Q. If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?

(1) Cut and optimize the Statutory Liquidity Ratio
(2) Increase the Marginal Standing Facility Rate
(3) Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

  • 1 and 2 only
  • 2 only
  • 1 and 3 only
  • 1, 2 and 3

Answer: (b) 2 only

Expansionary Monetary Policy
  • An expansionary monetary policy is focused on expanding (increasing) the money supply in an economy. This is also known as Easy Monetary Policy.
    • It is implemented by lowering key interest rates thus increasing market liquidity (money supply). High market liquidity usually encourages more economic activity.
    • When RBI adopts Expansionary Monetary Policy, it decreases Policy Rates (Interest Rates) like Repo, Reverse Repo, MSF, Bank Rate etc.
  • Implications:
    • Causes an increase in bond prices and a reduction in interest rates.
    • Lower interest rates lead to higher levels of capital investment.
    • The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises.
    • The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies)
    • A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase.
Contractionary Monetary Policy
  • A contractionary monetary policy is focused on contracting (decreasing) the money supply in an economy. This is also known as Tight Monetary Policy.
    • A contractionary monetary policy is implemented by increasing key interest rates thus reducing market liquidity (money supply). Low market liquidity usually negatively affects production and consumption. This may also have a negative effect on economic growth.
    • When RBI adopts a contractionary monetary policy, it increases Policy Rates (Interest Rates) like Repo, Reverse Repo, MSF, Bank Rate etc.
  • Implications:
    • Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates.
    • Higher interest rates lead to lower levels of capital investment.
    • The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls.
    • The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies)
    • A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.
Marginal Standing Facility
  • Marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely.
    • The Marginal standing facility is a scheme launched by RBI while reforming the monetary policy in 2011-12.
    • MSF rate or Marginal Standing Facility rate is the interest rate at which the Reserve Bank of India provides money to the scheduled commercial banks who are facing acute shortage of liquidity.
    • It is a penal rate at which banks can borrow money from RBI when they are completely exhausted of all borrowing assistance. The Marginal Standing facility allows banks to borrow money with an interest rate above the repo rate and can be termed as the Marginal standing facility rate.
    • The MSF rate is pegged 100 basis points or a percentage point above the repo rate.
    • Under MSF, banks can borrow funds up to one per cent of their net demand and time liabilities (NDTL).
    • Banks can borrow through MSF on all working days except Saturdays.
    • The minimum amount for which RBI receives application is Rs.1 Crore, and afterwards in multiples of Rs.1 Crore.
    • MSF provides a safety valve against unexpected liquidity shocks to the banking system.
    • If RBI decided to adopt an expansionist monetary policy, it will not increase the MSF rate.
  • Differences between Repo Rate and MSF
    • Repo rate is the rate at which RBI lends money to commercial banks, while MSF is a rate at which RBI lends money to scheduled banks.
    • The repo rate is given to banks that are looking to meet their short-term financial needs. While, the MSF is meant for lending overnight to banks.
    • Lending at repo rates involves a repurchase agreement of securities. While it is not so in MSF.
    • Under MSF, banks are also allowed to use the securities that come under Statutory Liquidity Ratio (SLR) in the process of availing loans from RBI.
      • Under SLR, commercial banks are mandated by RBI to maintain a stipulated proportion of their deposits in the form of liquid assets like cash, gold and unencumbered (free from debt) securities.