(a) Discuss the monetary policy of the Reserve Bank of India over the years. Explain the tools of monetary policy available with…

(a) Monetary policy of the RBI and its tools (10 + 10 = 20 marks)

Evolution (10). Monetary policy is the RBI's use of money supply, credit and interest rates to attain price stability, growth and financial stability (RBI Act, 1934).

• Till 1991, policy was administered: high CRR and SLR pre-empted bank resources for the government, interest rates were regulated, and credit was allocated through selective controls and priority sectors. Following the Chakravarty Committee (1985), monetary targeting with a feedback from broad money (M3) was adopted, and fiscal deficits were monetised through ad hoc Treasury bills.
• After 1991 the Narasimham Committee (1991, 1998) pushed liberalisation: CRR and SLR were cut, interest rates were freed, ad hoc Treasury bills were phased out (1994 agreement with the government, effective 1997), and indirect, market-based instruments took over.
• From 1998, under Governor Bimal Jalan, a multiple-indicators approach replaced monetary targeting. The Liquidity Adjustment Facility (repo and reverse repo) began in 2000, and open market operations, the market stabilisation scheme (2004) and the Marginal Standing Facility (2011) were added.
• The Urjit Patel Committee (2014) recommended a nominal anchor. The RBI Act was amended in 2016 to adopt flexible inflation targeting, with the Government setting a CPI target of 4% with a tolerance band of ±2%, and a six-member Monetary Policy Committee (three from the RBI, three external) deciding the repo rate by majority. In 2022 the Standing Deposit Facility became the floor of the corridor (SDF at repo minus 0.25%, MSF at repo plus 0.25%).
• Since then the RBI has responded to shocks: liquidity and rate cuts during COVID-19 (repo to 4%), tightening in 2022-23 (to 6.5%), and easing during 2025, with the repo rate reduced from 6.5% to 5.25% and a cut in CRR to 3%.

Tools (10). Quantitative (general) tools regulate the volume of money and credit; qualitative (selective) tools regulate its direction.

• Repo rate: the rate at which the RBI lends against government securities under the LAF, the main policy rate; reverse repo and SDF absorb surplus liquidity; MSF is emergency overnight borrowing by banks.
• Cash Reserve Ratio: the share of net demand and time liabilities kept with the RBI (without interest); SLR is the share kept in liquid assets (government securities, cash and gold), currently 18%.
• Open market operations: outright sale or purchase of government securities to absorb or inject durable liquidity; variable rate repo and reverse repo auctions manage short-term liquidity; the market stabilisation scheme sterilises capital inflows.
• Bank rate: the long-term lending rate, now aligned to the MSF rate.
• Selective tools: margin requirements on loans against securities, regulation of consumer credit, credit rationing, moral suasion, and directives on sectoral exposure and risk weights.
• Forex intervention also moves the money supply. Transmission works through the repo rate to lending rates, which since 2019 are linked to external benchmarks such as the repo rate.

(b) Modigliani-Miller arbitrage (15 marks)

Modigliani and Miller hold that, in a perfect market, two firms in the same risk class with the same operating income must have the same total value, and that any difference is removed by arbitrage, as investors sell the overvalued firm's shares and buy the undervalued one's.

Value of firms:

• Company X: equity = 2,00,000 × ₹1.30 = ₹2,60,000; debt = ₹1,00,000; V_X = ₹3,60,000.
• Company Y: equity = 3,00,000 × ₹1.00 = ₹3,00,000; no debt; V_Y = ₹3,00,000. Both earn the same ₹40,000 before interest, yet V_X > V_Y by ₹60,000, so the levered firm X is overvalued and Y is undervalued.

Investor's present position (10% of X's shares):

• Shares held: 20,000, with market value ₹26,000.
• Income: (₹40,000 - ₹10,000 interest) = ₹30,000 distributed; 10% = ₹3,000.

Arbitrage steps:

1. Sell the 20,000 shares of X for ₹26,000.
2. Borrow personally ₹10,000 (10% of X's debt, at 10%, the same rate as the debentures), reproducing the leverage of X in proportion to his stake. Total funds = ₹36,000.
3. Buy shares of Y: ₹36,000 ÷ ₹1 = 36,000 shares, that is 12% of Y.

Income after switching:

• Share of Y's profit = 12% × ₹40,000 = ₹4,800.
• Less: interest on personal loan = 10% × ₹10,000 = ₹1,000.
• Net income = ₹3,800.

The investor's income rises from ₹3,000 to ₹3,800, a gain of ₹800, with the same financial risk. As investors sell X and buy Y, the price of X falls and that of Y rises until V_X = V_Y, when arbitrage stops, which shows that the value of a firm is independent of its capital structure.

(c) Receivables (15 marks)

Costs of maintaining receivables (7). Granting credit ties up funds and creates the following costs:

• Capital or carrying cost: the return forgone on funds locked in receivables, being the cost of financing them, whether the firm's cost of capital or the interest on borrowings.
• Administrative cost: credit investigation and information, record-keeping, billing, and staff and system costs.
• Collection cost: reminders, follow-ups, legal and agency charges for recovering dues.
• Delinquency cost: the cost of delay beyond the due date, including extra interest and the cost of blocked funds.
• Default cost: bad debts and losses when customers do not pay at all. Against these costs stand the benefit of higher sales and profit; the firm should extend credit until the marginal benefit equals the marginal cost.

Factors affecting the size of receivables (8):

• Level of sales, and the proportion made on credit: more credit sales mean larger receivables.
• Credit policy: the credit standards (how strict), the credit period, cash discount terms, and the collection policy, whether tight or liberal.
• Terms of sale and credit period: a longer period or generous discount terms raise receivables.
• Industry practice and competition: a firm must match competitors' credit terms.
• Nature and seasonality of the business and the product, such as perishability, durability and price.
• Economic conditions, such as recession or credit squeeze, which slow collections.
• Cost of capital and the firm's own liquidity, which limit how much credit can be financed.
• Customer base: their financial strength and payment habits.