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Mastering Money Market Operations & Monetary Policy Tools

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Mastering Money Market Operations & Monetary Policy Tools

Introduction

The Money Market is a vital part of the financial system, enabling short-term borrowing and lending of funds. It plays a crucial role in maintaining liquidity and supporting monetary policy execution. Whether you're a finance student, CA aspirant, or preparing for IB Operations interviews, understanding money market instruments and tools of monetary policy is key.

What is the Money Market?

The Money Market is a component of the financial market where short-term instruments with high liquidity and maturities of less than a year are traded.

Purpose of Money Market

  • Maintain short-term liquidity
  • Help government manage monetary policy
  • Channel funds between institutions
  • Provide safe investment avenues

Key Institutions

  • Central Bank (RBI)
  • Commercial Banks
  • Mutual Funds
  • Primary Dealers
  • Insurance Companies
  • NBFCs

Major Money Market Instruments

1. Call/Notice Money

Very short-term interbank loans. Call = Overnight. Notice = 2–14 days.

2. Treasury Bills (T-Bills)

Short-term govt instruments with no interest. Sold at a discount, redeemed at face value.

3. Commercial Papers (CPs)

Unsecured short-term notes by companies, issued at discount for working capital.

4. Certificates of Deposit (CDs)

Time deposits by banks, offering fixed interest. Higher yield than savings accounts.

5. Commercial Bills

Bill of exchange used for trade finance. Can be traded before maturity.

6. Repo & Reverse Repo

Short-term borrowing/lending using securities.

7. Inter-Corporate Deposits (ICDs)

Short-term unsecured loans between corporates.

Government Securities (G-Secs)

Long-term instruments issued by government with fixed interest. Safe investment. Not strictly a money market instrument, but crucial to liquidity management.

Tools of Monetary Policy

1. Repo Rate

Definition: Rate at which RBI lends to banks.
Example: RBI reduces repo from 6.5% to 6.25% → Cheaper funds for banks → More lending → Economic boost.

2. Reverse Repo Rate

Definition: Rate at which RBI borrows from banks.
Example: Increase reverse repo to absorb excess liquidity and control inflation.

3. CRR (Cash Reserve Ratio)

Definition: % of total bank deposits kept with RBI in cash.
Example: CRR = 4.5% → ₹4.50 of every ₹100 deposit kept idle → Reduces money for loans → Controls inflation.

4. SLR (Statutory Liquidity Ratio)

Definition: % of deposits to be held in gold/cash/G-Secs.
Example: SLR = 18% → ₹18 out of ₹100 must be invested in safe assets → Reduces lending capacity.

5. Marginal Standing Facility (MSF)

Emergency borrowing for banks above repo rate.

6. Liquidity Adjustment Facility (LAF)

Daily repo/reverse repo operations to adjust liquidity.

7. Market Stabilization Scheme (MSS)

Govt bonds issued to absorb liquidity, e.g., post demonetization.

Inflation & Interest Rate Relationship

High inflation → RBI raises interest rates to reduce money supply. Low inflation → Lower rates to boost economic growth.

Expansionary vs. Restrictive Policy

ObjectiveTools UsedResult
Control InflationRaise Repo, CRR, SLRReduce liquidity
Boost EconomyLower Repo, CRRIncrease lending

Functions of the Money Market

  • Efficient short-term capital allocation
  • Implements monetary policy
  • Ensures financial stability
  • Supports working capital needs

Conclusion

Understanding money markets and monetary tools is vital for finance professionals. This knowledge bridges the gap between classroom theory and real-world financial systems.

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