28-Apr-2023

MC 602
FINANCIAL INSTITUTIONS AND MARKETS

Supplementary Study Material

Unit IV A - Money Market

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The money market is a market for financial assets that are close substitutes for money. It is a

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market for overnight to short-term funds and instruments having a maturity period of one or less
than one year. It is not a physical location (like the stock market), but an activity that is

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conducted over the telephone. The money market constitutes a very important segment of
the Indian financial system.

The characteristics of the money market are as follows:

● It is not a single market but a collection of markets for several instruments.
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● It is a wholesale market of short-term debt instruments.
● Its principal feature is honor where the creditworthiness of the participants is important.
● The main players are: the Reserve Bank of India (RBI), the Discount and Finance House
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of India (DFHI), mutual funds, insurance companies banks, corporate investors,
non-banking finance companies (NBFCs), state governments, provident funds, primary
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dealers, the Securities Trading Corporation of India (STCI), public sector undertakings
(PSUs), and non-resident Indians.
● It is a need-based market wherein the demand and supply of money shape the market.
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● Transactions in the money market can be both secured and unsecured, i.e., without
collaterals.
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Functions of Money Market

The money market plays an important role in the economy by providing a platform for
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companies, financial institutions, and governments to meet their short-term funding

requirements. The main functions of the money market are:
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1. Providing liquidity: The money market provides a platform for companies and financial
institutions to borrow and lend funds for short periods of time, typically ranging from
overnight to one year. This allows them to meet their short-term liquidity needs and
manage their cash flows effectively.

2. Setting short-term interest rates: The money market plays a crucial role in setting
short-term interest rates. The demand and supply of funds in the money market

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determine the interest rates for short-term financial instruments, which in turn influence
the cost of borrowing for companies and financial institutions.

3. Facilitating monetary policy: The central bank of a country uses various monetary
policy tools to regulate the money supply in the economy. The money market is an
important channel through which the central bank can implement its monetary policy by
influencing short-term interest rates.

4. Providing a platform for investors: The money market provides a platform for
investors to invest their surplus funds in short-term financial instruments. These

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instruments are generally considered to be low-risk investments and provide a stable
source of income to investors.

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5. Supporting government borrowing: The government also participates in the money

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market by issuing Treasury bills to meet its short-term funding requirements. The money
market provides a platform for the government to borrow funds at competitive interest
rates.

In summary, the money market plays a critical role in the economy by providing short-term
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funding to companies, financial institutions, and governments, setting short-term interest rates,
facilitating monetary policy, providing a platform for investors, and supporting government
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borrowing.

Instruments of Money Market

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The instruments traded in the Indian money market are:

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1. Treasury Bills (T-bills);

2. Cash Management Bills (CMBs);
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3. Call/notice money market—Call (overnight) and short notice (up to 14 days);

4. Commercial Papers (CPs);
5. Certificates of Deposits (CDs);
6. Commercial Bills (CBs);
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7. Collateralized Borrowing and Lending Obligation (CBLO).

Call/notice money market and treasury bills form the most important segments of the Indian
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money market. Treasury bills, call money market, and certificates of deposit provide liquidity for
government and banks while commercial paper and commercial bills provide liquidity for the
commercial sector and intermediaries.

Treasury Bills
Before learning about the Treasury bills, it is important to understand what are government
securities and why one should invest in them.

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What is Government Security (G-Sec)?

● A Government Security (G-Sec) is a tradable instrument issued by the Central

Government or the State Governments. It acknowledges the Government’s debt
obligation.

● Such securities are short term (usually called treasury bills, with original maturities of
less than one year) or long term (usually called Government bonds or dated securities
with original maturity of one year or more).

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● In India, the Central Government issues both, treasury bills and bonds or dated
securities while the State Governments issue only bonds or dated securities, which are

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called the State Development Loans (SDLs).

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● G-Secs carry practically no risk of default and, hence, are called risk-free gilt-edged
instruments.

Why should one invest in G-Secs?

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Holding of cash in excess of the day-to-day needs (idle funds) does not give any return.
Investment in gold has attendant problems in regard to appraising its purity, valuation,
warehousing and safe custody, etc. In comparison, investing in G-Secs has the following
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advantages:
● Besides providing a return in the form of coupons (interest), G-Secs offer the maximum
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safety as they carry the Sovereign’s commitment for payment of interest and repayment
of principal.
● They can be held in book entry, i.e., dematerialized/ scripless form, thus, obviating the
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need for safekeeping. They can also be held in physical form.

● G-Secs are available in a wide range of maturities from 91 days to as long as 40 years to
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suit the duration of varied liability structure of various institutions.

● G-Secs can be sold easily in the secondary market to meet cash requirements.
● G-Secs can also be used as collateral to borrow funds in the repo market.
● Securities such as State Development Loans (SDLs) and Special Securities (Oil bonds,
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UDAY bonds etc) provide attractive yields.

● The settlement system for trading in G-Secs, which is based on Delivery versus
Payment (DvP), is a very simple, safe and efficient system of settlement. The DvP
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mechanism ensures transfer of securities by the seller of securities simultaneously with

transfer of funds from the buyer of the securities, thereby mitigating the settlement risk.
● G-Sec prices are readily available due to a liquid and active secondary market and a
transparent price dissemination mechanism.
● Besides banks, insurance companies and other large investors, smaller investors like
Co-operative banks, Regional Rural Banks, Provident Funds are also required to
statutory hold G-Secs

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Now, let’s understand what are treasury bills

Treasury bills, also known as T-bills, are short term money market instruments. The RBI on
behalf of the government to curb liquidity shortfalls. It is a promissory note with a guarantee of
payment at a later date. The funds collected are usually used for short term requirements of the
government. It is also used to reduce the overall fiscal deficit of the country.

Treasury bills or T-bills have zero-coupon rates, i.e. no interest is earned on them. Individuals
can purchase T-bills at a discount to the face/value. Later, they are redeemed at a nominal
value, thereby allowing the investors to earn the difference. For example, an individual
purchases a 91-day T-bill which has a face value of Rs.100, which is discounted at Rs.95. At the

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time of maturity, the T-bill holder gets Rs.100, thus resulting in a profit of Rs.5 for the individual.
Therefore, it is an essential monetary instrument that the Reserve Bank of India uses. It helps

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RBI to regulate the total money supply in the economy as well as raising funds.
● At present, the Government of India issues three types of treasury bills through auctions,

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namely, 91-day, 182-day and 364-day treasury bills.
● The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills
of 91 day, 182 day and 364 day tenors. Settlement for the T-bills auctioned is made on
T+1 day i.e. on the working day following the trade day.
● The government is required to maintain a minimum balance of ₹10 crore in its account
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on a daily basis and ₹100 crore on Fridays

Types of treasury bills:

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● On-Tap Treasury Bills - could be bought from the RBI at anytime at the interest yield of
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4.66 per cent

● Ordinary Treasury Bills - issued to public and other financial institutions for meeting the
short-term financial requirements of the central government.
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● Ad-hoc Treasury Bills - always issued in favor of RBI and they are not sold through
tender or auction.
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Development of Indian Treasury Bills Market

● Ad-hocs 91 Days Treasury Bills Introduced in 1937
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● Agreement between GOI and RBI that government would maintain the balance of not
less that ₹50 Cr on friday and ₹4 Crores on other days and whenever it doesn’t happen,
the government account would be replenished by creating of ad hocs in favor of RBI
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● In the mid-1960s, the auction system for the issue of 91-day T-bills was replaced by
on-tap bills.
● Until 1974, the tap bills rate changed with changes in the bank rate which sustained the
interest of the participants in the T-bills market.
● However, ad hocs came to be issued at an unduly low rate for a longer period of time.
The rate of interest remained 4.6 per cent for many years.
● They became the vehicle of automatic monetisation of the budget deficit.

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● However, the interest in T-bills revived with the introduction of the 182-day T-bills on an
auction basis in November 1986.
● In 1992, 364 Day T-Bills were introduced in India to further expand the government
securities market.
● In 1994, GOI and RBI entered into an agreement to phase out the system of ad-hocs
and Tap TBs and they were discontinued with effect from 01 April, 1997.
● System of ways and means advances (WMA) by the RBI to the GOI, was introduced
with effect from 1 April, 1997 to accommodate temporary mismatches in GOI receipts
and payments,
● The limit of WMA and interest rate on WMA was to be mutually agreed upon by the GOI

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and RBI
● To further diversify the TBs market, 14 day T-Bills were introduced in April 1997.

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● These bills are of two types: one was intermediate treasury bills (ITB) issued in April,
1997 and the other was Auction T-bills (ATB) issued in May, 1997

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● Intermediate T-Bill (ITB) replaced the 91 days Tap T Bill and sold only to state
governments, foreign central banks and other specified bodies
● The surplus cash balances of state governments are automatically invested in 14-day
intermediate treasury bills (ITBs).
● The 182-day T-bills were reintroduced to provide variety in treasury bills. However, both
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the 182 and 14-day T-bills were discontinued from March 2001. The 182-day T-bills were
reintroduced in April 2005.
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Treasury Bill Rate
● It used to be administered as well as the lowest rate of interest until 1993.
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● It increased from 2.52 percent in 1955–56 to 4.60 percent in 1974.

● In view of the narrow and inactive nature of the TBs market, the Chakravarty Committee
(1985) and Vaghul Committee (1987) had made a number of suggestions to correct the
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situation.
● The major suggestion made by them was to deregulate and revise the discount rate
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suitably upwards with a view to provide an adequate yield to the investor.

● In this context, the major step was taken with effect from 1st January, 1993. The system
of fixed rate of discount of 4.6 per cent on 91-day TBs was replaced by the system of
flexible interest rate system.
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Participants in the T-Bills Market

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The Reserve Bank of India, banks, mutual funds, financial institutions, primary dealers,
provident funds, corporates, foreign banks, and foreign institutional investors are all participants
in the T-bills market. The state governments can invest their surplus funds as non-competitive
bidders in T-bills of all maturities.

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Different category of Treasury Bills

Four types of treasury bills are auctioned. The primary distinction for these treasury bills is their
holding period.

91-day Treasury bill

● Introduced in 1937, 91-day treasury bills are the oldest type of T-Bills
● In the mid-1960s, the auction system for the issue of 91-day T-bills was replaced by
on-tap bills.

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● Until 1974, the tap bills rate changed with changes in the bank rate which sustained the
interest of the participants in the T-bills market.

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● After 1974, the discount rate on ad hoc and tap bills was fixed uniformly at 4.6 percent.
● With the discontinuance of ad hoc treasury bills, the system of 91-day tap treasury bills
was also discontinued with effect from 1 April, 1997.

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● These bills complete their maturity in 91 days from the date of issue. They are auctioned
on Wednesday, and the payment is made on the following Friday. They are auctioned
every week.
● These bills are sold in the multiples of Rs.25000 and the minimum amount to invest is
also Rs.25000. A
182-day Treasury bill
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● In Nov 1986, 182 days treasury bills were introduced. It became a handy instruments for
banks, financial institutions, corporate finance managers, and so on to invest their short
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term liquid funds

● Were normally issued at discount to face value for minimum value of ₹1 Lakh and in
multiple thereof
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● Unlike 91-day Treasury bills, they were not purchased by state governments and
provident funds. Also, RBI did not purchase these bills at all.
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● On the whole, its market was much lower than 91-day Treasury Bills. Hence, 182-day
T-Bill was discontinued wef April 1992.
● Upon discontinuing the 182-day treasury bill, the authorities introduced a new money
market instrument, namely 364-day treasury bill.
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● In May 1999, 182-day T-bill was reintroduced and again it was discontinued from May
2001 to March 2005 and again it was reintroduced in April 2005.
● They are auctioned on Wednesday, and the payment is made on the following Friday
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when the term expires. They are auctioned every alternate week.

364-days Treasury bill

● Since its first auction in April 1992, it has evoked a moderate to good response from
investors in terms of number of bids and amount tendered at the time of each auction.

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● They are auctioned on Wednesday, and the payment is made on the following Friday
when the term expires. They are auctioned every alternate week (except on the day of
auction of 182 days T-Bill).
● As mentioned above, the holding period for each bill remains constant. However, the
face value and the discount rates of treasury bills can change periodically. This depends
on the funding requirements and monetary policy of RBI along with total bids received.
● Also, The Reserve Bank of India issues treasury bills calendar for auction. It announces
the exact date of the auction, the amount to be auctioned and the maturity dates before
every auction.

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14-day Treasury bill

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● To further diversify the TBs market, 14 day T-Bills were introduced in April 1997.
● These bills are of two types: one was intermediate treasury bills (ITB) issued in April,

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1997 and the other was Auction T-bills (ATB) issued in May, 1997
● Intermediate T-Bill (ITB) replaced the 91 days Tap T Bill and sold only to state
governments, foreign central banks and other specified bodies.
● The surplus cash balances of state governments are automatically invested in 14-day
intermediate treasury bills (ITBs).
● These bills were sold in the multiples of Rs.1 lakh and the minimum amount to invest
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was also Rs.1 lakh.
● 14 Days T-Bills were discontinued in 2001.
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Cash Management Bills (CMBs)
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● GOI in consultation with RBI, has decided to issue new short-term instrument, known as
CMBs, to meet the temporary mismatches in the cash flow of the government.
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● First set of CMBs were issued on May 12, 2010.

● CMBs have generic character of T-Bills but are issued for maturities less than 91 days.
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● Like T-Bills, CMBs are issued at discount and redeemed at face value at maturity.
● The tenure, notified amount and date of issue of the CMBs depends upon the temporary
cash requirement of the Government.
● The settlement of the auction is on T+1 basis.
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● Non-competitive bidding scheme has not been extended to the CMBs.

● However, these instruments are tradable and qualify for ready forward facility.
● Investment in CMBs is also reckoned as an eligible investment in Government securities
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by banks for SLR purpose under Section 24 of the Banking Regulation Act, 1949.
● Cash Management bills are also issued under market stabilization scheme for liquidity
management.

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Ways and Means Advances (WMA)

● A system of Ways and Means Advances from April 1, 1997 was introduced to replace
adhoc bills and to accommodate temporary mismatches in the government of India
receipts and payments.
● This scheme replaced the practice of automatic monetization of the deficit.
● Any withdrawals by the government from the RBI in excess of the limit of WMA would be
permissible only for ten consecutive working days.
● When 75 percent of WMA is utilized, the RBI would trigger fresh floatation of government
securities.

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● With the discontinuance of ad hoc T-bills and tap T-bills and with the introduction of
WMA, the concept of conventional budget deficit was no more relevant. Therefore, the

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practice of showing budgetary deficit was discontinued; the gross fiscal deposit (GFD) is
now the key indicator of deficit.

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● Gross fiscal deficit is the excess of total expenditure including loans, net of recoveries
over revenue receipts (including external grants) and non-debt capital receipts.

Features of WMA
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The government can avail immediate cash from the RBI, if required. But it has to return
the amount within 90 days. Interest is charged at the existing repo rate.
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● Section 17(5) of the RBI Act, 1934 authorizes the central bank to lend to the Centre and
state governments subject to their being repayable “not later than three months from the
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date of the making of the advance”.

● If the WMA exceeds 90 days, it would be treated as an overdraft (the interest rate on
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overdrafts is 2 percentage points more than the repo rate).

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● The limits for WMA are decided by the government and RBI mutually and revised
periodically.

● A higher limit provides the government flexibility to raise funds from RBI without
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borrowing them from the market.

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WMA also entails important obligations. If the central government is not in a position to address
its fiscal deficit suitably and if this results in a disproportionate rise in market borrowing, the rate
of interest on government paper will start rising, affecting the entire interest rate structure.

Advantages of WMA
● The cash flow problems of States have been aggravated by the impact of Covid-19, thus
many States are in need of immediate and large financial resources to deal with

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challenges, including medical testing, screening and providing income and food security
to the needy.
● WMA can be an alternative to raising longer-tenure funds from the markets, issue of
State government securities (State development loans) or borrowing from financial
institutions for short-term funding. WMA funding is much cheaper than borrowings from
markets.
● It is expected that WMA will not put an undue pressure on money supply as it is not a
source of financing deficit.
● It would reflect the perceptions of both the issuer (the government) and the investors
since the entire market borrowing programme of the government is on an auction basis.

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This would lead to the deepening of the government securities market which, in turn,
would facilitate the pricing of private corporate debt issues in relation to those of risk-free

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government paper.
● The introduction of WMA is a major step towards the achievement of greater discretion.

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The RBI has larger flexibility in the choice of its assets which, in turn, provide it larger
expertise over management of liquidity in the system.

Issuance of G-Secs
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G-Secs are issued through auctions conducted by RBI.
Auctions are conducted on the electronic platform called the E-Kuber, the Core Banking
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Solution (CBS) platform of RBI.
● Commercial banks, scheduled UCBs, Primary Dealers, insurance companies and
provident funds, who maintain funds account (current account) and securities accounts
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(Subsidiary General Ledger (SGL) account) with RBI, are members of this electronic
platform.
● All members of E-Kuber can place their bids in the auction through this electronic
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platform. The results of the auction are published by RBI at stipulated time (For Treasury
bills at 1:30 PM and for GoI dated securities at 2:00 PM or at half hourly intervals
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thereafter in case of delay).

● All non-E-Kuber members including Urban Cooperative banks (UCBs) can participate in
the primary auction through scheduled commercial banks or PDs. For this purpose, the
UCBs need to open a securities account with a bank / PD – such an account is called a
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Gilt Account. A Gilt Account is a dematerialized account maintained with a scheduled

commercial bank or PD.
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● The Reserve Bank of India conducts auctions usually every Wednesday to issue T-bills.
Payments for the T-bills purchased are made on the following Friday.
● The 91-day T-bills are auctioned on every Wednesday. The treasury bills of 182 days
and 364 days tenure are auctioned on alternate Wednesdays.
● The first reporting Friday fixed by RBI was on 29.3.1985 and every alternate Friday
subsequent to this date is known as reporting Friday.
● T-bills of 364 days tenure are auctioned on the Wednesday preceding the reporting
Friday whereas 182 T-bills are auctioned on the Wednesday prior to non-reporting
Fridays.

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Types of Auctions used for G-Sec

Prior to the introduction of auctions as the method of issuance, the interest rates were
administratively fixed by the Government. With the introduction of auctions, the rate of interest
(coupon rate) gets fixed through a market-based price discovery process.

An auction may either be yield based or price based.

I. Yield Based Auction: A yield-based auction is generally conducted when a new G-Sec
is issued. Investors bid in yield terms up to two decimal places (e.g., 8.19%, 8.20%,
etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield

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corresponding to the notified amount of the auction. The cut-off yield is then fixed as the
coupon rate for the security. Successful bidders are those who have bid at or below the

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cut-off yield. Bids which are higher than the cut-off yield are rejected.

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For example, the notified amount is 1000 crores and bids are received as under in
ascending order.
● Bid yield @6.84 for 400 crores, cumulative 400 crores
● Bid yield @6.85 for 100 crores cumulative 500 crores
● Bid yield @6.86 for 200 crores cumulative 700 crores
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● Bid yield @6.87 for 500 crores cumulative 1200 crores
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● Bid yield @6.88 for 300 crores cumulative 1800 crores

The issuer would get the notified amount by accepting successful bids up to serial no. 4.
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Since the bid number 4 exceeds the notified amount of 1000 crores by 200 crores, he
would get an allotment of only 300 crores against Rs.500 crore applied by him at a cut
off yield of 6.87 crore. Bid number 5 is rejected as the yield is higher than the cut-off
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yield.
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II. Price Based Auction: A price based auction is conducted when the Government of
India re-issues securities which have already been issued earlier. Bidders quote in terms
of price per ₹100 of face value of the security (e.g., ₹102.00, ₹101.00, ₹100.00, ₹ 99.00,
etc., per ₹100/-). Bids are arranged in descending order of price offered and the
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successful bidders are those who have bid at or above the cut-off price. Bids which are
below the cut-off price are rejected.
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● In case of uniform price auction, all successful competitive bids (i.e bids higher
than the cut-off) will be accepted at the cut-off price, determined at the auction,
irrespective of bid prices tendered by the bidder.
● In case of multiple price auction, successful competitive bids will be accepted
at the bid prices tendered by the individual bidders at the auction.
● Competitive bids at offer prices lower than the ‘cut off’ price will be rejected in the
case of both uniform and multiple price auctions

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Let us try and understand this with the help of an example.

Let us assume that for a sale of securities of the maximum size of Rs. 100 Million, the
following bids were received. Price range for each security is Rs. 100 to Rs. 120
Bidder Bid Price No. of security Bid Amount Cumulative
(Rs) (Rs Million) Bid Amount
(Rs Million)

A Rs 120 250,000 30 30

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B Rs 115 250,000 28.75 58.75

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C Rs 110 375,000 41.25 100

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D Rs 100 500,000 50 150

➔ In the auction the cut-off price was determined at Rs. 110. Thus bids offered by
A, B, C (which is higher than the cut-off price) were accepted, while D's bid was
rejected.
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➔ In the case of the ‘Uniform Price’ auction, each successful bidder will be allotted
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security that he bid for at Rs. 110 each; irrespective of bid prices individually
quoted. Thus the total amount payable will be (875000 securities @ Rs. 110 per
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share) Rs. 96.25 Million

➔ Whereas in the case of Multiple Price Auction, each successful bidder will be
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allotted securities at the bid price he had offered. Thus the total amount payable
would be Rs. 100 Million.
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Competitive and Non-Competitive Bidding

An investor, depending upon his eligibility, may bid in an auction under either of the following
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categories:
01. Competitive Bidding:
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a. In a competitive bidding, an investor bids at a specific price / yield and is allotted

securities if the price / yield quoted is within the cut-off price / yield.
b. Competitive bids are made by well-informed institutional investors such as banks,
financial institutions, PDs, mutual funds, and insurance companies.
c. The minimum bid amount is ₹10,000 and in multiples of ₹10,000 in case of dated
securities and T-Bills.
d. Multiple bidding is also allowed, i.e., an investor may put in multiple bids at
various prices/ yield levels.

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02. Non-Competitive Bidding (NCB):

a. With a view to encouraging wider participation and retail holding of Government
securities, retail investors are allowed participation on a “non-competitive” basis
in select auctions of dated Government of India (GoI) securities and Treasury
Bills.
b. Participation on a non-competitive basis in the auctions will be open to a retail
investor who
i. does not maintain current account (CA) or Subsidiary General Ledger
(SGL) account with the Reserve Bank of India; and
ii. submits the bid indirectly through an Aggregator/Facilitator permitted

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under the scheme.
c. Retail investor, for the purpose of scheme of NCB, is any person, including

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individuals, firms, companies, corporate bodies, institutions, provident funds,
trusts, and any other entity as may be prescribed by RBI.

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d. However, non-competitive bidding in treasury bills is available only to state
governments and other select entities and is not available to the co-operative
banks.
e. Under the Scheme, an investor can make only a single bid in an auction.

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T-bills auctions are held on the Negotiated Dealing System (NDS) and the members
electronically submit their bids on the system.
Non-competitive bids are routed through the respective custodians or any bank or PD
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which is an NDS member.
● RBI issues an indicative auction calendar that contains information about the borrowing,
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tenor range and auction duration.

● During the auction duration, bids can be placed on the electronic platform of RBI called
E-Kuber. E-Kuber is the Core Banking Solution (CBS) platform of RBI.
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● Competitive bidders who maintain funds or current account and securities account
(Subsidiary General Ledger (SGL) account) with RBI are members of the E-Kuber
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Platform.
● Through this electronic platform, all E-Kuber members can submit bids in the auction.
● RBI publishes the auction results within a stipulated time period for Treasury bills at 1:30
PM.
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● Non-Competitive bidders can place their bids to purchase T-bills through RBI retail direct
platform or stock exchanges (NSE goBID and BSE Direct) or through brokers.
● The allotted bonds will directly reflect in the bidder’s demat account. Therefore,
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non-competitive bidders must have a demat account. The allotted bonds will reflect in
your account in T+1 days.

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Yield of a Treasury Bill

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Commercial Paper
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● The Reserve Bank introduced commercial papers in January 1990.
● A commercial paper is an unsecured short-term promissory note, negotiable and
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transferable by endorsement and delivery with a fixed maturity period. It is generally

issued at a discount by the leading creditworthy and highly rated corporates to meet their
working capital requirements.
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● Depending upon the issuing, a commercial paper is also known as a finance paper,
industrial paper, or corporate paper.
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● CP shall be issued in denominations of ₹5 lakh and multiples thereof.

● CP shall be issued at a discount to face value as may be determined by the issuer.
● A commercial paper can be issued to individuals, banks, companies, and other
registered Indian corporate bodies and unincorporated bodies.
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● The CP market is dominated by corporates having tangible net-worth of ₹ 50 crore and

above.
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● Scheduled commercial banks are the major investors in commercial papers and their
investment is determined by bank liquidity conditions.
● Banks prefer a commercial paper as an investment avenue rather than sanctioning bank
loans. It is because loans involve high transaction costs and money is locked
● for a long time period whereas in a commercial paper which is an attractive short-term
instrument, allows banks to park funds during times of high liquidity.
● Some banks fund commercial papers by borrowing from the call money market. Usually,
the call money market rates are lower than the commercial paper rates. Hence, banks
book profits through arbitrage between the two money markets.

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● Moreover, the issuance of commercial papers has been generally observed to be

inversely related to the money market rates.

The Finance Act, 2019 brought amendments to the Indian Stamp Act, 1899 that changed the
entire regime of stamp duty on commercial papers. Post amendment, CPs have been
specifically included in the definition of debentures and securities, thereby attracting similar
stamp duty as in case of debentures.
Hence, the stamp duty applicable for CP and CD stands revised as hereunder:
A. In case of issue : 0.005% or Rs. 500 per 1 crore rupees of the market value
B. In case of Transfer and Reissue – 0.0001% or Rs. 10 per 1 crore rupees

L
Eligibility for Issue of CP

A
A. Companies, PDs and FIs are permitted to raise short-term resources through CP.

RW
B. A company would be eligible to issue CP provided:
a. the tangible net worth of the company, as per the latest audited balance sheet, is
not less than ₹4 crore;
b. the company has been sanctioned working capital limit by bank/s or FIs; and
c. the borrowal account of the company is classified as a standard asset by the
A
financing bank/institution.
G
Eligibility for Investment in CP
A. Individuals, banks, other corporate bodies (registered or incorporated in India) and
A

unincorporated bodies, Non-Resident Indians and Foreign Institutional Investors (FIIs)

shall be eligible to invest in CP.
B. FIIs shall be eligible to invest in CPs subject to such conditions as may be set for them
T

by Securities Exchange Board of India (SEBI) and compliance with the provisions of the
other relevant acts.
JA

Certificates of Deposit
● Certificates of deposit (CDs) are unsecured, negotiable, short-term instruments in bearer
A

form, issued by commercial banks and development financial institutions.

● Certificates of deposit were introduced in June 1989.
R

● CDs are issued by banks during periods of tight liquidity, at relatively high interest rates.
● CDs are issued at a discount to face value. Banks and FIs can issue CDs on a floating
rate basis provided the methodology of computing the floating rate is objective,
transparent and market-based.
● Minimum amount of a CD should be ₹1 lakh, i.e, the minimum deposit that could be
accepted from a single subscriber should not be less than ₹1 lakh, and in multiples of ₹1
lakh thereafter.
● Certificates of deposit can be issued by

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A. scheduled commercial banks (excluding regional rural banks and local area
banks); and
B. selected All-India Financial Institutions (FIs) that have been permitted by RBI to
raise short-term resources within the umbrella limit fixed by RBI.
● CDs can be issued to individuals, corporations, companies (including banks and PDs),
trusts, funds, associations, etc. Non-Resident Indians (NRIs) may also subscribe to CDs,
but only on a non-repatriable basis, which should be clearly stated on the Certificate.
● The maturity period of CDs issued by banks should not be less than 7 days and not
more than one year, from the date of issue. FIs can issue CDs for a period not less than
1 year and not exceeding 3 years from the date of issue.

L
● All OTC trades in CDs shall necessarily be cleared and settled under DVP I mechanism
through the authorised clearing houses.

A
Difference between Commercial paper and Certificates of Deposit

RW
Commercial paper and certificates of deposit are both short-term financial instruments that are
issued by companies and financial institutions to raise funds. However, there are some key
differences between the two:

Basis of
difference
A
Commercial Paper Certificates of Deposit
G
Issuer Highly rated companies Banks and financial institutions
A

Banks, mutual funds,

Individuals, corporations, trusts, and
Eligible investors insurance companies, pension
eligible funds
funds, etc.
T
JA

Minimum
Rs. 5 lakh Rs. 1 lakh
denomination
A

Regulated by RBI and subject to

Regulation Regulated by RBI additional guidelines issued by the
R

Indian Banks' Association

Interest rate Higher than CDs Lower than CPs

Generally secured by the issuing bank

Security Unsecured
or financial institution

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Market size Relatively larger Relatively smaller

Call and Notice Money Market

● The money market is a market for short-term financial assets that are close substitutes
of money. The most important feature of a money market instrument is that it is liquid
and can be turned into money quickly at low cost and provides an avenue for

L
equilibrating the short-term surplus funds of lenders and the requirements of borrowers.
● The call/notice money market forms an important segment of the Indian money market.

A
● The call money market is a market for very short-term funds repayable on demand and
with a maturity period varying between one day to a fortnight.

RW
● When money is borrowed or lent for a day, it is known as call (overnight) money.
Intervening holidays and/or Sundays are excluded for this purpose. When money is
borrowed or lent for more than a day and upto 14 days, it is known as notice money.
● Call money is required mostly by banks. Commercial banks borrow money without
collateral from other banks to maintain a minimum cash balance known as the cash
A
reserve requirement (CRR). This interbank borrowing has led to the development of the
call money market.
● CRR is an important requirement to be met by all commercial banks. Once every
G
fortnight on a reporting Friday, banks have to satisfy reserve requirements which often
entails borrowing in the call/notice money market.
A

● Participants - Scheduled commercial banks (excluding RRBs), co-operative banks

(other than Land Development Banks) and Primary Dealers (PDs), are permitted to
T

participate in call/notice money market both as borrowers and lenders.

JA

● Trading - The call/notice money transactions can be executed either on NDS-Call, a

screen–based, negotiated, quote-driven electronic trading system managed by the
Clearing Corporation of India (CCIL), or Over The Counter (OTC) through bilateral
communication.
A

Call Rate
R

● The interest rate paid on call loans is known as the ‘call rate.’ It is a highly volatile rate. It
varies from day-to-day, hour-to-hour, and sometimes even minute-to-minute.
● It is very sensitive to changes in the demand for and supply of call loans. Within one
fortnight, rates are known to have moved from 1–2 per cent to over 140 per cent per
annum.
● With effect from May 1, 1989, call rates were freed from an administrative ceiling. Now
the rate is freely determined by the demand and supply forces in the call money market.

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● The interest rate in the call and notice money market is determined by the prevailing
MIBOR rate.
● MIBOR stands for the Mumbai Interbank Offered Rate. MIBOR is calculated by obtaining
a weighted average of call money transactions of a panel of selected banks.
● The National Stock Exchange (NSE) developed and launched the NSE Mumbai
Inter-bank Bid Rate (MIBID) and the NSE Mumbai Inter-bank Offer Rate (MIBOR) for
overnight money markets on June 15, 1998. NSE MIBID/MIBOR are based on rates
pooled by the NSE from a representative panel of 31 banks/institutions/primary dealers.
● The banks use MIBOR as a benchmark rate to price their lending and borrowing
transactions in the call and notice money market. For example, if the MIBOR rate is 5%,

L
a bank may lend funds to another bank at a slightly higher rate of, say, 5.5% in the call
money market.

A
● It is also used as a benchmark for setting the interest rates of other financial instruments,
such as floating rate bonds and mortgages.

RW
Link Between the Call Money Market and Other Financial Markets
● There is an inverse relationship between call rates and short-term money market
instruments such as certificates of deposit and commercial papers. When call rates peak
A
to a high level, banks raise more funds through certificates of deposit. When call money
rates are lower, many banks fund commercial papers by borrowing from the call money
market and earn profits through arbitrage between money market segments.
G
● A large issue of government securities also affects call money rates. When banks
A

subscribe to large issues of government securities, liquidity is sucked out from the
banking system. This increases the demand for funds in the call money market which
pushes up call money rates. Similarly, a rise in the CRR or in the repo rate absorbs
T

excess liquidity and call rates move up.

JA

● The call money market and the foreign exchange market are also closely linked as there
exist arbitrage opportunities between the two markets. When call rates rise, banks
borrow dollars from their overseas branches, swap them for rupees, and lend them in the
call money market. At the same time, they buy dollars forward in anticipation of their
A

repayment liability. This pushes forward the premia on the rupee– dollar exchange rate.
It happens many a times that banks fund foreign currency positions by withdrawing
from the call money market. This hikes the call money rates.
R

Collateralized Borrowing and Lending Obligation

● Collateralized Borrowing and Lending Obligation (CBLO) is a short-term money market
instrument which serves as an agreement between two parties, whereby one party
borrows funds from the other party and provides collateral in the form of government
securities as security for the loan.

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● CBLO is a discounted instrument available in electronic book entry form for the maturity
period ranging up to one year as per the RBI guidelines.
● It is an obligation by the borrower to return the borrowed money, at a specified future
date, and an authority to the lender to receive money lent, at a specified future date with
an option/privilege to transfer the authority to another person for value received.
● CBLO is issued by Clearing Corporation of India Ltd (CCIL), which acts as an
intermediary between the borrower and the lender.
● Banks, Cooperative Banks, Financial institutions, Insurance Companies, Mutual Funds,
and Primary Dealers who are members of a negotiated dealing system (NDS) are
allowed to participate in CBLO transactions.

L
● Non-members like corporates, NBFCs, pension/provident funds, and trusts are allowed
to participate by obtaining associate membership to CBLO segment. Associate members

A
are entities not eligible to maintain a current account and SGL account with the Reserve
Bank.

RW
● Members can access CBLO Dealing System through INFINET connectivity whereas
associate members can access CBLO Dealing System through internet.
● Mutual funds and insurance companies have emerged as the largest supplier of funds
as they are flush with liquidity. The cooperative banks, public and private sector banks,
and primary dealers are large borrowers in this market on account of favourable

●
A
borrowing cost in the CBLO segment vis-.-vis the call market.
CBLO Dealing System is an automated order driven, online anonymous matching
system provided by Clear Corp Dealing System (CCDS) to enable members to borrow
G
and lend funds against CBLO.
● The interest rates on the CBLOs mirror call money rates. The borrowing costs in the
A

CBLOs are low as compared to the call market.

● The borrower pledges government securities as collateral to CCIL, and in return, CCIL
issues CBLO to the borrower. The lender then purchases CBLO from CCIL and receives
T

interest on the investment until the maturity date. At maturity, the borrower returns the
borrowed funds and receives back the pledged collateral.
JA

● CBLO is similar to other collateralized lending instruments, such as repo and reverse
repo agreements. However, CBLO is considered more flexible than other instruments, as
it can be traded in smaller denominations, and the collateral requirement is only in the
form of government securities.
A

The Discount and Finance House of India (DFHI)

R

DHFI was set up as a money market institution jointly by the Reserve Bank, public sector banks,
and financial institutions in 1988 to impart liquidity to money market instruments and help the
development of a secondary market in such instruments.

● DFHI was incorporated on March 8, 1988 under the Companies Act, 1956 with an
authorized share capital of ₹250 Crores.

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● It was a joint stock company which was jointly owned by and whose paid-up capital was
contributed by the RBI, Public Sector Banks, and All-India Financial Institutions in the
ratio of 5:3:2.

● Money market instruments such as the 182-day treasury bill, certificate of deposit, and
inter-bank participation certificate were introduced in the late 1980s. Commercial paper
was introduced in January 1990.

● To enable price discovery, the interest rate ceiling on call money was freed in stages
from October 1988.

L
● As a first step, operations of the DFHI in the call/notice money market were freed from

A
the interest rate ceiling in 1988. Interest rate ceilings on interbank term money (10.5 per
cent to 11.5 per cent), rediscounting of commercial bills (12.5 per cent), and inter-bank

RW
participation without risk (12.5 per cent) were withdrawn effective May 1989.

● All the money market interest rates are, by and large, determined by market forces.
There has been a gradual shift from a regime of administered interest rates to
market-based interest rates.

●
A
With financial sector reforms, efforts have been made to develop and widen the
government securities market.
G
● With effect from the year 1992-93, The Discount and Finance House of India (DFHI)
A

was allowed to participate in treasury bills and dated securities.

● After DFHI was accredited as a Primary Dealer in February 1996, its operations
T

significantly increased particularly in Treasury Bills and dated Government Securities.

JA

● The RBI, during 2001–02, started to disinvest its holdings in the Discount and Finance
House of India (DFHI) and the latter was promoted for developing an active secondary
market for government securities.
A

● In 2004, there was an amalgamation between the RBI promoted Discount & Finance
House of India (DFHI) and SBI Gilts Ltd., a subsidiary of India’s largest commercial bank and
the total holding of DHFI was transferred to SBI Giltz Limited. It is now SBI DFHI Ltd.
R

● SBI DFHI Limited is a Standalone Primary Dealer, an institution created by RBI to support
the book building process in primary auctions of Government Securities and provide
necessary depth and liquidity to the secondary market in Government Securities.

● As a Primary Dealer, the Company trades in Treasury Bills, Government securities, State
Development Loans, Corporate Bonds and Short Term Money Market instruments

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(Certificates of Deposit, Commercial Paper, Inter-Corporate Deposits, Call & Notice / Term
Money). It is very active in retailing Government Securities, including small lots.

Functions of SBI DFHI

Primary functions of DFHI are as follows:
● To discount, re-discount purchase and sell Treasury bills, trade bills, bills of exchange,
commercial bills and commercial papers.
● To play an important role as a lender, borrower, or broker in the interbank call money
market.

L
● To promote and support company funds, trusts and other organizations for the
development of the short-term money market.

A
● To advise the government, banks and financial institutions in evolving schemes for
growth and development of the money market.

RW
Role of DFHI in Money Market
1. To even out the liquidity imbalances in the banking system i.e. to balance the demand
with the supply for short term finance in the money market.
A
2. To promote secondary markets in short term money market instruments i.e. to be an
active trader in money market instruments rather than a mere repository, and thereby,
G
impart improved liquidity to short term money market instruments.
3. to integrate markets at regional centers with the main market at Mumbai, through its
network.
A

4. Provide safe and risk-free short-term investment avenues to institutions; DFHI being an
institution promoted by the public sector banks/financial institutions and RBI, enjoys
excellent credit rating in the market.
T

5. Provide greater liquidity to money market instruments.

6. Facilitate money market transactions for small and medium sized institutions who are not
JA

regular participants in the market.

7. DFHI provides the 'Constituent SGL' Account facility which enables even those entities
which otherwise do not have an SGL Account facility with the RBI to reap the full benefits
of investing in government securities. A Constituent Subsidiary General Ledger Account
A

(CSGL) is a service provided by Reserve Bank of India through Primary Dealers and
Banks to those entities who are not allowed to hold direct SGL Accounts with it. This
R

account provides for holding of Central/State Government Securities and Treasury bills
in book entry/dematerialized form. Individuals are also allowed to hold a Constituent SGL
Account.

Primary Dealers
Primary dealers are registered entities with the RBI who have the license to purchase and sell
government securities. They are entities who buy government securities directly from the RBI

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(the RBI issues government securities on behalf of the government), aiming to resell them to
other buyers. In this way, the Primary Dealers create a market for government securities. The
Primary Dealers system in the government securities market was introduced by the RBI in 1995.

There are two types of primary dealers in India. Standalone primary dealers and bank primary
dealers.
● The standalone primary dealers are either subsidiaries of scheduled commercial banks,
Indian subsidiaries of entities incorporated abroad or companies incorporated under
companies act 1956 and are registered as Non-Banking Financial Company (NBFC).
● The bank primary dealers are the banks who wish to undertake PD business and do not

L
have any subsidiaries doing PD business already.

A
The RBI instructs PDs to have a minimum turnover ratio, bidding ratio, underwriting ratio,
secondary market participation etc to ensure that they are active in supporting the trade in

RW
government securities. PDs are active in the stock market also for enhancing the trading of
government securities.

Eligibility Conditions for PDs:

a. Subsidiary of scheduled commercial bank/s and All India Financial Institutions
A
b. Subsidiaries/ joint ventures set up in India by entities incorporated abroad.
c. Company incorporated under the Companies Act and does not fall under (a) or (b).
G
The applicant for PD should register as an NBFC for at least one year prior to the submission of
application. Other conditions like net owned funds etc are mentioned by the RBI.
A

The decision to authorize PDs will be taken by RBI based on its perception of market needs,
suitability of the applicant and the likely value addition to the system. Some other functions
T

besides trading in government securities are also assigned to them.

JA

Role and Functions of Primary Dealers

The role of Primary Dealers is to:
I. commit participation as Principals in Government of India issues through bidding in
A

auctions,
II. provide underwriting services,
III. offer firm buy – sell / bid ask quotes for T-Bills & dated securities,
R

IV. development of Secondary Debt Market

Reserve Bank of India

The Reserve Bank of India was established by legislation in 1934 through the Reserve Bank of
India Act, 1934. It started functioning from April 1, 1935. Its central office is at Mumbai since

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1937. Though originally privately owned, since nationalization in 1949, it is fully owned by the
Government of India. The Reserve Bank of India is the central bank of our country.

History
● The Reserve Bank, as the central bank of the country, started its operations as a private
shareholder’s bank. RBI replaced the Imperial Bank of India and started issuing the
currency notes and acting as the banker to the government.
● Imperial Bank of India was allowed to act as the agent of the RBI. RBI covered all over
undivided India.

L
● To have close integration between policies of the Reserve Bank and those of the
Government, it was decided to nationalize the Reserve Bank immediately after the

A
independence of the country.
● From 1st January 1949, the Reserve Bank began functioning as a State-owned and

RW
State-controlled Central Bank.
● To streamline the functioning of commercial banks, the Government of India enacted the
Banking Companies Act,1949 which was later changed as the Banking Regulation Act
1949.

Structure of the RBI

A
G
Board of Directors
The bank is managed by a central board of directors and four local boards of directors:
A

1. Central board:
The functions of the central board are general superintendence and direction of the
T

bank’s affairs. The central board is appointed/nominated by the central government for a
period of four years. It consists of official directors and non-official directors.
JA

● Official directors: The governor and not more than four deputy governors are
full-time official directors.
● Non-official directors: They are fifteen in number. Ten directors from various fields
and one government official are nominated by the government while four
A

directors from four local boards are nominated as non-official directors.

R

2. Local boards:
There are four local boards, one each for the four regions of the country in Mumbai,
Kolkata, Chennai, and New Delhi. The membership of each local board consists of five
members appointed by the central government for a term of four years. The functions of
the local board is to advise the central board on local matters; to represent territorial and
economic interns of local cooperative and indigenous banks’ interests, and to preform
such other functions as delegated by the central board from time to time.

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Offices:
The RBI has 22 regional offices, most of them in state capitals.

Training establishments:
The Reserve Bank has six training establishments:
● Three training establishments, namely, the College of Agricultural Banking, the Banker’s
Training College, and the Reserve Bank of India Staff College are part of the RBI.

● Others such as the National Institute for Bank Management, Indira Gandhi Institute for

L
Development Research (IGIDR), and the Institute for Development and Research in
Banking Technology (IDRBT) are autonomous.

A
Subsidiaries of RBI

RW
● The Reserve Bank has fully owned three subsidiaries: National Housing Bank (NHB), the
Deposit Insurance and Credit Guarantee Corporation of India (DICGC), and Bharatiya
Reserve Bank Note Mudran Private Limited (BRBNMPL).

●
A
The Reserve Bank has a majority stake in the National Bank for Agriculture and Rural
Development (NABARD).
G
National Housing Bank
A

The National Housing Bank (NHB) is wholly owned by the RBI. It was set up in July 1988, under
an act of the parliament. The NHB was conceived and promoted to function as the apex
institution in the housing sector. It promotes housing finance institutions both at local and
regional levels and provides financial and other support to such institutions. The Reserve Bank
T

added to the equity of its 100 per cent owned National Housing Bank.
JA

Deposit Insurance and Credit Guarantee Corporation of India

The DICGC, a fully-owned undertaking of the RBI, operates both deposit and credit guarantee
Schemes. The Union Budget 2002–03 announced that the DICGC would be converted into the
A

Bank Deposits Insurance Corporation (BDIC) to make it an effective instrument for dealing with
depositors risks and distressed banks.
R

Discount and Finance House of India

The RBI, during 2001–02, disinvested its holdings in the Discount and Finance House of India
(DFHI) and the Securities Trading Corporation of India (STCI) which were promoted for
activating and deepening the money market and developing an active secondary market for
government securities and PSU bonds, respectively.

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The committee on banking sector reforms suggested that the Reserve Bank should not own the
institutions it regulates. The Reserve Bank accepted the recommendation for transfer of
ownership of its shares in the State Bank of India, National Housing Bank, and National Bank
for Agriculture and Rural Development to the central government.

Main Functions of the RBI

The main functions of the Reserve Bank are as follows:
● To formulate, implement, and monitor monetary policy.
● To prescribe broad parameters of banking operations within which the country’s banking

L
and financial system functions.
● To facilitate external trade and payment and promote orderly development and

A
maintenance of foreign exchange market in India.
● To issue and exchange or destroy currency and coins not fit for circulation.

RW
● To perform a wide range of promotional functions to support national objectives.
● To perform merchant banking functions for the central and the state governments.
● To maintain banking accounts of all scheduled banks.

Monetary Policy Framework A

● In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the
G
implementation of the flexible inflation targeting framework.
● Inflation Target: Under Section 45ZA, the Central Government, in consultation with the
RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in
A

five years and notifies it in the Official Gazette.

● Accordingly, on August 5, 2016, the Central Government notified in the Official Gazette 4
per cent Consumer Price Index (CPI) inflation as the target for the period from August 5,
T

2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower
tolerance limit of 2 per cent.
JA

● On March 31, 2021, the Central Government retained the inflation target and the
tolerance band for the next 5-year period – April 1, 2021 to March 31, 2026.

Failure to Maintain Inflation Target:

A

The Central Government has notified the following as the factors that constitute failure to
achieve the inflation target:
R

(a) the average inflation is more than the upper tolerance level of the inflation target for any
three consecutive quarters; or
(b) the average inflation is less than the lower tolerance level for any three consecutive
quarters.

Where the Bank fails to meet the inflation target, it shall set out in a report to the Central
Government:
(a) the reasons for failure to achieve the inflation target;

24
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(b) remedial actions proposed to be taken by the Bank; and

(c) an estimate of the time-period within which the inflation target shall be achieved pursuant
to timely implementation of proposed remedial actions.

Section 45ZB of the RBI Act provides for the constitution of a six-member Monetary Policy
Committee (MPC) to determine the policy rate required to achieve the inflation target.

Monetary Policy Committee

L
● Monetary policy refers to the policy of the central bank with regard to the use of
monetary instruments under its control to achieve the goals specified in the Act.

A
● The primary objective of the RBI’s monetary policy is to maintain price stability while
keeping in mind the objective of growth.

RW
● Before the establishment of the Monetary Policy Committee (MPC), major decisions
related to interest rates were only taken by the Governor of RBI.
● Under Section 45ZB of the amended (in 2016) RBI Act, 1934, the central government is
empowered to constitute a six-member Monetary Policy Committee (MPC).
● The first such MPC was constituted on September 29, 2016 and the first meeting of
MPC was conducted on October 3, 2016 in Mumbai.
A
● Further, Section 45ZB lays down that “the Monetary Policy Committee shall determine
the Policy Rate required to achieve the inflation target”.
G
● The Monetary Policy Committee was formed with the mission of fixing the benchmark
policy interest rate (repo rate) to restrain inflation within the particular target level.
● The constitution of this six-member committee is an initiative to bring more transparency
A

and accountability in fixing the Monetary Policy of India.

Structure of MPC
T

● The RBI Monetary Policy Committee (MPC) is a 6 member committee. It consists of

JA

three internal members and three external experts.

○ RBI Governor as its ex officio chairperson
○ Deputy Governor in charge of monetary policy, member ex officio
○ An officer of the Bank to be nominated by the Central Board as member ex officio
A

○ Three persons are to be appointed by the central government who will hold office
for a period of four years or until further orders, whichever is earlier
R

● The MPC is required to meet at least four times in a year. The quorum for the meeting of
the MPC is four members.
● Each member of the MPC has one vote, and in the event of an equality of votes, the
Governor has a second or casting vote.
● Each Member of the Monetary Policy Committee writes a statement specifying the
reasons for voting in favor of, or against the proposed resolution.

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● The Reserve Bank is obligated to issue a document called the Monetary Policy Report
every six months to explain the origins of inflation and inflation estimates for the next six
to eight months.

The Monetary Policy Report

Once in every six months, the Reserve Bank publishes the Monetary Policy Report containing
the following elements:

● Explanation of inflation dynamics in the last six months and the near term inflation

L
outlook;

A
● Projections of inflation and growth and the balance of risks;

RW
● An assessment of the state of the economy, covering the real economy, financial
markets and stability, fiscal situation, and the external sector, which may entail a bearing
on monetary policy decisions;

● An updated review of the operating procedure of monetary policy; and

●
A
An assessment of projection performance.
G
Objectives Of Monetary Policy Committee [MPC]
A

● The monetary policy Committee is concerned with setting policy rates and other
monetary policy decisions in order to achieve:
○ Price stability
T

○ Accelerating the growth of the economy

○ Exchange rate stabilization
JA

○ Balancing savings and investment

○ Generating employment
○ Financial stability
A

● The primary goal of the monetary policy committee is to maintain price stability while
keeping growth in mind as per the monetary policy framework agreement. Price stability
is a prerequisite for long-term growth.
R

Instruments of Monetary Policy

There are several direct and indirect instruments that are used for implementing monetary
policy.

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1. Repo Rate: The interest rate at which the Reserve Bank provides liquidity under the
liquidity adjustment facility (LAF) to all LAF participants against the collateral of
government and other approved securities.

2. Standing Deposit Facility (SDF) Rate: The rate at which the Reserve Bank accepts
non collateralized deposits, on an overnight basis, from all LAF participants. The SDF is
also a financial stability tool in addition to its role in liquidity management. The SDF rate
is placed at 25 basis points below the policy repo rate. With introduction of SDF in April
2022, the SDF rate replaced the fixed reverse repo rate as the floor of the LAF corridor.

L
A
RW
Source: www.icicipruamc.com
A
3. Marginal Standing Facility (MSF) Rate: The penal rate at which banks can borrow, on
an overnight basis, from the Reserve Bank by dipping into their Statutory Liquidity Ratio
G
(SLR) portfolio up to a predefined limit (2 percent). This provides a safety valve against
unanticipated liquidity shocks to the banking system. The MSF rate is placed at 25 basis
points above the policy repo rate.
A

4. Liquidity Adjustment Facility (LAF): The LAF refers to the Reserve Bank’s operations
through which it injects/absorbs liquidity into/from the banking system. It consists of
T

overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF and
MSF. Apart from LAF, instruments of liquidity management include outright open market
JA

operations (OMOs), forex swaps and market stabilization scheme (MSS).

5. LAF Corridor: The LAF corridor has the marginal standing facility (MSF) rate as its
upper bound (ceiling) and the standing deposit facility (SDF) rate as the lower bound
A

(floor), with the policy repo rate in the middle of the corridor.
R

6. Main Liquidity Management Tool: A 14-day term repo/reverse repo auction operation
at a variable rate conducted to coincide with the cash reserve ratio (CRR) maintenance
cycle is the main liquidity management tool for managing frictional liquidity requirements.

7. Fine Tuning Operations: The main liquidity operation is supported by fine-tuning

operations, overnight and/or longer tenor, to tide over any unanticipated liquidity
changes during the reserve maintenance period. In addition, the Reserve Bank
conducts, if needed, longer-term variable rate repo/reverse repo auctions of more than
14 days.

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8. Reverse Repo Rate: The interest rate at which the Reserve Bank absorbs liquidity from
banks against the collateral of eligible government securities under the LAF. Following
the introduction of SDF, the fixed rate reverse repo operations will be at the discretion of
the RBI for purposes specified from time to time.

9. Bank Rate: The rate at which the Reserve Bank is ready to buy or rediscount bills of
exchange or other commercial papers. The Bank Rate acts as the penal rate charged on
banks for shortfalls in meeting their reserve requirements (cash reserve ratio and
statutory liquidity ratio). The Bank Rate is published under Section 49 of the RBI Act,

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1934. This rate has been aligned with the MSF rate and changes automatically as and
when the MSF rate changes alongside policy repo rate changes.

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10. Cash Reserve Ratio (CRR): The average daily balance that a bank is required to

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maintain with the Reserve Bank as a percent of its net demand and time liabilities
(NDTL) as on the last Friday of the second preceding fortnight that the Reserve Bank
may notify from time to time in the Official Gazette. Also, the daily balance cannot be
lower than 90% of the required CRR, and the average of daily balances must meet the
CRR requirement set by the Reserve Bank.
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11. Statutory Liquidity Ratio (SLR): Every bank shall maintain in India assets, the value of
which shall not be less than such percentage of the total of its demand and time
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liabilities in India as on the last Friday of the second preceding fortnight, as the Reserve
Bank may, by notification in the Official Gazette, specify from time to time and such
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assets shall be maintained as may be specified in such notification (typically in

unencumbered government securities, cash and gold).
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12. Open Market Operations (OMOs): These include outright purchase/sale of government
securities by the Reserve Bank for injection/absorption of durable liquidity in the banking
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system.

An example to understand Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
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Let's say that the reporting fortnight is the first fortnight of April and a bank has the following
demand and time liabilities (i.e. the amount of money its customers have deposited in the bank)
as on the last Friday of the second preceding fortnight i.e. last Friday of March:
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● Demand liabilities: ₹5,000

● Time liabilities: ₹10,000

Based on these liabilities, we can calculate the amount of reserve and liquid assets that the
bank needs to maintain with the Reserve Bank of India (RBI).

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Cash Reserve Ratio (CRR):

Assuming the current cash reserve ratio is 4.5%, we need to calculate 4.5% of the bank's net
demand and time liabilities (NDTL)

● NDTL = ₹5,000 (demand liabilities) + ₹10,000 (time liabilities) = ₹15,000

● CRR = 4.5% of ₹15,000 = ₹675

Therefore, the bank needs to maintain an average daily balance of ₹675 with the RBI as a
reserve against its liabilities, and it cannot use this amount for lending or investing purposes.

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As per RBI's regulations, the bank needs to maintain a minimum CRR of not less than 90% of
the required CRR on all days during the reporting fortnight. This means that the bank needs to

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maintain a minimum CRR balance of ₹607.5 (i.e., 90% of ₹675) on all days of the first fortnight
of April.

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At the end of the fortnight, the bank needs to ensure that the average daily balance maintained
is not less than the prescribed CRR of 4.5% of its NDTL as on the last Friday of the second
preceding fortnight, which in this case is ₹675.

Statutory Liquidity Ratio (SLR):

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Assuming the current statutory liquidity ratio is 18%, we need to calculate 18% of the bank's
total demand and time liabilities to determine the value of the assets that the bank needs to
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maintain in India:
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● Total demand and time liabilities = ₹5,000 (demand liabilities) + ₹10,000 (time liabilities)
= ₹15,000
● SLR = 18% of ₹15,000 = ₹2,700
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Therefore, the bank needs to maintain assets in India with a value of at least ₹2,700, which can
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include government securities, cash, gold and other eligible securities. The value of these
assets cannot be less than ₹2,700 at any given time, as per the RBI's regulations.

In summary, both the CRR and SLR are regulatory tools used by the RBI to ensure that banks
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maintain a certain amount of reserves and liquid assets to safeguard against financial risks and
maintain financial stability.
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Monetary Policy Committee Meeting (February 2023)

​On the basis of an assessment of the current and evolving macroeconomic situation, the
Monetary Policy Committee (MPC) at its meeting held on February 8, 2023 decided to:

● Increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis
points to 6.50 per cent with immediate effect.

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● Consequently, the standing deposit facility (SDF) rate is adjusted to 6.25 percent and the
marginal standing facility (MSF) rate and the Bank Rate to 6.75 per cent.

● Keep the Cash Reserve Ratio and Statutory Liquidity Ratio at 4.5 per cent and 18 per
cent respectively.

● The MPC also decided to remain focused on withdrawal of accommodation to ensure

that inflation remains within the target going forward, while supporting growth.

These decisions are in consonance with the objective of achieving the medium-term target for

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consumer price index (CPI) inflation of 4 per cent within a band of +/- 2 per cent, while
supporting growth.

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Inflation

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Inflation is a sustained increase in the general price level of goods and services in an economy
over a period of time. In other words, it is a decrease in the purchasing power of money. Inflation
is typically measured by the Consumer Price Index (CPI), which tracks the prices of a basket of
goods and services commonly purchased by households.
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There are several causes of inflation in an economy, including:
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1. Increase in demand: When there is an increase in demand for goods and services in an
economy, it can lead to a rise in prices as producers are able to charge higher prices due
to the increased demand.
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2. Increase in production costs: When the cost of production for goods and services
increases, it can lead to a rise in prices. This can happen due to an increase in raw
material prices, wages, or other production-related costs.
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3. Increase in money supply: When there is an increase in the money supply in an

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economy, it can lead to inflation as there is more money chasing the same amount of
goods and services.
4. Decrease in supply: When there is a decrease in the supply of goods and services in an
economy, it can lead to inflation as producers are able to charge higher prices due to the
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scarcity of goods and services.

5. Expectations of inflation: When consumers and producers expect prices to rise in the
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future, it can lead to inflation as they may take actions such as buying goods now or
raising prices in anticipation of future price increases.
In summary, inflation is a sustained increase in the general price level of goods and services in
an economy. It can be caused by a variety of factors, including increases in demand, production
costs, money supply, decreases in supply, and expectations of future price increases.

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While high inflation can stifle the economy by lowering purchasing power, too-low inflation can
also stifle growth by retaining too much money in savings accounts, as consumers hold off on
spending while waiting for the value of their dollars to rise. The optimal inflation rate encourages
people to spend now rather than save later, resulting in just-right economic development.

● In India, the Wholesale Price Index (WPI) and the Consumer Price Index (CPI) are used
to measure inflation (CPI). WPI, as the name suggests, measures wholesale prices and
was used by the Reserve Bank of India to make monetary policy until 2014. The
wholesale pricing index (WPI) is the price of a typical basket of wholesale items. It
considers a basket of 697 items and displays the total costs.

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● The CPI is a measure that examines the weighted average of prices of a basket of
goods and services that are of primary consumer needs. They include transportation,

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food, and medical care. The CPI is a measure of price change at the retail level that is
based on 260 commodities, including some services.

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● The Ministry of Statistics and Programme Implementation collects prices of sample
goods and services on a regular basis (typically every month) and records any changes.
● Considering the average inflation rate 7.27% p.a., the cumulative inflation rate in India
between 1958 and 2022 was 8,808.16%. This means that 100 rupees in 1958 are
equivalent to 8,908.16 rupees in 2022.
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The Monetary Policy Transmission Mechanism
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The way in which monetary policy affects inflation and the real economy – output and
employment, for example – is referred to as the monetary policy transmission mechanism. The
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transmission mechanism is actually not one but several different mechanisms that act in
parallel, through different channels. Some of these mechanisms affect inflation rather directly,
while others take longer to have an effect.
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The transmission of monetary policy describes how changes made by the Reserve Bank to its
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monetary policy settings flow through to economic activity and inflation. This process is complex
and there is a large degree of uncertainty about the timing and size of the impact on the
economy. In simple terms, the transmission can be summarized in two stages:
● Changes to monetary policy affect interest rates in the economy.
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● Changes to interest rates affect economic activity and inflation.

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One common way of describing the monetary policy transmission mechanism is that it operates
through the following channels:
A. the interest rate channel,
B. the exchange rate channel,
C. the asset price channel, and
D. the expectations channel.

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Let us take as an example below that inflation is too high and that the RBI therefore raises the
policy rate. How does monetary policy affect inflation via the four channels of the monetary
policy transmission mechanism?

Interest rate channel

● The interest rate channel describes how the RBI can influence interest rates and thus
the level of activity in the economy, which in turn affects inflation.
● One aspect that is important to bear in mind when discussing the level of the policy rate
is that its normal level is affected by the general level of interest rates. A rate lower than

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normal stimulates demand and inflation, while a higher rate has the opposite effect.
● Let us take as an example that inflation is too high and that the RBI therefore raises the

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policy rate. This at first affects the short-term interest rate that the central bank is trying
to control. In the RBI’s case, this is the overnight rate, which is the interest rate paid by

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banks when they borrow from each other from one day to the next. Market rates with
longer maturities are affected by expectations of what short interest rates will be going
forward. This means that an increase in the overnight rate spreads and pushes up other
interest rates in the economy, such as the banks’ and mortgage institutions’ interest
rates.
●
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For households, saving becomes more attractive when interest rates are higher. In
addition, households need to use a larger proportion of their income for interest
payments on loans. Both of these factors contribute to the consumption of fewer goods
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and services by households.
● For companies, higher interest rates mean that it becomes more expensive to finance
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investments and they therefore invest less in machinery and property. When households
reduce their consumption and companies their investment, this causes inflation to fall.
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Exchange rate channel

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● A change in the policy rate also affects the exchange rate. When Indian interest rates
rise in relation to interest rates abroad, foreign agents become more interested in
investing in India as it gives higher returns than investments in other currencies.
● This leads to an increase in demand for the rupee (INR). When demand for the rupee
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Increases, its price rises, just as the price of any product does when demand for it
increases.
● As the exchange rate in relation to other currencies represents the price of INR, the
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rupee exchange rate strengthens, i.e. we have to pay less INR for a dollar or euro, for
example. This makes Indian goods more expensive for households and companies
abroad, which means that demand for Indian products declines.
● The result is a reduction in Indian exports to other countries. This leads to lower activity
in the Indian economy and puts downward pressure on inflation.
● At the same time, the prices of imported goods become cheaper in INR, which also
contributes to lower inflation.

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Asset price channel

● Asset prices and people's wealth influence how much they can borrow and how much
they spend in the economy. The asset prices and wealth channel typically affects
consumption and investment.
● Lower interest rates support asset prices (such as housing and equities) by encouraging
demand for assets. One reason for this is because the present discounted value of
future income is higher when interest rates are lower.
● Higher asset prices also increase the equity (collateral) of an asset that is available for
banks to lend against. This can make it easier for households and businesses to borrow.

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● An increase in asset prices increases people's wealth. This can lead to higher
consumption and housing investment as households generally spend some share of any

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increase in their wealth.

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Expectations channel
● Higher interest rates thus dampen demand in the economy. Since households' and
companies’ consumption and investment today are influenced by what they think about
the future development of the economy, demand can also be dampened if they expect
higher interest rates going forward.
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● The fact that the central bank raises the policy rate and also communicates about the
level of the policy rate in the future, for example when the RBI adjusts its forecast for the
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policy rate upwards, can therefore have a dampening effect on the economy via
expectations.
● The inflation expectations of households and companies are important for the
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development of inflation. For example, if workers expect inflation to increase, they might
ask for larger wage increases to keep up with the changes in inflation. Higher wage
growth would then contribute to wage-pull inflation.
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● On the contrary, If they instead expect inflation to be 4 per cent, they will again adjust
their price- and wage-setting decisions accordingly. This also makes it easier for the RBI
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to maintain the target.

● By having an inflation target, the central bank can anchor inflation expectations. This
should increase the confidence of households and businesses in making decisions
about saving and investment because uncertainty about the economy is reduced.
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Impact of monetary policy on inflation and liquidity

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Monetary policy is the process through which the central bank of a country manages the money
supply and interest rates to achieve its macroeconomic goals. In India, the Reserve Bank of
India (RBI) is responsible for formulating and implementing monetary policy. The impact of
monetary policy on inflation and liquidity in the Indian context is as follows:

1. Inflation: The RBI uses various monetary policy tools, such as the repo rate, reverse
repo rate, cash reserve ratio (CRR), and statutory liquidity ratio (SLR), to manage the

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money supply and influence inflation in the economy. When the RBI raises the repo rate,
it makes borrowing more expensive, which reduces the money supply and curbs
inflation. Conversely, when the RBI lowers the repo rate, it makes borrowing cheaper,
which stimulates economic growth and can increase inflation. Similarly, the CRR and
SLR also affect the money supply and, therefore, inflation.

2. Liquidity: The RBI also uses monetary policy to manage liquidity in the banking system.
When the RBI injects liquidity into the system through measures such as open market
operations (OMOs) and reductions in the CRR and SLR, it increases the supply of
money and makes borrowing cheaper, which stimulates economic growth. Conversely,

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when the RBI withdraws liquidity from the system through measures such as selling
government securities or increasing the CRR and SLR, it reduces the supply of money

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and makes borrowing more expensive, which can lead to a slowdown in economic
growth.

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In summary, the impact of monetary policy on inflation and liquidity in the Indian context
depends on the various monetary policy tools used by the RBI to manage the money supply and
interest rates. The RBI's actions in this regard can have a significant impact on the overall
macroeconomic environment, including inflation, growth, and liquidity.
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References
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https://scripbox.com/pf/treasury-bills/
https://www.drishtiias.com/daily-updates/daily-news-analysis/ways-and-means-advance
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https://bankingdigests.com/blog/history-structure-and-functions-of-rbi/
https://www.sbidfhi.co.in/about-us/company-profile/
https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752
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https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12131
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https://www.riksbank.se/en-gb/monetary-policy/what-is-monetary-policy/how-monetary-policy-aff
ects-inflation/
https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Monetary-Policy
https://www.rba.gov.au/education/resources/explainers/the-transmission-of-monetary-policy.html
https://europe.pimco.com/en-eu/resources/education/understanding-inflation
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Note:
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The supplementary study material is not exhaustive and is for reference purposes only. It is
strongly recommended that students thoroughly read suggested readings for examination.

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