UNIT-4

Reserve Bank of India (RBI)

The Reserve Bank of India (RBI) is the central bank of India, tasked with regulating and
supervising the country's monetary system. It plays a key role in shaping India’s economic and
financial policies.
Objectives of the RBI
1. Monetary Stability: One of the primary functions of the RBI is to maintain price stability
in the economy. It works towards controlling inflation and managing interest rates to
sustain economic growth.
2. Issuance and Management of Currency: The RBI has the sole authority to issue and
manage the currency in India. It ensures an adequate supply of currency in the system to
meet the demand of the economy.
3. Regulation of the Financial System: RBI regulates and supervises commercial banks,
financial institutions, and non-banking financial companies (NBFCs). It sets guidelines to
ensure financial stability and safeguard the interests of depositors.
4. Control of Inflation and Deflation: The RBI controls inflation by adjusting interest rates
(repo rate, reverse repo rate) and by using tools like the cash reserve ratio (CRR) and
statutory liquidity ratio (SLR).
5. Foreign Exchange Management: It manages the foreign exchange market and reserves,
ensuring that the rupee maintains an appropriate value against foreign currencies.
6. Development of the Financial Market: It aims to ensure the stability and development
of money and capital markets by fostering a sound banking system and facilitating credit
flow for economic development.
7. Government’s Banker: The RBI acts as the banker to the Indian government, managing
its accounts, issuing government securities, and facilitating the process of borrowing and
repayment.

Structure of the RBI

 1. Governor: The Governor of RBI is the head of the Reserve Bank and oversees the
implementation of monetary policy, supervision of the financial system, and all key
functions of the bank.
2. Deputy Governors: There are typically four Deputy Governors appointed to assist the
Governor. They look after specialized functions such as monetary policy, financial
markets, supervision, and currency management.
3. Central Board of Directors: The RBI’s central board consists of the Governor, Deputy
Governors, and other directors appointed by the government. The Board meets
periodically to review the activities of the bank and make major decisions.
4. Regional Offices: RBI operates regional offices and local offices in different cities of India
to effectively monitor the country’s banking system across regions.
5. Departments:
o Monetary Policy Department: Responsible for formulating and implementing
monetary policy.
o Financial Markets Operations Department: Handles management of foreign
exchange, liquidity, and government securities.
o Department of Banking Supervision: Ensures financial institutions comply with
the regulations set by the RBI.
o Department of Currency Management: Deals with issues related to currency
printing, circulation, and management of coins and notes.

Role of the RBI

1. Regulation of the Banking System: The RBI ensures that the banking sector operates
efficiently, providing credit for economic growth while safeguarding financial stability. It
has the authority to issue licenses to banks and monitors their activities to ensure sound
financial practices.
2. Monetary Policy Formulation: The RBI sets policies to control inflation and stabilize the
economy through tools like interest rates, cash reserve ratios, and open market
operations.
3. Development of Financial Infrastructure: It promotes the development of systems such
as electronic payments, banking technology, and financial inclusion to enhance the
overall financial market.
 4. Management of Foreign Exchange: The RBI regulates foreign exchange and deals with
exchange rate policies. It is also responsible for managing India’s foreign exchange
reserves, ensuring stability in the value of the rupee.
5. Public Debt Management: The RBI manages government debt, borrowing, and
repayment processes, along with conducting auctions for government securities.
6. Consumer Protection: The RBI plays a significant role in protecting the rights of
consumers by regulating banking practices, addressing grievances, and setting
regulations related to deposit rates, fees, and transparency in services.
7. Emergency Response Mechanism: The RBI is expected to act as a lender of last resort,
providing funds to the banking system in times of liquidity crises, thereby preventing
financial system collapses.

FUNCTIONS OF RBI
1. Monetary Authority
• Formulation and Implementation of Monetary Policy: The RBI formulates and
implements monetary policy to control inflation, stabilize the currency, and ensure
economic growth. This includes using instruments like:
o Repo Rate: The rate at which commercial banks borrow from RBI.
o Reverse Repo Rate: The rate at which RBI borrows from commercial banks.
o Cash Reserve Ratio (CRR): The percentage of a bank's total deposits that must be
kept with RBI in cash form.
o Statutory Liquidity Ratio (SLR): The percentage of a bank's net demand and time
liabilities to be kept as liquid assets.
• Inflation Control: The RBI also uses tools to control inflation, helping to maintain price
stability in the economy.
2. Issuer of Currency
• Issuance and Management of Currency: The RBI has the exclusive authority to issue
currency notes (except one-rupee notes and coins, which are issued by the Government
of India). It manages the supply of currency in circulation and ensures that adequate
cash is available to meet the economy's needs.
• Currency Management: It is responsible for monitoring and maintaining the quality of
currency notes, including replacing damaged and worn-out notes.
3. Custodian of Foreign Exchange
• Foreign Exchange Management: The RBI manages India's foreign exchange reserves,
formulates the Foreign Exchange Management Act (FEMA), and stabilizes the external
value of the rupee.
• Regulation of Foreign Exchange Markets: It intervenes in the forex market to keep the
value of the rupee stable against foreign currencies and manage exchange rates.
• Cross-Border Transactions: It controls the convertibility of currency and oversees cross-
border capital flows.
4. Regulator of the Financial System
• Supervision and Regulation of Banks: The RBI regulates and supervises banks, financial
institutions, and non-banking financial companies (NBFCs) in India. This ensures that the
banking system operates soundly and remains stable.
• Risk Management: It implements prudential norms for banks to mitigate financial risks,
which include managing capital adequacy and monitoring liquidity.
5. Government’s Banker and Debt Manager
• Banker to the Government: The RBI acts as the government's banker by managing its
accounts, processing payments and receipts, and serving as an intermediary for
transactions like collecting taxes, making public payments, etc.
• Public Debt Management: It is responsible for managing India's public debt, issuing
bonds, and managing the sale of government securities (both domestic and external).
6. Regulator of Payment and Settlement Systems
• The RBI regulates the country's payment and settlement systems, ensuring their security,
efficiency, and integrity.
• It supports electronic banking and payment services like IMPS, NEFT, and RTGS, and
works to enhance the quality of service through innovations in banking technology.
7. Developmental Role
• Development of the Financial System: It works towards strengthening the banking
system by fostering competition, enhancing efficiency, and expanding financial inclusion
(for example, extending banking services to rural and unbanked populations).
• Promotion of Financial Literacy: RBI encourages financial literacy programs and ensures
that people are aware of the financial products and services available.
8. Consumer Protection
 • Protection of Consumer Interests: The RBI regulates consumer rights in the banking
sector, ensuring that the terms and conditions of banking services are transparent and
fair. It also looks into customer complaints and grievance redressal systems.
9. Lender of Last Resort
• Liquidity Support: In times of crisis, the RBI can act as a lender of last resort to
commercial banks, offering short-term liquidity to banks facing sudden financial
difficulties.
• Financial Stability: The RBI ensures that financial institutions stay solvent, preventing
systemic collapses by providing funding if necessary.
10. Monitoring and Reporting on the Economy
• Economic Data and Reports: The RBI regularly publishes reports on the state of the
economy, inflation, economic growth, and monetary policy.
• Analysis of Credit Conditions: It provides guidance on monetary and credit conditions
by monitoring the banking sector and overall economic health.

INSTRUMENTS OF MONETARY AND CREDIT CONTROL BY RBI

The Reserve Bank of India (RBI) uses a range of monetary and credit control instruments to
regulate the money supply, control inflation, and stabilize the financial system. These
instruments help the RBI manage economic growth, prevent financial instability, and ensure the
availability of credit in the economy.
1. Quantitative Instruments
These instruments affect the overall money supply in the economy.
a. Open Market Operations (OMOs)
• Definition: OMOs involve the buying and selling of government securities (bonds) in the
open market.
• Purpose: The RBI uses OMOs to manage liquidity in the banking system.
o Buying securities injects liquidity (increases money supply).
o Selling securities withdraws liquidity (decreases money supply).
• OMOs help control inflation and influence interest rates in the economy.
b. Cash Reserve Ratio (CRR)
 • Definition: The CRR is the percentage of a commercial bank's total deposits that must be
maintained in the form of reserves with the RBI.
• Purpose: By raising or lowering the CRR, the RBI controls the amount of money available
for lending by banks.
o Higher CRR reduces the amount of funds available to banks for lending, thereby
reducing credit growth.
o Lower CRR allows banks to lend more money, stimulating economic activity.
c. Statutory Liquidity Ratio (SLR)
• Definition: The SLR is the minimum percentage of a commercial bank’s net demand and
time liabilities (NDTL) that banks are required to maintain in the form of liquid assets
such as cash, government securities, or gold.
• Purpose:
o By raising the SLR, the RBI reduces the bank's ability to lend, reducing credit
creation and money supply.
o By lowering the SLR, the RBI encourages banks to lend more, thus increasing
credit growth.
d. Bank Rate
• Definition: The bank rate is the rate at which the RBI lends long-term funds to
commercial banks.
• Purpose: It is a signal to the market about the RBI’s stance on monetary policy. A change
in the bank rate affects the lending rates of commercial banks, impacting credit
availability.
o Higher bank rate discourages borrowing by commercial banks and reduces credit
growth.
o Lower bank rate makes credit cheaper, encouraging borrowing and stimulating
economic activity.
e. Reserve Repo Rate
• Definition: This is the rate at which the RBI borrows money from commercial banks,
typically for short periods.
• Purpose:
o Higher reserve repo rate helps the RBI absorb excess liquidity from the banking
system, reducing inflationary pressures.
 o Lower reserve repo rate injects liquidity into the system, stimulating credit
growth.
f. Cash Management Bills (CMBs)
• Definition: CMBs are short-term debt instruments used by the RBI to manage short-term
liquidity mismatches in the system.
• Purpose: They are issued to manage liquidity temporarily and smoothen out temporary
fluctuations in the liquidity of the banking system.
2. Qualitative Instruments
These instruments focus on the quality of credit flow in the economy, aiming to influence
specific sectors or objectives.
a. Marginal Standing Facility (MSF)
• Definition: The MSF is an emergency lending facility through which banks can borrow
overnight funds from the RBI at a higher interest rate than the repo rate.
• Purpose: The MSF helps banks access emergency liquidity when there is a short-term
shortfall, maintaining stability in the financial system. It also ensures that banks have
access to liquidity during periods of extreme stress.
b. RBI's Selective Credit Control (SCC)
• Definition: These are measures taken by the RBI to regulate the flow of credit into
specific sectors of the economy (like agriculture, industry, etc.).
• Purpose: The RBI can control credit flow into particular sectors to avoid overheating in
specific areas (like real estate) and direct more credit to priority sectors, such as
agriculture or small industries.
c. Directives on Credit to Priority Sectors
• Definition: RBI sets guidelines for banks on the allocation of credit to certain priority
sectors of the economy, such as agriculture, small and medium enterprises (SMEs),
housing, etc.
• Purpose: This aims to ensure that adequate credit is made available to sectors that are
crucial for overall economic development but may not always have easy access to
financial services.
d. Moral Suasion
• Definition: This refers to the informal guidance and persuasion used by the RBI to
influence banks' lending behavior without any formal regulatory or legal measures.
 • Purpose: While not a direct regulatory tool, moral suasion influences the behavior of
commercial banks, encouraging them to act in ways that align with broader economic or
monetary goals (e.g., reducing inflationary pressures or boosting specific economic
sectors).
e. Credit Monitoring Arrangement (CMA)
• Definition: RBI closely monitors the credit provided by financial institutions, especially
larger loans to ensure proper usage.
• Purpose: It ensures that credit is being given prudently, reducing the risk of over-
leveraging or speculative borrowing.

3. Other Tools
a. Currency Management
• The RBI controls the supply of money in the form of currency notes and coins. By
managing currency supply in line with demand, it influences overall economic
conditions, such as inflation and the money supply.
b. Liquidity Adjustment Facility (LAF)
• Definition: LAF provides a platform for banks to borrow or park short-term funds with
RBI against eligible securities. It consists of both repo and reverse repo operations.
• Purpose: To manage short-term liquidity in the banking system, keeping interbank
interest rates within the target range set by the RBI.
c. Foreign Exchange Operations
• The RBI engages in the buying and selling of foreign currencies to regulate the exchange
rate of the Indian Rupee. It ensures foreign exchange liquidity and stability in the forex
market.

Various Rates in India

1. Repo Rate
• Definition: The repo rate is the rate at which the RBI lends short-term funds to
commercial banks in exchange for government securities.
• Purpose: It is used by the RBI to control inflation and manage the money supply in the
economy. When the repo rate is increased, it becomes costlier for banks to borrow
 funds, which in turn reduces the money supply in the economy, thus controlling
inflation.
• Impact: An increase in the repo rate tends to lead to higher interest rates on loans for
the public and businesses, slowing down credit growth and economic activity.
2. Reverse Repo Rate
• Definition: The reverse repo rate is the rate at which the RBI borrows money from
commercial banks, usually for very short periods (overnight).
• Purpose: It is used to control the money supply in the economy and absorb excess
liquidity from the banking system. A rise in the reverse repo rate encourages banks to
park more funds with the RBI.
• Impact: A higher reverse repo rate makes it more attractive for banks to lend money to
the RBI, thus reducing the amount of funds available in the market for lending to
consumers and businesses.
3. Bank Rate
• Definition: The bank rate is the long-term rate at which the RBI lends funds to
commercial banks against collateral.
• Purpose: The bank rate is used as a benchmark for lending rates in the economy. It
indirectly influences the cost of borrowing from the commercial banks.
• Impact: An increase in the bank rate will lead to higher borrowing costs for banks, and
these higher costs are generally passed on to borrowers in the form of higher loan rates.
4. Marginal Standing Facility (MSF) Rate
• Definition: The MSF rate is the rate at which banks can borrow overnight from the RBI in
case of any emergency or shortfall in liquidity.
• Purpose: It serves as a last-resort borrowing mechanism for banks. The rate is usually
higher than the repo rate.
• Impact: The MSF rate is used by the RBI to lend to banks during times of financial stress
or liquidity crises, providing a safety net for the banking system.
5. Cash Reserve Ratio (CRR)
• Definition: The CRR is the percentage of a commercial bank's total deposits that it must
maintain with the RBI in the form of liquid cash.
 • Purpose: The CRR is used as a tool by the RBI to regulate the liquidity in the banking
system and ensure that banks hold enough reserves to meet customer withdrawal
demands.
• Impact: Increasing the CRR reduces the funds available with banks for lending to the
public, tightening credit flow. Decreasing the CRR increases the amount available for
banks to lend.
6. Statutory Liquidity Ratio (SLR)
• Definition: The SLR is the minimum percentage of a bank's total net demand and time
liabilities (NDTL) that it must maintain in the form of liquid assets, such as government
bonds, cash, or gold.
• Purpose: The SLR is used by the RBI to ensure that banks maintain a certain level of
liquidity, helping them meet their obligations and preventing excessive credit growth.
• Impact: Higher SLR requirements mean that banks are required to maintain more liquid
assets, reducing their ability to lend. Lower SLR encourages banks to extend more credit
by increasing available funds.
7. Deposit Rates
• Definition: Deposit rates refer to the interest rates paid by commercial banks on
deposits made by customers.
• Purpose: These rates are influenced by the RBI’s monetary policy. Higher deposit rates
attract more savings, while lower rates can dampen deposits.
• Impact: The rate of interest paid on deposits by commercial banks is crucial for
consumer savings behavior. It also impacts liquidity and bank lending ability. A lower
deposit rate might discourage savings and reduce the funds available for banks to lend.
8. Bond Rates
• Definition: Bond rates refer to the interest rates or yields offered on bonds issued by the
government, corporations, or other entities.
• Purpose: Bond rates are influenced by prevailing market interest rates and economic
conditions. They are used by investors to gauge returns from fixed-income investments.
• Impact: When bond rates rise, the value of existing bonds falls. This typically happens in
an environment of rising interest rates, as new bonds offer higher returns, reducing the
attractiveness of older bonds.
9. Bill Rates
 • Definition: Bill rates are the interest rates at which short-term government or corporate
bills (such as treasury bills or commercial paper) are issued.
• Purpose: Bill rates represent the cost of short-term borrowing in the money market.
They provide a way for governments and corporations to raise short-term capital.
• Impact: High bill rates indicate higher short-term borrowing costs. Bill rates are closely
tied to prevailing interest rates in the economy, and they influence the general lending
environment.
10. Prime Lending Rate (PLR)
• Definition: The Prime Lending Rate is the interest rate charged by banks to their most
creditworthy customers for loans.
• Purpose: The PLR serves as a benchmark for determining the interest rates for various
types of loans. It is primarily used for large corporate and high-rated borrowers.
• Impact: The PLR is influenced by the RBI's policy rates (like the repo rate and the bank
rate). When the RBI raises or lowers its policy rates, the PLR typically adjusts accordingly,
influencing borrowing costs for businesses and consumers.

In summary:
• Repo rate, reverse repo rate, and bank rate primarily influence the cost of borrowing
and credit availability in the economy.
• CRR and SLR regulate banks' liquidity and their ability to lend.
• Deposit rates and PLR directly affect consumer savings behavior and borrowing costs.
• Bond and bill rates are crucial for determining yields and borrowing costs in the capital
and money markets.

INFLATION EXPECTATIONS
Inflation expectations refer to the anticipations or forecasts about the future rate of inflation
within an economy. These expectations are formed based on factors such as current economic
conditions, past inflation trends, monetary policy, and external factors (like commodity prices or
global economic conditions). Inflation expectations indicate how individuals, businesses, and
investors believe prices will evolve in the future.
Types of Inflation Expectations:
 1. Short-Term Expectations: These pertain to how inflation will behave in the near future
(e.g., over the next year). They are often influenced by current events like changes in
government policy, global supply chain disruptions, or sudden economic shocks.
2. Long-Term Expectations: These reflect predictions about inflation over a longer horizon
(e.g., 5 years or more). They tend to be more stable and are influenced by factors like
the long-term credibility of monetary policy, historical inflation rates, and institutional
factors.
Factors Influencing Inflation Expectations:
1. Monetary Policy: Central banks, such as the Reserve Bank of India (RBI), influence
inflation expectations through their actions (like changing interest rates or using tools
like quantitative easing). If people expect the central bank to keep inflation under
control, their inflation expectations remain low.
2. Current Inflation: If inflation is rising or has risen sharply in the recent past, it can lead to
higher inflation expectations, as individuals and businesses anticipate that prices will
continue to rise.
3. Government Policies: Fiscal policies, such as changes in taxes or subsidies, can influence
inflation expectations. For example, large government spending might lead people to
expect higher inflation in the future.
4. External Shocks: Events such as oil price hikes, global supply chain disruptions, or
pandemics can suddenly alter inflation expectations, as they directly impact the prices of
essential goods and services.
5. Consumer and Business Sentiment: If businesses and consumers believe prices will rise,
they may act in a way that can fuel inflation. For instance, workers might demand higher
wages, and businesses might raise prices preemptively.
Why Inflation Expectations Matter:
1. Monetary Policy: Central banks closely monitor inflation expectations to guide their
decisions on setting interest rates and other policy measures. If inflation expectations
become unanchored (i.e., rise significantly), it may prompt the central bank to act
aggressively (by raising interest rates) to avoid high inflation becoming entrenched in the
economy.
2. Wage and Price Setting: If inflation expectations are high, businesses might increase
prices, and workers might demand higher wages, contributing to an inflationary cycle
(also called a wage-price spiral).
 3. Investor Behavior: Investors often adjust their strategies based on inflation
expectations. Higher expected inflation can influence investment in assets like real
estate, commodities, or inflation-protected securities.

INFLATIONARY EXPECTATIONS
Inflationary expectations refer to the beliefs or anticipations held by individuals, businesses,
and investors about the future rate of inflation in an economy. These expectations are shaped
by past inflation trends, current economic conditions, government policies, central bank
actions, and global economic factors. Essentially, inflationary expectations reflect how people
expect prices to rise or fall in the future.
Key Points About Inflationary Expectations:
1. Influence on Behavior:
o If people expect inflation to rise significantly, businesses might increase prices
preemptively, and workers may demand higher wages to keep up with the
expected cost of living increases.
o If people expect inflation to be low or stable, they may not alter their behavior in
ways that would cause inflation to rise.
2. Source of Expectations:
o Past Inflation Trends: If inflation has been consistently high or low in the past, it
can influence what people expect to happen in the future.
o Monetary Policy: Actions taken by central banks, such as raising or lowering
interest rates, directly impact expectations about inflation. A central bank
signaling that it will keep inflation low in the future can help anchor inflationary
expectations.
o Supply Shocks: Events like natural disasters, oil price spikes, or disruptions to
global supply chains can cause people to expect short-term increases in inflation.
o Government Policies: Fiscal measures, such as increased government spending
or changes in taxation, can lead people to believe that inflation will increase.
3. Types of Inflationary Expectations:
o Short-Term Expectations: These are expectations about inflation in the near
future (e.g., the next few months or a year). For example, if the economy is
experiencing a temporary supply shock (like a rise in oil prices), people may
expect inflation to rise in the short term.
 o Long-Term Expectations: These reflect expectations about inflation over a longer
horizon (e.g., several years). If people trust a central bank’s commitment to price
stability, they might expect inflation to remain low over the long term, even if
short-term inflation is volatile.
Impact of Inflationary Expectations:
1. Monetary Policy Decisions: Central banks closely monitor inflationary expectations to
guide decisions on interest rates and other measures. If expectations of high inflation
become unanchored (i.e., expectations that inflation will be much higher than desired),
it may prompt central banks to take aggressive actions (like raising interest rates) to
prevent runaway inflation.
2. Wage-Price Spiral: When inflationary expectations rise, businesses may increase their
prices, and workers may demand higher wages to keep pace with the cost of living. This
can result in a cycle of rising prices and wages, known as the wage-price spiral.
3. Investment Decisions: Inflationary expectations also influence how investors allocate
capital. If inflation is expected to rise, people might shift investments into assets that
tend to perform well during inflationary periods, such as commodities or real estate.
4. Consumer Behavior: If inflationary expectations increase, consumers might accelerate
purchases before prices rise, further contributing to inflationary pressure in the
economy.