions. It issues these notes in exchange for gold bullion, foreign securities, rupee coins, trade bills and promissory notes, and Legislative Assembly of India bonds.
  2. Banker to other banks:
    The RBI, as the apex institution, is obligated to guide, assist, and direct other banks and financial institutions in the economy. The RBI can control the amount of money that a bank holds and allow different banks to make credit to that extent. Each bank is required to keep a portion of its reserves with the RBI. As a result, when these banks are in desperate need of funds, they approach the RBI. Along these lines, it is referred to as a lender of last resort.
  3. Banker to the Government:
    For both the central and state governments, the RBI functions as an agent. It carries out a variety of banking functions, such as authorizing to receive payments from the government for taxes, payments, and deposits. It also represents the government on an international market. It is in charge of managing government finances and giving the government financial recommendations. Additionally, it maintains foreign currency reserves on behalf of the government and handles its public obligations. The overdraft facility is available to the government in times of financial difficulty.
  4. Exchange rate management is a critical function of the Reserve Bank of India. To keep the rupee's external value stable, domestic policies must be prepared in this direction. It must also develop and implement a foreign exchange rate policy that contributes to exchange rate stability. To accomplish this, the RBI must bring foreign currency demand and supply closer together.
  5. Credit Control Function:
    The country's commercial banks make credit decisions based on economic demand. However, if this credit creation is not checked or regulated properly, the economy may enter an inflationary cycle. On the other hand, if credit creation falls below the required level, the economy's growth suffers.The RBI, thus, must aim for growth that has stable prices & controls the credit creation capacity of other commercial banks with the help of numerous credit control tools.
  6. Supervisory Function:
    The RBI has been given significant powers to oversee the country's financial industry. It has the authority to provide licences for the establishment of new banks, to create new branches, to determine minimum reserves, to examine the operations of commercial banks in India and overseas, and to advise and steer commercial banks in India. It may be subjected to frequent inspections and audits by various commercial banks.

Developmental / Promotional Functions Of RBI:

In addition to its conventional tasks, the RBI is required to execute a number of other functions that are nation specific and vary depending on the needs of the economy. Since its inception, the RBI has fulfilled its role as a promoter of the financial system.

The RBI's key development functions are as follows:

  1. Financial System Development:
    Financial institutions, financial markets, and financial goods make up the financial system. The fast expansion of the economy requires a sound and efficient monetary system. In order to fulfil the credit requirements of diverse economic sectors, the RBI has promoted the formation of significant banking and non-banking enterprises.
  2. Agriculture Development:
    Because India is an agrarian country, the RBI must pay special attention to the credit needs of agriculture and allied activities. By expanding the flow of credit, the RBI has been successful in meeting the demands of the agricultural sector. Some of the RBI's efforts in this direction include Regional Rural Banks (RRBs), Agriculture Refinance & Development Corporation (ARDC), and the National Bank for Agriculture & Rural Development (NABARD).
  3. Industrial Finance:
    Rapid industrial expansion is the key to accelerating economic development. For this, the RBI has provided enough and timely credit to small, medium, and big industries, and has always contributed to the establishment of specific financial institutions such as ICICI Ltd., IDBI, SIDBI, and EXIM BANK.
  4. Training Provisions:
    The RBI has always attempted to offer critical training to banking industry personnel. It has created bankers' training institutes around the country, including the National Institute of Bank Management, Bankers Staff College, College of Agriculture Banking, and others.
  5. Data Collection:
    As the premier financial institution, the RBI must gather, process, and distribute statistics data on a wide range of issues. These contain information on interest rates, inflation, and savings and investments. These statistics are valuable to policymakers and scholars.
  6. Report Publication:
    The RBI has a separate publication section that collects and publishes data on many sectors of the economy. These reports and bulletins are issued on a regular basis. This material is also available to the general public at a lower cost.
  7. Promotion of Banking Habits:
    The RBI is continually working to improve the nation's banking habits. It institutionalizes deposits and works to grow the banking network. It established various organizations, including as the Deposit Insurance Corporation in 1962, UTI in 1964, IDBI in 1964, NABARD in 1982, and NHB in 1988, to develop and encourage banking practices in the economy.
  8. Export Promotion via Refinance:
    The RBI aims to stimulate the provision of facilities for providing credit for overseas commerce, particularly exports from India. EXIM Bank India and the Export Credit Guarantee Corporation of India (ECGC) are aided by refinancing their export lending.

Supervisory Functions Of RBI

The RBI also performs many supervisory functions. It has authority to control & manage the entire banking & financial system.

Some of its supervisory functions are given below:
  1. Bank licences:
    The RBI issues licences to banks in order for them to conduct business. Licenses are also granted for the establishment of expansion counters or new branches, as well as the closure of any existing branches.
  2. Bank Inspection:
    The RBI grants permission to banks to fill in according to directives in a reasonable and risk-free manner. Regardless, it may request periodic data from banks on various asset and liability categories.
  3. Non-Bank Financial Institutions (NBIFs):
    NBIFs are unaffected by the operation of monetary policy. However, the RBI has the authority to give orders to NBFIs about their operations on a regular basis. It can control the NBFIs by periodic examination.
  4. Implementing the Deposit Insurance Scheme:
    The Reserve Bank of India established the Deposit Insurance Guarantee Corporation to cover the deposits of small depositors.The RBI also works to implement the Deposit Insurance Scheme in case of a bank failure.

Tools Of The Central Bank

Bank Rate

The RBI loans to financial institutions against recognised securities through its discounting window to assist banks in meeting long-term depositor demands and margin requirements. The interest rate charged by the RBI to banks for this reason is known as the bank rate. If the RBI wishes to expand market liquidity and supply of money, it will lower the bank rate; if the RBI wants to decrease market liquidity and money supply, it will raise the bank rate.

As the RBI conveys its attitude through changes in repo rates, the Bank Rate has lost its significance as a monetary policy instrument (the rate at which banks borrow short-term funds. Bank rate is now utilised as a penalty rate that banks must pay for failing to satisfy the statutory Cash Reserve Ratio (CRR).

Cash Reserve Ratio - Reserve Requirement (CRR)

Every commercial bank in the country must keep a minimum cash reserve with the RBI. The CRR for designated banks ranges from 5% to 25%, as recommended by the RBI to ensure the economy's monetary stability. The CRR is used to increase or decrease the money supply. When the CRR rises, banks are required to keep a considerable portion of their deposits with the RBI. This reduces the amount of their deposits and causes them to lend less. As a result, the money supply will be reduced.

Statutory Liquidity Ratio (SLR)

Along with CRR, banks must retain a specific level of liquid assets with the RBI in the form of gold, cash, and authorised securities. A high liquidity ratio encourages banks to keep a large amount of their reserves liquid, reducing their ability to provide loans and advances. This has a deflationary effect. A greater SLR would direct bank funds away from loans and advances and toward investments in government and authorised securities.

In well-developed financial systems, central banks use open market operations (OMO), or the purchasing and sale of government securities in the financial markets by the central bank, to sway the amount of cash reserves with banking industry, and thus the volume of lending activities they can make to the industrial and service sectors. These are exchanged in the open money market at economy interest rates.

Repo Rate And Reverse Repo Rate

The interest rate at which the RBI lends to commercial banks in return for government assets is known as the repo rate. Banks can receive a payment at a lesser cost when the repo rate falls, but banks are deterred from doing so when the repo rate rises since it becomes more burdensome. The interest rate at which the RBI borrows money from commercial bank is known as the reverse repo rate. Banks' cost of borrowing and lending increases in response to an increase in the reverse repo rate. As a result, people are discouraged from borrowing money and are encouraged to deposit it instead. Low inflation is the outcome of reduced credit demand and availability due to high interest rates.

What Is Open Market Operation (OMO)?

OMO refers to the purchasing and selling of government securities by the Reserve Bank of India in order to control market liquidity and potentially boost govt market borrowing.

It is one of the primary instruments of monetary policy via which the RBI injects liquidity into the market and can be used to sterilise capital movements (managing excess inflow of capital). Liquidity Adjustment Facility (LAF) to control liquidity and Market Stabilization Scheme (MSS) to manage long-term surplus liquidity are effective mechanisms for OMOs. The LAF system is made up of two rates: repo and reverse repo. The repo rate is used to inject liquidity on a daily basis, while the reverse repo rate is used to absorb securities on a daily basis.

The bills are dated securities that are acquired and traded in OMOs. Because of the liquidity crisis, the RBI is now acquiring bonds from the market.

OMO In India

Prior to the 1991 financial reforms, the RBI's primary instruments for controlling the money supply and interest rates in the market were the CRR and SLR. However, these characteristics quickly lost their significance, and the application of OMO increased enormously since these are judged comparable successful in correcting market liquidity.

In India, the Reserve Bank of India executes OMO in two ways:

  1. Outright Purchase (PEMO):
    Through PEMO, the RBI purchases and sells securities in order to increase or contract the money supply over time.
  2. Repurchase Agreement (REPO):
    The RBI uses REPO to buy and sell securities with the option to repurchase them.
Established in 1935, RBI is India's central banking organisation and manages the country's monetary policy. The traditional duties of the RBI include currency issuance, financing to banks and the government, managing exchange rates, regulating credit, and performing supervisory duties.

Development of the Financial System, Development of Agriculture, Provision of Industrial Finance, Provision of Training, Collection of Data and Publication of Reports, Promotion of Banking Habits, and Promotion of Export via Refinance are the development and promotion tasks of the RBI. The RBI's supervisory duties include: issuing licences to banks, conducting bank inspections, exercising control over non-banking financial institutions, and putting the Deposit Insurance Scheme into effect. The rate at which the RBI loans to commercial banks is known as the "bank rate."

Every commercial bank is required by the RBI to maintain CRR, which stands for Cash Reserve Ratio. SLR is the minimal level of liquid assets that banks are required to keep, such as gold, cash, and authorized securities. The Open Market Operation (OMO), which the RBI conducts to control market liquidity and may boost government borrowing, entails purchasing or selling of government securities.

  • Kimberly Amadeo, "Central Banks, Their Functions and Role" (2020) The Balance.
  • ReemHeakal, "What Central Banks Do"(2021) Investopedia
  • Wikipedia contributors, 'Central bank', Wikipedia, The Free Encyclopedia, 17 November 2021, 12:23 UTC,
  • Acocella, N., Di Bartolomeo, G., and Hughes Hallett, A. [2012], "Central banks and economic policy after the crisis: what have we learned?", ch. 5 in: Baker, H. K. and Riddick, L. A. (eds.), Survey of International Finance, Oxford University Press.
  • DelhiNovember 12, India Today Web Desk New; November 12, 2021UPDATED; Ist, 2021 12:10. "PM Modi launches 2 RBI schemes: All you need to know". India Today. Retrieved 12 November 2021.

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