Indian Economy · Topic 8 of 20
Money supply, the RBI and the instruments of monetary policy, banking structure and reforms
The Basics
Demand for money means how much wealth people want to hold as cash. This is instead of holding it in bonds or property. It is a stock idea. It asks how much money people want to hold now, not how much they earn or spend in a year.
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Money supply means the total stock of money in an economy at one time. Money exists in many forms, from cash in hand to fixed deposits. These forms differ in liquidity. The Reserve Bank of India groups these forms into monetary aggregates called M1, M2, M3 and M4. M1 is the most liquid. M4 is the least liquid.
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Money creation is how banks turn one deposit into many deposits and much more credit. Banks do not just store money people deposit. They lend most of it out. That lent money comes back as a new deposit. Then banks lend it again.
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The Reserve Bank of India is India's central bank. A central bank controls money and banks in a country. The Reserve Bank issues currency, regulates banks, and runs monetary policy.
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Monetary policy means how a central bank controls money and credit supply. In India, RBI alone has legal power over these tools.
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The Cash Reserve Ratio is the share of a bank's deposits kept as cash with the Reserve Bank of India. These deposits are called demand and time liabilities. This cash cannot be lent out. It sits idle with the Reserve Bank of India as a reserve.
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The Statutory Liquidity Ratio is the share of a bank's deposits that the bank must keep with itself. The bank must keep it in safe, liquid forms. These include cash, gold, or approved government securities. This is a form of fractional banking. In fractional banking, banks keep only part of deposits ready for withdrawal. They lend out the rest.
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Interest rates are the price of money. The Reserve Bank of India also sets the price at which it lends to banks or borrows from them. These prices are the Bank Rate, the Repo Rate, and the Reverse Repo Rate. They form the core of day-to-day monetary policy.
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The Liquidity Adjustment Facility (LAF) is how the Reserve Bank of India manages short-term cash in banks every day. It started in June 2000. Under it, the Reserve Bank either lends money to banks, using the repo rate. Or it borrows extra money from banks, using the reverse repo rate. These deals are short. They last from overnight to seven days. Both sides agree to reverse the deal later. The Liquidity Adjustment Facility carries the Reserve Bank's rate decisions to banks each day.
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Open Market Operations (OMO) means the Reserve Bank of India buys and sells government securities in the open market. The goal is to manage liquidity. Liquidity means cash and deposits that banks can quickly use.
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The Monetary Policy Committee sets India's key interest rate, called the repo rate. Its goal is to keep inflation inside a target range set by the government.
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A lending rate benchmark is a rule banks use to set their lowest loan rate. The Reserve Bank of India (RBI) decides this rule. This keeps loan pricing clear. It also helps repo rate changes reach borrowers faster.
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Demonetisation means the government declares some currency notes invalid. These notes stop being legal tender overnight. Legal tender means money that must be accepted to pay a debt.
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Banking in India is not one single system. It is a mix of different bank types. Each type was made for a different purpose. Each is regulated differently. The Reserve Bank of India (RBI) regulates and supervises most of them. All banks do the same basic job. They take deposits and give loans. But ownership, customers, and control vary.
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The Government of India nationalised banks in 1969 and in 1980.
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Small Finance Banks and Payments Banks are new 'differentiated' or 'niche' bank types. A differentiated bank is a bank that can do only some banking activities, not all. They were created to push financial inclusion further than Regional Rural Banks and Local Area Banks did. Unlike those older banks, they have no fixed local area limit. Unlike full commercial banks, each can do only a limited set of activities. Each type serves a specific group that had no bank access.
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Priority Sector Lending, called PSL, forces banks to lend a fixed share of credit to sectors the government sees as important for inclusive growth. Left alone, banks prefer safer, bigger city borrowers. So PSL pushes them to also lend to farmers, small businesses and the poor.
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Digital payment infrastructure moves money between bank accounts electronically. It works instantly, across any bank. It replaces cash and paper cheques. A modern economy needs fast, cheap, and traceable transfers. So this infrastructure exists. Financial inclusion also needs it. A bank account is useless if a person cannot use it easily. People also need it to receive government benefits directly. This system grew from the Jan Dhan-Aadhaar-Mobile base. Demonetisation in 2016 pushed people towards cashless payments. So the system grew fast after that.
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A Non-Performing Asset (NPA) is a loan that has stopped acting like a loan. The borrower is not paying it back. Exactly, a non-performing asset is a loan where interest or principal has not been paid for ninety days. This rule is called the ninety-day overdue norm. The Reserve Bank of India adopted it from 2004 to match global best practice and to make bank accounts more honest. For farm loans, the overdue period follows the crop season instead of a fixed ninety days.
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Capital Adequacy Ratio (CAR) is also called Capital to Risk Weighted Assets Ratio (CRAR). It is the share of a bank's own funds held against its risky assets. This fund cushions losses when borrowers fail to repay. The ratio is total capital divided by risk-weighted assets, shown as a percentage. Regulators fix this ratio. Banks do not choose it themselves. It is a safety rule to protect depositors and the whole financial system.
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Recapitalisation means the government puts fresh money into public sector banks. This money covers their losses. It also helps them meet capital rules.
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A Non-Banking Financial Company (NBFC) is a company that lends money or invests in financial assets. It does not hold a banking licence. The Reserve Bank of India defines it broadly. It is a financial institution set up as a company. It receives deposits or lends money in some form. It cannot have agriculture, industry, or property sale, purchase or construction as its main business. This rule keeps it a financial firm, not an industrial or real estate firm.
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The Government of India announced Local Area Banks in the Union Budget for 1996-97. A Local Area Bank is a small bank that works in one small area. It collects savings and gives loans in that area.
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