Examkin

Question

Difficulty: MediumMonetary Policy Framework, RBI Mechanisms, Banking System, and Financial Markets

When the Reserve Bank of India (RBI) increases the Repo Rate during a monetary tightening phase to manage inflation, which of the following is the direct operational impact on commercial banks and short-term money markets?

  1. The borrowing cost for commercial banks accessing funds through the Liquidity Adjustment Facility (LAF) increases, driving up short-term money market rates and constraining credit expansion.Answer
  2. B
    Commercial banks are mandated to deposit a larger fraction of their Net Demand and Time Liabilities (NDTL) as cash reserves directly with the RBI without receiving interest.
  3. C
    The yields on government securities decline immediately due to an injection of primary liquidity into the banking system.
  4. D
    Commercial banks earn interest on excess deposits parked with the RBI at a rate higher than the Marginal Standing Facility (MSF) rate.

Answer

An increase in the Repo Rate raises short-term borrowing costs for commercial banks under the Liquidity Adjustment Facility (LAF), driving up short-term money market rates and constraining bank credit expansion.
The Repo Rate is the key policy rate at which commercial banks borrow short-term funds from the RBI against approved government securities under the Liquidity Adjustment Facility (LAF). Raising the Repo Rate elevates the marginal cost of funds for banks, transmitting higher interest rates across short-term money markets and dampening credit expansion to control inflation.

Step-by-Step Solution

1
Identify the monetary policy instrument specified
The instrument is the Repo Rate, which serves as the primary policy rate under the RBI's Liquidity Adjustment Facility (LAF).
Understanding the operational role of the Repo Rate is required to determine its immediate monetary transmission mechanism.
2
Analyze the economic impact of raising the Repo Rate
A higher Repo Rate increases the interest cost incurred by commercial banks when borrowing overnight funds from the RBI against government securities.
Banks pass on higher borrowing costs to borrowers by increasing their lending rates and raising short-term money market rates.
3
Differentiate the Repo Rate from other RBI quantitative tools and corridor rates
CRR regulates non-interest-bearing cash reserve balances, while bond yields rise (not fall) when policy rates increase. The Standing Deposit Facility (SDF) rate forms the lower bound of the LAF corridor, while MSF forms the upper bound.
Distinguishing between reserve requirements, corridor bounds, and policy rates verifies that LAF borrowing cost escalation is the unique correct operational effect.

Key Concept

Repo Rate Transmission and Liquidity Adjustment Facility (LAF)
Rate this question

Topics

Monetary Policy Framework, RBI Mechanisms, Banking System, and Financial Markets