What is Liquidity?

By Liquidity, we simply mean to refer to the money floating in the system that is available to all stakeholders of the markets viz.  Individuals, corporate entities and the government.

We know that liquidity is influenced by the demand and supply of money in the system.  RBI can either inject liquidity in the system or absorb the liquidity in the system. However there are three ways the liquidity can get affected.

  • Government Borrowings: Government is the biggest borrower in India. It borrows in the form of the securities to fund the deficit that arises when its income falls short of expenses.
  • Corporate Borrowings: Increased borrowings by the corporate sector to fund the Capital expenditures and short term credit needs can affect the liquidity of the system.
  • RBI Interference: RBI may reduce the availability of the rupee by buying rupee and selling a foreign currency such as the US dollar. This is primarily done to maintain the value of rupee. RBI can withdraw excess liquidity from the financial market also when it sees that assets prices are approaching towards a bubble situation.

As far as monetary policy is concerned, RBI uses the weapons of Repo Rate and Reverse Repo Rate for injection or absorption of liquidity that is consistent with the prevailing monetary policy stance. The repo rate (at which liquidity is injected) and reverse repo rate (at which liquidity is absorbed) under the Liquidity Adjustment Facility (LAF) have emerged as the main instruments for the Reserve Bank’s interest rate signalling in the Indian economy. The Repo Rate, Reverse Repo Rate, MSF, CRR and SLR are also known as Key Policy Indicators of the RBI.