I have assumed that you have studied two articles: article related to Nature of Indian Economy and National income and another article related to inflation and deflation. If not, please read those articles before proceeding.
Liquidity: It is availability of cash. More liquidity economy means more solid cash and vice verse.
Government Securities : It is a promise by government or any organisation on the behalf of the government to repay borrowed money with interest after certain years. They are used by government to raise fund for developmental projects or to handle any liquidity problem.
Repo rate or Policy Rate:interest rate at which RBI gives loan to banks by borrowing Government security or gold. Reverse Repo Rate:interest rate at which RBI borrows loan by issuing government security .It is 1% lesser than repo rate. Cash reserve ratio(CRR): Percentage of amount that has to be deposited in RBI for which bank receives no interest.
Statutory liquidity ratio(SLR):percentage of amount needed to be deposited by every bank in Government securities with RBI for which bank receives interest.The difference between CRR and SLR is later amount is invested in government security hence they receive interest for it
All the above monetary tools are classical monetary tool used to handle inflation,deflation and other economics problem.As the time passes,Indian economy became so complex that this tools became ineffective in handling the new problems .So there comes new monetary tools such as Liquidity adjustment Facility, Open Market Operation and Marginal Standing Facility.
Liquidity adjustment Facility(LAF) is introduced by RBI in 2000 to manage day to day liquidity mismatches. LAF allows bak to borrow money from RBI at repo rate and lend money to RBI at reverse repo rate. Bank can borrow from RBI by selling government securities to match day to day liquidity problem.
Open Market Operation is a process in which RBI buys/sells Government security on open market based on the nature of present economy. There are two types of open market operation used by RBI: Permanent sell or buy and another is temporary sell of Government security with the promise to buy it in future.
Market stabilization scheme is used by RBI to absorb excess liquidity from he economy.It was introduced in 2004. Marginal standing facility(MSF) is introduced by RBI in 2011 which allows bank to borrow money on overnight basis from RBI when they cannot borrow under Liquidity adjustment Facility .Hence it is last option for bank to borrow money.Bank borrows money by selling government security that was borrowed to maintain SLR. Maximum limit of MSF is 2% of net demand and time liabilities(NDTL).MSF is 1% higher than repo rate. NDTL is the sum of money that needs to be paid by bank. Demand Liability is sum of money of money that needs to paid on the demand of the customer and time Liability is sum of money of money that needs to paid in future.
Role of RBI and Banking in India will be discussed tomorrow. Please do comment if you don’t understand any concept.