Mastering Monetary Policy: The Role of Liquidity Management


Fiscal policy and monetary policy are terms we see often in financial papers. We also talk about them in the Commerce undergraduate classrooms. The two are separate roles and responsibilities of the domain of different branches of the government.

Fiscal policy, expressed every year in the Union Budget and at other points of time during the year is in the domain of the Central Government.

The Role of Monetary Policy and Liquidity Management

Monetary policy is one of the hats that the Reserve Bank of India wears as the banking regulator. ‘Banker to the Government’ is just the headline role of the Central Banker. As a banker to the Nation, custodian of foreign currency reserves, ‘Lender of Last Resort’ and other roles the RBI displays greater responsibility for India than a Rahul Dravid or Rishabh Pant have with the bat on the cricket field. Monetary Policy has 3 primary objectives – controlling inflation, encouraging employment, and maintaining stable economic growth.

Former RBI Governor Dr. D. Subba Rao stated that “The objectives of monetary policy in India are price stability and growth. These are pursued through ensuring credit availability with stability in the external value of rupee and overall financial stability.”

All these monetary policy objectives dovetail into managing the liquidity of money in the economy. Too much will push up inflation and reduce the value of the currency. Too little money in the economy will act as a choke on business. The Goldilocks scenario, getting it ‘just right’ is a lot more complex than expressed in the old and popular children’s tale of 3 bears and a little girl. The tools that the RBI uses are broadly classified under “Liquidity Adjustment Facility”, referred to by its acronym LAF.

Cash is described as the ‘oil to lubricate the ever-turning wheels of business – without it, the process grinds to a stop.’ The RBI uses LAF as financial engineering to keep oiling the economy’s wheels. LAF has tools that are availed by the market on a daily basis. These are the reverse repo, in which banks with excess funds park the funds with the RBI, either overnight, or for a very short period. The RBI pays interest on the money, the current rate (in February 2021) being 3.35%. Banks that need money for the very short term can borrow from the RBI through the repo window, against acceptable securities (called ‘repoable’ securities). The interest rate charged is 4% now, in early 2021. Note that the RBI does not provide securities to back up the funds placed with it. Being the creator and custodian of all government securities (as well as foreign exchange reserves), the printer and issuer of all Indian rupees (through its subsidiary, RBI Note Mudran Limited), the RBI is as safe as, ahem, a bank! The active management of the excess money sloshing around in the economy, or demand creating a thirst for cash has a profound impact on the running of the economy.

Multi-Impact Open Market Operations (OMO) by the RBI

Open Market Operations (OMO) are a multi-impact action of the RBI. For a longer-term impact than just overnight, the RBI might use OMO to suck out excess liquidity by selling bonds, introduce liquidity by buying bonds, or set a desired trajectory to the yield curve. The most important impact of OMOs is the unwritten message the RBI sends to the market through its actions. The tea leaves are read by the market and promptly acted upon!

Truly, the three little letters, LAF make a sound and impact louder than a chunk of dynamite.

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