How does central bank (RBI) control inflation?

How does central bank (RBI) control inflation?

“Let us continue our discussion where we had left”, said Apurva after enjoying the delicious fish curry my mother had prepared. “I now understand that RBI cannot print infinite money because more money would lead to inflation, but we were discussing about Liquidity through which RBI can control this inflation. What does Liquidity actually mean?”

“Liquidity as its name suggests means smoothness of the flow of liquid”, I started explaining her. In financial world it means flow of cash. If there is more liquidity in the economy then there is enough cash available. Controlling liquidity would mean controlling flow of cash and other assets which can be readily converted into cash. RBI controls this flow of cash to control inflation. Let me explain this with an example.

Let us consider there is a commercial bank, say RBM bank which is new emerging bank in India, which started its operation on 1^st January 2014 and you & I are their only two customers. Commercial banks such as RBM bank, provide us facility to deposit our money and pay us interest on the money deposited. These banks then lend out the money at higher interest rate to others and enjoy the difference in the interest rate which is called as “spread”.

Now suppose on the first day i.e. on 1^st of January, you deposit Rs.10000 which you had saved from the pocket money at the RBM bank. RBM bank promised you to pay 6% interest on it annually. You are very happy to get this interest because the money was anyways lying idle in your house. On 2^nd of January suppose I go to the bank and requests for Rs.10000 loan for one year to purchase a new mobile phone promising to pay the money with 10% interest to bank. RBM Bank lent the money to me that you had deposited to, with aspiration of receiving 4% spread on the deal.

On 2^nd January it was win-win situation for everyone, as you would earn interest on money you deposited, I can buy a mobile and the Bank would earn spread of 4%. But on 10^th January suppose you require Rs.2000 of that Rs.10000 deposited money urgently for an emergency. When you go to bank the manager says that the bank does not have the money because it has lent the money to me and money would only be available if bank receives some more deposits.

This is certainly not desirable situation for you. You don‘t get back the money you had deposited when you need it the most. The word spreads around and no one wants to deposit their hard earned money with this bank which does not ensure to return your money when needed. You have to wait for a year to get your money back. This is called as liquidity crunch and RBI comes to the rescue of banks in these situations. In this situations RBI, which has the authority of printing money, lends to these bank on short term basis at predefined rates decided in its policy called “Monetary Policy”. But this is a curative measure. To avoid such situations RBI has also set some preventive norms which all commercial banks need to follow.

In the example we discussed, out of the Rs. 10000 that you deposited, which is called as Net Demand and Time Liabilities (NDTM), 4% (Cash Reserve Ratio CRR) i.e. Rs. 400 banks would have to keep with RBI as Cash Reserve, and 22% (Statutory Liquidity Ratio SLR) i.e. Rs. 2200 would have to keep with itself, which it cannot lend, in the form of Cash or assets such as gold that can be easily converted into cash. Hence out of Rs. 10000, banks can only lend Rs. 7400 so that if demanded by the bank depositors, bank can give back up to Rs. 2600. But it is possible that depositor can ask for more than Rs. 2600 in that case bank would face the liquidity crunch as they would not have the money. The liquidity crunch is mostly temporary as the banks would have more deposits the next day. Banks do not expect a “Bank Run”, i.e. they do not expect all their depositors to take out money from the bank at the same time. For meeting the temporary liquidity crunch RBI lends money to Banks at the rate known as “Repo Rate” which is decided in a monetary policy. This rate will be lower than the rate at which banks would lend to a customer so that bank makes profit from the spread.

Inflation as we discussed is a supply, demand imbalance where either supply is less or demand is more like we discussed in the example of Video Game previously. Hence inflation can be controlled by either increasing the supply or reducing the demand. Increasing the supply is a long process for which government of India needs to make policies which takes time or depends on the monsoon for better crop production. Hence, quicker way is to reduce the demand which is done through RBI through liquidity control. So when inflation is high and RBI wants to control the inflation, it increases either CRR, SLR or Repo rate.

Increasing CRR would mean that Banks would need to keep more cash with RBI and increasing the SLR would mean Banks would need to keep more cash or liquid assets with itself both resulting into reduction in the amount of money it can lend to its customers. Increase in Repo rate means it becomes expensive for banks to borrow money from RBI to meet its temporary liquidity crisis and banks would then pass on this increase to their customer increasing the lending rate to continue making profit. RBI is more likely to take Repo rate route to cut down demand as this would mean in-genuine need would be reduced. e.g.  If Repo rate is increased by 1% the Banks would also increase the rate by 1%, which would mean that Car loan which had interest rate of 12% then it would now be 13%. Since car is not a necessity, people would rather want to wait for interest rate to come down than buying a car at higher interest rate and indirectly the demand will reduce for cars. This is applicable for all commodities and goods. Increasing CRR or SLR has a direct impact on amount of cash available with banks which reduces demand irrespective of whether it’s genuine  or not and hence less preferred.

“It is very interesting, how RBI can control the demand through its policy rates and curb inflation. But I had also heard that if there is a change in our currency it also causes inflation? Is it true” she added. “Currency is different topic altogether, we will discuss it some other day”, I said.  I knew I would be leaving to Kashipur to comeback only once in three months during my term breaks. So I struck a deal with Apurva to have a Skype session every Saturday. The questions will get tougher I knew, probably I would find few more answers during my MBA, I hoped.

PS: The policy rates mentioned in the blog are taken from www.rbi.org.in which keep changing as decided by the RBI in its monetary policy.