To increase the money supply, the RBI reduces reserve requirements. Banks make more loans from each rupee of reserves, which increases the money multiplier and so money supply.
To reduce the money supply, the CRR is raised and the process works in reverse.
The RBI rarely uses this because frequent changes would disrupt the banking system.
The reverse repo rate is what the banks get when they deposit their excess funds in the RBI for short periods. Basis points are often mentioned in monetary policy reviews. 1% is equivalent to 100 basis points. For example, if the reverse repo rate is 7.75% and the RBI increases it by 25 basis points, the new rate is 8%. It is currently 3.35%.
The discount rate or bank rate is the rate of interest which a central bank charges on its loans and advances to commercial banks (loans). It is currently 4.25%.
Repo rate is the rate at which commercial banks borrow money (short-term funds) from the RBI by selling their securities. It is currently 4%.
The reverse repo rate is the rate of interest offered by the RBI when banks deposit their surplus funds with it for short periods. When banks have surplus funds but no lending/investment options, they must deposit these funds with the RBI, which they earn interest on. Discount lending is used to provide extra liquidity when financial institutions are in trouble.
Banks are mandated to invest a quarter of their deposit/borrowings inflows into government securities. Only the excess over this mandated investment can be used to borrow funds from repo window. The banks’ core borrowing usually comes from deposits, so RBI is a “lender of last resort”.
The RBI raises the repo rate to increase the overall cost of funds in the banking system. Higher costs keeps the check on demand for funds. As demand slows, so does the demand pull inflation. In a tight liquidity scenario, the repo rate acts as the base rate at which banks can borrow funds.
If funds are not very available and banks are unable to borrow at the repo rate, they may have to increase deposit rates to attract depositors.
There is a trade-off between inflation and growth.
To raise the bank rate, the RBI sells government bonds.
If households hold more money as currency (so banks have fewer reserves) or banks hold more as reserves, money supply falls. The RBI can compensate for this.
When people suspect that their banks are in trouble, a run on banks occurs where people go to withdraw their funds, holding more currency and less deposits. Under fractional-reserve banking, they do not have enough reserves to pay off all the depositors, so banks may have to close. Therefore, banks may make fewer loans and hold more reserves to satisfy depositors. These increase \(R\), reverse the process of money creation, and cause the money supply to fall.
Money demand refers to how much wealth people want to hold in liquid form. It depends on \(P\), the price level (CPI or GDP deflator). An increase in \(P\) reduces the value of money, so more money is required to buy goods and services. The quantity of money demanded is negatively related to the value of money and positively related to \(P\), other things equal.
Nominal variables are measured in monetary units, whereas real variables are measured in physical units (for example, nominal GDP and real GDP). A relative price is the price of one good with respect to the other (it is a real variable).
The real wage is equal to the ratio of the nominal wage to the price level.
Classical dichotomy is the theoretical separation between nominal and real variables. Hume and classical economists claim that monetary developments affect nominal variables and not real variables. This is referred to as monetary neutrality. It is widely believed that these do hold in the long run.