What is the Monetary Policy

Jethamal, the Guajarati Seth, true to his clan, was a champ when it came to financial matters. On the other hand, his Bengali batchmate in school - Arindam Da, a painter now, was completely oblivious of financial matters.  Jethamal called Arindam Da, who now stays in Kolkata, on the 24^th of January explaining to him how happy he was that the Reserve Bank of India had cut the Cash Reserve Ratio (CRR) in the Third Quarter Review of Monetary Policy for 2011-12 announced on January 24, 2012.  His portfolio of banking stocks had gone up by about 5%.  But Arindam, who was more interested in the fine arts, had no clue about all this. 

Jethamal: The RBI announced the Third Quarter Review of Monetary Policy for 2011-12 on January 24, 2012.  The key decisions taken were:

• Cut in the CRR by 50 basis points (100 basis points = 1%) from 6% to 5.5%.
• The repo rate remains unchanged at 8.5%.
• The reverse repo rate will continue at 7.5%, as earlier. 

Arindam Da: But Jetha, what exactly is the monetary policy and what do all these terms mean, and what implication do they have for commoners such as you and me?

Jetha: Monetary policy is the policy governed by the central bank (in our country, the RBI), which deals with manipulating the money supply in the country.  If there is too much of money floating with banks and with the general public, you and I would want to buy more and more things.  Arindam, if people had more money, they would be willing to pay a higher price for your paintings.  Therefore, with limited supply and higher demand, this will lead to sellers hiking prices.  Remember that the salaried people and the pensioners earn a fixed wage.  As prices go up (and wages remain the same), their capacity to buy goods and services goes down.  Therefore, the RBI has to maintain an appropriate flow of money to avoid inflation (increase in prices), yet ensure that you and I have sufficient sums of money for consumption and for businesses to undertake trade and commerce. 

Arindam Da: That is fine but what is all this technical jargon – CRR, repo rate, reverse repo rate?

Jethamal: Arindam, do you know that out of every Rs 100 that you and I put into a bank, some amount of this money is kept with the RBI as a safety cushion.  This money is called the CRR.  Any decrease in the CRR means that the banks have to keep lesser money with the RBI and therefore have more money to lend.  For instance, in the present policy announcement, the RBI decreased the CRR by 50 basis points to 5.5%.  Arindam, while this may seem pocket change, let me tell you that as a result of this change, banks would have Rs 32,000 crore more to lend.  With more money to lend, they may be willing to charge you a lower rate of interest on the home loan that you have been wanting to take. 

The repo rate is the rate at which the central bank lends to commercial banks (HDFC Bank, ICICI Bank, State Bank of India).  Any reduction in this rate means that these banks can borrow at lower rates, meaning lower rate on your home loan.  Unfortunate for you Arindam, the RBI has not announced any reduction in the repo rate.

On the other hand, the reverse repo is the rate at which banks can park extra money with the RBI.  An increase in the reverse repo rate means that banks can now place their money with the RBI at a higher rate.  This means that one investment alternative with the banks earns them extra money.  Because of this, banks may charge you a higher rate if you wish to borrow from them.  Now, thankfully for you, there has been no increase here. 

Arindam Da: Ok, I now understand how the monetary policy and its various tools could impact me.  Any change in any of these tools could change the rate at which I could take out the home loan.

Jethamal: Yes, you are right.  While I understand your interests in the finer arts, I would suggest that you also pay some attention to finances.  I have been making loads of money in the stock markets because of my understanding of these concepts.