CENTRAL BANKING MODULE C QUIZ 2

Outright OMOs change the RBI’s holdings of government securities and inject or absorb durable liquidity. Repo and reverse repo operations are generally used to manage liquidity over a specified tenor, while CRR changes can have a broad and immediate effect on system liquidity. The choice depends on whether the liquidity imbalance is temporary or persistent.

LAF is an RBI framework for injecting or absorbing liquidity through operations that include repo and reverse repo of various tenors, along with standing facilities such as SDF and MSF in the current operating framework. It helps manage short-term liquidity and support alignment of the operating target with the policy rate. It is not a fiscal spending programme.

Sterilisation offsets the domestic liquidity impact of foreign-exchange intervention or capital inflows. Selling government securities outright withdraws rupee liquidity from the banking system. Sterilisation can involve trade-offs, including effects on interest rates, the RBI’s balance sheet and the supply of government securities available to the market.

The MSS provides a mechanism to absorb excess liquidity, including liquidity associated with capital inflows, through issuance of government securities or Treasury Bills under the scheme. Proceeds are impounded in a separate account and are not ordinary government-spending resources. MSS complements, rather than replaces, other liquidity-management tools.

Monetary policy primarily influences financial conditions, demand and inflation expectations, while fiscal policy affects demand through taxation, transfers, spending and borrowing. A coherent policy mix can reduce the burden on monetary policy. Coordination does not mean that the central bank should abandon its mandate or mechanically monetise government deficits.

The primary balance is the fiscal balance excluding interest payments on past debt. It helps distinguish the current fiscal stance from the legacy cost of servicing accumulated debt. A primary deficit means non-interest expenditure exceeds receipts; the overall fiscal deficit also includes interest expenditure.

The SDF is the floor of the LAF corridor, the policy repo rate is in the middle, and the MSF is the ceiling. The standard arrangement places SDF 25 basis points below the repo rate and MSF 25 basis points above it, subject to applicable RBI decisions. Do not confuse the SDF floor with the fixed reverse repo rate, which remains a separate tool.

A repo is a collateralised transaction in which the RBI provides funds against eligible securities, with an agreement to reverse the transaction at maturity. In a liquidity-injection repo, funds flow to eligible participants. A reverse repo in the conventional sense absorbs funds from participants against collateral, while SDF absorbs overnight funds without collateral.

Transmission can be incomplete or delayed because banks have different deposit repricing schedules, funding structures, liquidity positions, asset quality, competition and credit-risk costs. Loan benchmarks and reset frequencies also matter. The policy rate influences the overall monetary conditions but does not mechanically determine every customer’s rate by the same amount on the same day.

A credit ceiling limits the quantity of credit available to a borrower, activity or category. A margin requirement limits the proportion of an asset’s value that may be financed by credit, requiring the borrower to fund the remainder. Both can be used as selective credit-control measures but operate through different mechanisms.

Nominal credit growth measures the change in the rupee amount of credit, while real credit growth adjusts for changes in prices. If credit grows at the same pace as prices, the real volume of credit has barely increased under the approximation. Real measures help analysts assess the change in purchasing-power-adjusted credit availability.

The weighted average call rate (WACR) is the operating target of monetary policy in the RBI framework. Liquidity operations aim to keep it aligned closely with the policy repo rate so that the policy signal is transmitted to short-term money-market rates. Alignment can vary with liquidity conditions and market frictions.

Higher real borrowing costs tend to reduce the number of consumption and investment projects that are financially viable. This can moderate aggregate demand and inflationary pressure over time. The strength of the effect depends on expectations, financial conditions, borrower leverage and the responsiveness of spending to interest rates.

Currency appreciation can lower the domestic-currency price of imported goods and inputs, all else equal. It may also affect net exports and aggregate demand. The actual outcome depends on global risk sentiment, trade invoicing, capital-flow conditions and the degree of exchange-rate pass-through.

The bank-lending channel operates when monetary policy changes banks’ funding, liquidity or balance-sheet capacity and thereby affects the supply of loans. A tightening may make funding more expensive or scarce and reduce lending, particularly for borrowers dependent on banks. This is distinct from the broad interest-rate channel, though the channels can operate together.

If households, firms and markets believe the central bank will return inflation to target, expected future inflation and wage- or price-setting behaviour may adjust sooner. This expectations channel can strengthen transmission, although credibility depends on consistent action, clear objectives and economic outcomes rather than communication alone.

The statutory framework treats failure as occurring when average inflation is above the upper tolerance level or below the lower tolerance level for three consecutive quarters. The framework also specifies reporting and remedial steps. A single monthly CPI reading outside the band is not, by itself, the same as the statutory three-quarter test.

The Standing Deposit Facility (SDF), introduced in April 2022, allows eligible participants to place overnight deposits with the RBI without collateral. It serves as the floor of the Liquidity Adjustment Facility corridor. The policy repo rate lies above the SDF rate, while the MSF rate forms the corridor ceiling.

MSF is an overnight liquidity backstop that allows eligible banks to obtain funds from the RBI at the applicable MSF rate against eligible securities, including by dipping into their SLR portfolio within the prescribed limit and conditions. It is designed to address unexpected liquidity shortages, and its rate is positioned above the policy repo rate in the corridor framework.

A variable rate reverse repo auction absorbs liquidity from participants through an auction-based rate. The RBI can use it to manage surplus liquidity and influence short-term money-market conditions. It differs from a repo auction, which injects liquidity, and from an outright OMO sale, which withdraws durable liquidity.