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FAQs on how central bank influences economy & financial market

Srinivasa Sharan
/ Categories: Mindshare, Edaily, Knowledge, General
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FAQs on how central bank influences economy & financial market
  1. What is a central bank? Discuss its main functions 

    A central bank is a financial institution that is usually owned by the government of a country, which manages the currency & monetary policy and also supervises the country’s commercial banking system. Sweden’s Sveriges Riksbank was founded in 1668 and is the world’s oldest central bank. India’s central bank was established in 1935 under the auspices of Reserve Bank of India Act, 1934, and was nationalised in 1949.  
      
  2. What are the main functions of Reserve Bank of India (RBI)? 
    In the Indian context, RBI manages the monetary policy for the country by setting benchmark interest rates and various liquidity measures. The apex financial institution of India also manages the government borrowing programme, supervises the orderly functioning of the debt market, regulates the commercial as well as other financial institutions of the country along with issuing currency on behalf of the Government of India.
      
  3. What are the key interest rates that RBI uses to influence monetary policy? 
    The repo rate is an important rate that RBI uses to set the cost of short-term borrowing for the banks. It is the rate at which RBI lends money to the commercial banks for a short-term i.e. less than 3 months. By increasing the repo rate, RBI makes it more expensive to borrow in the debt market while by decreasing, RBI makes it less expensive for borrowings in the debt market. The reverse repo rate, on the other hand, is the rate at which RBI borrows money from the banks. Today, the repo rate is set at 4 per cent while the reverse repo rate is set at 3.35 per cent, indicating a loose monetary policy.  
      
  4. What are the liquidity ratios that RBI uses to influence the amount of liquidity in the market?  
    One of the most important liquidity ratios that RBI uses is the cash reserve ratio (CRR). CRR is the percentage of a commercial bank’s cash reserves that need to be maintained with RBI at all times. By increasing the CRR, RBI removed the number of cash reserves in the banking system. A 1 per cent increase in CRR reduces the number of cash reserves in the banking system by over Rs 1.3 lakh crore.  Another liquidity ratio that the bank sets is the statutory liquidity ratio (SLR). SLR refers to the minimum amount that a commercial bank needs to maintain in the form of liquid assets such as gold, government securities, cash, etc.  
      

    5)      What are the open market operations (OMO) and how does this affect liquidity? 
    Open market operations (OMO) refer to liquidity management operations of RBI that influences the number of lendable funds in the banking system. When RBI decides to reduce the number of lendable funds, it sells part of its government securities in the open market thereby, decreasing the liquidity as well as the lendable funds of commercial banks. In FY21, to ensure that government bond yields stayed relatively low, RBI implemented OMO in conjunction with ‘operation twist’, which involved the sale of shorter-term government securities and the purchase of long-term government bonds. 
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