The LAF is a tool used by the Reserve Bank of India (RBI) to manage liquidity in the banking system. It consists of two windows: the repo window and the reverse repo window.
- The repo window allows banks to borrow money from the RBI by selling government securities to it.
- The reverse repo window allows banks to lend money to the RBI by buying government securities from it.
The RBI sets the interest rates at both the repo and reverse repo windows. The repo rate is the rate at which banks can borrow money from the RBI, and the reverse repo rate is the rate at which banks can lend money to the RBI.
Underlying Instruments
The underlying instruments for the conduct of the LAF are:
- Government securities: The RBI uses government securities as collateral for repo and reverse repo transactions. Government securities are considered to be safe and liquid assets, which makes them suitable for use as collateral.
- Treasury bills: Treasury bills are short-term government securities that are issued at a discount to their face value. They are also considered to be safe and liquid assets, and they can be used as collateral for repo and reverse repo transactions.
- Commercial paper: Commercial paper is a short-term debt instrument issued by companies. It is not as safe as government securities, but it can be used as collateral for repo and reverse repo transactions in certain cases.
MCQs on underlying instruments for the conduct of LAF
- Which of the following is not an underlying instrument for the conduct of the LAF?
- Government securities
- Treasury bills
- Commercial paper
- Bank deposits
- The answer is bank deposits. Bank deposits are not considered to be safe and liquid assets, and they cannot be used as collateral for repo and reverse repo transactions.
- What is the main purpose of using government securities as collateral for repo and reverse repo transactions?
- To ensure that the RBI is able to recover its funds in case of a default by a bank.
- To provide banks with access to cheap money.
- To make the LAF more efficient and transparent.
- All of the above.
- The answer is all of the above. Government securities are considered to be safe and liquid assets, which makes them suitable for use as collateral. This ensures that the RBI is able to recover its funds in case of a default by a bank. It also provides banks with access to cheap money, and it makes the LAF more efficient and transparent.
- What is the difference between repo and reverse repo transactions?
- In a repo transaction, the bank borrows money from the RBI by selling government securities to it.
- In a reverse repo transaction, the bank lends money to the RBI by buying government securities from it.
- The repo rate is always lower than the reverse repo rate.
- All of the above.
- The answer is all of the above. In a repo transaction, the bank borrows money from the RBI by selling government securities to it. The bank then repurchases the securities from the RBI at a later date, at a higher price. The repo rate is the interest rate that the bank pays to the RBI for the borrowed money.
- What is the role of the LAF in the Indian monetary system?
- To manage liquidity in the banking system.
- To set the benchmark interest rates in the economy.
- To provide banks with access to short-term funds.
- All of the above.
- The answer is all of the above. The LAF is a key tool used by the RBI to manage liquidity in the banking system. It also helps to set the benchmark interest rates in the economy, and it provides banks with access to short-term funds.