Macroeconomic Effects on Interest Rates        

Monetary Policy Instruments used by Reserve Bank of India to control interest rates

Cash Reserve Ratio (CRR) - Banks in India are required to hold a certain proportion of their deposits in the form of cash. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio.  This gives the power to RBI to reduce the lendable amount in the banking system by increasing the CRR. Thus, it is a tool used by RBI to control liquidity in the banking system. Currently CRR is at 4%

Statutory Liquidity Ratio (SLR) - Apart from CRR, every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities (NDTL) as liquid assets in Government Securities (G-Sec). The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). An increase in SLR also restricts the bank’s leverage position to pump more money into the economy. Currently SLR is at 23%

Repo and Reverse Repo - Repo rate is the rate at which RBI lends to commercial banks generally against government securities. Reverse Repo rate is the rate at which RBI borrows money from the commercial banks.

Reduction in Repo rate helps the commercial banks to get money at a cheaper rate and increase in Repo rate discourages the commercial banks to get money as the rate increases and becomes expensive. The increase in the Repo rate will increase the cost of borrowing and lending of the banks which will discourage the public to borrow money and will encourage them to deposit. As the rates are high the availability of credit and demand decreases resulting to decrease in inflation. This increase in Repo Rate and Reverse Repo Rate is a symbol of tightening of the policy. Currently Repo is at 7.25% and Revere repo is at 6.25%

Marginal Standing Facility (MSF): MSF is the rate at which banks can borrow overnight from RBI. This was introduced in the monetary policy of RBI for the year 2011-2012. Banks can borrow funds through MSF when there is a considerable shortfall of liquidity. This measure has been introduced by RBI to regulate short-term asset liability mismatches more effectively. Recently, RBI has hiked the MSF rate from 8.25% to 10.25%.

Open Market Operations (OMO) - An open market operation is an instrument of monetary policy which involves buying or selling of government securities from or to the public and banks. This mechanism influences the reserve position of the banks, yield on government securities and cost of bank credit. The RBI sells government securities to contract the flow of credit and buys government securities to increase credit flow. Open market operation makes bank rate policy effective and maintains stability in government securities market.

Inflation and Interest Rates

The effect of Inflation on interest rate:

The nominal interest rate is the price a borrower pays a lender for two things:

Ø  Losing the opportunity to use the amount borrowed

Ø  The devaluing of the money that result from inflation

The real interest rate is the price paid by a borrower to compensate a lender only for the amount borrowed.

Ø  The forces of demand and supply determine both the nominal and real interest rates.

Ø  When inflation is anticipated, the nominal interest rate increases by an amount equal to the expected inflation rate.

Ø  The real interest rate remains constant.

There are other factors like Fiscal Deficit, Current Account Deficit and Currency which also have an impact on RBI’s stance on Interest Rates

We will explain Currency and its impact on Debt Markets in the next edition on Mirae Asset Knowledge Academy Tutorials.        

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