The Reserve Bank of India (RBI) has an important role in the functioning of the Indian economy. One of the key methods it employs is the Liquidity Adjustment Facility (LAF), a monetary policy tool through which it injects or absorbs liquidity into or from the banking system. In October 2022, RBI injected Rs 72,860.7 crore of liquidity into the banking system, marking the highest since April 2019. This move was necessitated by tightening liquidity conditions due to increased credit demand during the festival season.
Decoding the Concept of Banking System Liquidity
Liquidity in the banking system essentially refers to readily available cash required by banks to fulfill short-term business and financial requirements. On any given day, if the banking system borrows from the RBI under the LAF, the system’s liquidity is considered to be in deficit. Conversely, if the banking system lends to RBI, the liquidity is deemed to be in surplus.
A Closer Look at Liquidity Adjustment Facility (LAF)
The implementation of LAF was one of the outcomes of the Narasimham Committee on Banking Sector Reforms in 1998. The LAF operates through two key components – repo (repurchase agreement) and reverse repo. Banks borrow from RBI through repo when there is a need for liquidity, at a rate called the repo rate. When banks have excess funds, they use the reverse repo mechanism and park their money with the RBI at the reverse repo rate. Through these mechanisms, LAF helps manage inflation in the economy by controlling the money supply. It also assists banks in tackling short-term cash shortages during economic instability or other stress situations beyond their control.
Monetary Policy: An Overview
Monetary policy refers to the central bank’s policy regarding the use of monetary tools to attain specified goals. The primary objective of RBI’s monetary policy is price stability, which is vital for sustainable growth. The RBI Act, 1934, as amended, also allows for an inflation target (4% +-2%) to be set by the Government of India in consultation with the Reserve Bank every five years. The monetary policy employs several tools including Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Bank Rate, Standing Deposit Facility (SDF), and Marginal Standing Facility (MSF).
Examining Statutory Liquidity Ratio (SLR)
One important tool under the Monetary Policy is the Statutory Liquidity Ratio (SLR). It helps the RBI assess liquidity at banks’ disposal, which is the minimum percentage of deposits that a commercial bank must maintain in the form of cash, gold, or other securities. Increasing SLR means banks have to park more money in government securities, reducing the level of cash in the economy. Conversely, reducing the SLR leaves more liquidity with banks, potentially fueling growth and demand in the economy.
Relevance of Monetary Policy for UPSC Civil Services Examination
A sound understanding of monetary policy tools and their impact on the economy is critical for aspirants preparing for UPSC Civil Services Examination. For instance, an examination question from 2020 asked candidates to analyze the expected actions of RBI when adopting an expansionist monetary policy. Similarly, a question from 2019 prompted candidates to discuss whether steady GDP growth and low inflation indicate a healthy Indian economy. Knowledge of concepts like LAF, SLR, and overall monetary policy equips candidates to tackle such questions with confidence.
