Answer to Question #122261 in Macroeconomics for Piyush Yadav

Question

On the basis of an assessment of the current and evolving macroeconomic
situation, the Monetary Policy Committee (MPC) reduced the policy repo rate
under the liquidity adjustment facility (LAF) by 40 bps to 4.0 per cent from 4.40
per cent with immediate effect. Assess the present liquidity scenario in India and
give your opinion about the impact of this reduction on money supply and also
suggest other measures that RBI can take in recent times to maintain
liquidity.

Answer 1

The decisions were in consonance with the objective of achieving the medium term target for consumer price index (CPI) inflation of $4$ per cent within a band of $+/-2$ per cent while supporting growth. The Monetary Policy Committee decided to continue with the accommodative stance as long as it is necessary to revive growth and mitigate the impact of the pandemic on the economy while ensuring that inflation remains within the target. The impact of this reduction has led to markets to be highly volatile. Panic sell offs have resulted in wealth destruction in equity markets. Flight to safety has pulled down government bond yields to record lows. Central banks and governments are in war modes responding to the situation with several conventional and unconventional measures targeted at easing financial conditions to avoid a demand collapse and to prevent financial markets from freezing due to ill liquidity. 

The Reserve Bank remains in pro-active liquidity management mode, expanding its array of measures, both in conventional and unconventional terms , to augment system-level liquidity and to channel liquidity to specific sectors facing funding constraints. Systemic liquidity remains in abundance, with average daily net absorptions under the liquidity adjustment facility (LAF) increasing to $\xi 5.66$ lakh crore from $\xi 4.75$ lakh crore. In order to distribute liquidity more evenly across the yield curve, the Reserve Bank should conduct an auction involving the simultaneous sale and purchase of government securities for $\xi 10,000$ crore. The Reserve Bank should also provide $\xi 22,334$ crore as refinance to National Bank for Agriculture and Rural Development (NABARD), small Industries Development Bank of India (SIDBI) and National Housing Bank (NHB) and $\xi 2,430$ crore to mutual funds through a special liquidity facility (SLF) with a view to easing liquidity constraints and de-stress financial markets.