Page 48 - DCOM208_BANKING_THEORY_AND_PRACTICE

Unit 3: Indian Banking System

number. Typically, a central bank controls certain types of short-term interest rates. These Notes
influence the stock and bond markets as well as mortgage and other interest rates.
The mechanism to move the market towards a ‘target rate’ (whichever specific rate is used) is
generally to lend money or borrow money in theoretically unlimited quantities, until the
targeted market rate is sufficiently close to the target. Central banks may do so by lending
money to and borrowing money from (taking deposits from) a limited number of qualified
banks, or by purchasing and selling bonds.

Monetary Policy Instruments: The main monetary policy instruments available to central banks
are open market operation, bank reserve requirement, interest-rate policy, re-lending and
rediscount (including using the term repurchase market), and credit policy (often coordinated
with trade policy).

Notes To enable open market operations, a central bank must hold foreign exchange
reserves (usually in the form of government bonds) and official gold reserves.
It will often have some influence over any official or mandated exchange rates. Some exchange
rates are managed, some are market based (free float) and many are somewhere in between
(managed float or dirty float).
Through open market operations, a central bank influences the money supply in an economy
directly. Each time it buys securities, exchanging money for the security, it raises the money
supply. Opposite to this, selling of securities lowers the money supply. Buying of securities thus
amounts to printing new money while lowering supply of the specific security.
The main open market operations are:
Temporary lending of money for collateral securities (Reverse Operations or repurchase
operations, otherwise known as the ‘repo’ market). These operations are carried out on a
regular basis, where fixed maturity loans (of 1 week and 1 month for the ECB) are auctioned
off.
Buying or selling securities (Direct Operations) as per need.

Foreign exchange operations such as forex swaps.
All of these interventions can also influence the foreign exchange market and thus the exchange
rate.

Task Compare the functions of central banks of India and U.S.

Self Assessment

State whether the following statements are true or false:
11. A central bank controls certain types of long-term interest rates.
12. Through open market operations, a central bank influences the money supply in an economy
directly.
13. Commercial banks can never expect the Reserve Bank of India to come to their help in
times of banking crisis.
14. The Reserve Bank has to act as the custodian of India’s reserve of international currencies.

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