




In the last two years, while there was an increase in liquidity in the system due to dollar purchases of RBI, this liquidity was sucked out by selling Monetary Stabilisation Scheme (MSS) bonds. Here, the costs of running the pegged exchange rate regime were placed upon the ministry of finance which has to pay interest on the MSS bonds. However, after October 2007, RBI stopped selling MSS bonds.
The limit on MSS issuance, the amount of bonds that the government had permitted RBI to sell, is Rs 2.5 lakh crore, while the outstanding amount in October 2007 (and since then) was only Rs 1.7 lakh crore. In other words, RBI could have continued to sterilise its currency trading through the sale of government bonds. Hence, the shift in policy is surprising. As is typical of the non-transparency of RBI, there was no announcement that the mechanisms of monetary policy had changed.
When RBI buys dollars, but does not scoop up the liquidity using MSS, reserve money growth remains high. What matters to the economy, however, is broad money (M3) and not reserve money. The banking system takes reserve money as a “raw material” and converts it to broad money. The CRR influences this multiplication process. A higher CRR, where banks are forced to hold money with RBI, induces a smaller multiplication factor. Thus money supply (M3) growth is held back even though reserve money growth is very high.


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