Page 126 - DMGT401Business Environment

Unit 5: Monetary Policy

In 1953, bank rate was 3.5% and rose to 10% in 1981, to 11% in July 1991, and to 12% in Notes
October 1991. In India, bank rate policy is not effective because commercial banks in India
are not much dependent on the RBI for financial assistance. Also, because of bill market
that is not well-organised, they lack adequate quantity of eligible bills which can be
rediscounted to the RBI. Proper organisation of the various components of the money
market is a prerequisite.
3. Direct Regulation of Interest Rates: It is expected that change in bank rate will bring a
change in all market rates of interest in the same direction. But when the bank rate loses its
significance in regulating market rates, the RBI is compelled to directly regulate interest
rates on bank deposits and credit. Since 1964 it has been fixing all deposits rates of
commercial banks, and since 1960, their lending rates. Deposit rates of co-operative banks
came under regulation in 1974 and their lending rates in 1980. The RBI and some other
authorities in India have been directly fixing many other interest rates also.

Deregulation in interest rate began in 1985 after the recommendation of the Chakravarty
Committee Report. In the past 14 years important changes in the deregulation of interest
rate are:
(a) The Bank Rate has been activated.
(b) Most of the money market rates have been deregulated.
(c) The ceiling on the call rate was withdrawn with effect from May 1, 1989.

(d) The interest rates on treasury bills, certificates of deposits, commercial paper, and
inter-bank participations are allowed to be flexible, variable and market determined.
(e) The deposits and lending rates of commercial banks, RRBs, urban co-operative banks,
and other co-operative banks have been freed.
(f) Interest on public deposits accepted by all non-banking companies (financial and
non-financial) have been deregulated.
(g) The coupon rate on government dated securities has been made market-related.
(h) The interest rates on convertible, non-convertible and other types of debentures
have been made free.
(i) The term lending institutions can now charge interest rates unhindered by State
intervention.

4. Cash Reserve Ratio: The CRR refers to the cash which banks have to maintain with the RBI
as a certain percentage of their demand and time liabilities.
According to the RBI Act 1935, every commercial bank has to keep certain minimum cash
reserve with the RBI. Initially, it was 5% against demand deposit and 2% against time
deposits. Under the RBI (Amendment Act) 1962, the RBI is empowered to determine CRR
for the commercial banks in the range of 3% to 15% for the aggregate demand and time
liabilities. CRR has been quite often used to control inflation.

An increase in CRR reduces the cash with commercial bank which results in low supply of
currency in the market, higher interest rate and low inflation. In the late 1980s there was
a rapid growth of liquidity which resulted in higher inflation and thus the CRR was raised
to its maximum limit of 15%, which resulted in higher interest rate and liquidity crunch in
early 1990s when Prime Lending Rate was raised to as high as 17%.

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