While the need for long term financing is met by the capital or financial markets, money market is a mechanism which deals with lending and borrowing of short term funds. Post reforms age in India has witnessed marvelous increase of the Indian money markets. Banks and other financial institutions have been able to meet the high opportunity of short term financial support of important sectors like the industry, services and agriculture. It performs under the regulation and control of the Reserve Bank of India (RBI). The Indian money markets have also exhibit the required maturity and flexibility over the past two decades. Decision of the government to permit the private sector banks to operate has provided much needed healthy competition in the money markets resulting in fair amount of improvement in their performance.
Money markets denote inter-bank market where the banks borrow and lend between themselves to meet the short term credit and deposit needs of the economy. Short term normally covers the time period up to one year. The money market operation help the banks rush over the provisional mismatch of funds with them. In case a particular bank needs funds for a few days it can lend from another bank by paying the strong-minded interest rate. The lending bank also gains as it is able to earn interest on the funds lying idle with it. In other words money market provides avenues to the players in the market to strike balance between the surplus funds with the lenders and the obligation of funds for the borrowers. An significant function of the money market is to provide a central point for interventions of the RBI to pressure the liquidity in the financial system and implement other monetary policy measures. Quantum of liquidity in the banking system is of dominant importance as it is an important determinant of the inflation rate as well as the formation of credit by the banks in the financial system. Market forces generally indicate the need for borrowing or liquidity and the money market adjusts itself to such calls. RBI facilitates such adjustments with monetary policy tools obtainable with it. Heavy call for funds overnight indicates that the banks are in need of short term funds and in case of liquidity crunch the interest rates would go up.
Depending on the financial situation and available market trends the RBI intervenes in the money market through a crowd of interventions. In case of liquidity crunch the RBI has the option of either dropping the Cash Reserve Ratio (CRR) or pumping in more money supply into the system. Recently to conquer the liquidity crunch in the Indian money market the RBI has released more than Rs 75,000 crores with two back-to-back reductions in the CRR. In adding to the lending by the banks and the monetary institutions, various companies in the commercial sector also issue fixed deposits to the public for shorter period and to that amount become part of the money market mechanism selectively. The maturities of the instruments issued by the money market as a whole, range from one day to one year. The money market is also closely linked with the Foreign Exchange Market throughout the procedure of covered interest arbitrage in which the forward premium acts as a bridge among the domestic and foreign interest rates. Determination of appropriate interest for deposits or loans by the banks or the other financial institutions is a complex device in itself. There are several issues that need to be determined before the optimum rates are determined. While the term arrangement of the interest rate is a very important determinant, the difference between the existing domestic and international
interest rates also emerges as a significant factor. Further, there are several credit instruments which involve similar maturity but diversely different risk factors. Such distortions are accessible only in rising and diverse economies like the Indian economy and need extra care while handling the issues at the policy levels.
Money markets are one of the most significant mechanisms of any developing financial system. In its place of just ensure that the money market in India regulate the flow of credit and credit rates, this instrument has emerge as one of the significant policy tools with the government and the RBI to control the financial policy, money supply, credit creation and control, inflation rate and overall economic policy of the State. Therefore the first and the leading function of the money market mechanism are regulatory in nature. While determining the total volume of credit plan for the six monthly periods, the credit policy also aims at directing the flow of credit as per the priorities fixed by the government according to the requirements of the economy. Credit policy as an instrument is important to ensure the availability of the credit in sufficient volumes; it also caters to the credit needs of various sectors of the economy. The RBI assist the government to realize its policies related to the credit plans throughout its statutory control over the banking system of the country.
Financial policy on the other hand, has longer term perspective and aims at correcting the imbalances in the economy. Credit policy and the financial policy both balance each other to achieve the long term goals strong-minded by the government. It not only maintains total control over the credit creation by the banks, but also keeps a close watch over it. The instruments of financial policy counting the repo rate cash reserve ratio and bank rate are used by the Central Bank of the country to give the necessary direction to the monetary policy.
Inflation is one of the severe economic problems that all the developing economies have to face every now and then. Cyclical fluctuations do influence the price level differently depending upon the demand and supply situation at the given point of time. Money market rates play a main role in controlling the price line. Higher rates in the money markets decrease the liquidity in the economy and have the effect of reducing the economic activity in the system. Reduced rates on the other hand increase the liquidity in the market and bring down the cost of capital considerably, thereby rising the investment. This function also assists the RBI to control the general money supply in the economy.