Examkin

Question

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

Consider the following statements regarding the operating framework of monetary policy and liquidity management by the Reserve Bank of India (RBI):

1. The Standing Deposit Facility (SDF) rate serves as the floor of the Liquidity Adjustment Facility (LAF) corridor and allows the RBI to absorb liquidity without requiring collateral securities.
2. An increase in the Cash Reserve Ratio (CRR) impounds bank liquidity, reducing money creation capacity and leading to a contraction in the monetary base multiplier.
3. When the Weighted Average Call Rate (WACR) consistently trades closer to the Marginal Standing Facility (MSF) rate than the Repo rate, it reflects a state of structural liquidity surplus in the banking system.

Which of the statements given above is/are correct?

  1. 1 and 2 onlyAnswer
  2. B
    2 and 3 only
  3. C
    1 and 3 only
  4. D
    1, 2 and 3

Answer

The statement combination '1 and 2 only' is correct.
The combination '1 and 2 only' is correct. Standing Deposit Facility (SDF) functions without collateral assets as the floor of the LAF corridor, and elevating the Cash Reserve Ratio (CRR) impounds liquidity to shrink the credit expansion potential and money multiplier. Conversely, short-term money market rates trading near the Marginal Standing Facility (MSF) rate indicate severe liquidity deficit rather than surplus.

Step-by-Step Solution

1
Analyze Statement 1
Statement 1 is true.
Introduced in 2022, the Standing Deposit Facility (SDF) acts as the lower bound (floor) of the LAF corridor at 25 bps below the policy repo rate. Unlike Reverse Repo, SDF does not require the RBI to provide Government Securities as collateral.
2
Analyze Statement 2
Statement 2 is true.
The Cash Reserve Ratio (CRR) mandates the share of NDTL commercial banks must keep with RBI as cash. Increasing CRR removes primary liquidity from banks, constrains loan growth, and decreases the money multiplier (m=1+cr+cm = \frac{1 + c}{r + c}).
3
Analyze Statement 3
Statement 3 is false.
The MSF rate is the upper bound (ceiling) of the LAF corridor where banks borrow emergency liquidity against penalty interest rates. If WACR trends upward near the MSF ceiling, money market liquidity is extremely tight (liquidity deficit), whereas WACR trading near SDF signifies liquidity surplus.

Key Concept

Operating Framework of Liquidity Adjustment Facility (LAF) Corridor, SDF, CRR, and Call Money Market Mechanics
Rate this question

Topics

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