My new on ‘How India is fighting against inflation’. This thread will answer most of your questions around macro-economics.

Please ‘re-tweet’ / share it in your Whatsapp groups & help us educate more investors. Happy #investing! (1/n)

(Q1) Why does inflation take place?

(1a) Like most of us believe, Inflation happens bcoz of the gap between demand & supply. When demand is more than supply, prices rise & boom u have inflation

But the question here is, y does the demand rise?
Ans - Liquidity! Let me explain

(1b) Imagine 10 of you’ll want to buy a laptop & there is only 1 laptop, we presume the price will go up right?

But in the same situation if I tell you that none of you’ll have the monies (liquidity) to buy the laptop; will the price of the laptop go up? Probably not! (3/n)

(1c) So remember, it’s the liquidity that creates the demand. Inflation happens because of the gap between liquidity led demand & supply.

Lets tackle both demand (liquidity) & supply separately as RBI can control demand & the Government can control supply (4/n)

(Q2) Lets start with understanding RBI’s work first; Lets go back to the COVID days, where it all started

(2a) In situations like COVID where there can be a challenge to sustain businesses, job losses etc., the central bank tries to maintain high liquidity in the system (5/n)

High liquidity means?
Keep rates low to encourage businesses & individuals to borrow & invest so that job losses are reduced & demand can be maintained. Ex - If rates are low, RE developers can borrow cheap & build more + buyers can borrow cheap & buy more houses (6/n)

(2b) How are rates kept low?

Rates are kept low using the below measures,
(i) Repo & Reverse Repo Rates
(ii) Buying Bonds from the market (also known as GSAP or OMO)

Let me explain, (7/n)

(i) Repo rate is the rate at which commercial banks borrow money from RBI for over night. So when banks borrow from RBI for 1 night, banks pay 4.4% per annum equivalent rate for one day called Repo Rate (8/n)

Reverse repo is the rate at which commercial banks lend to RBI for over night. So when banks lend to RBI for 1 night, banks receive 3.35% per annum equivalent rate for one night of lending from RBI called the reverse repo rate (9/n)

So if RBI reduces Repo, banks get money cheaper & hence can lend cheaper. Similarly when RBI reduces the reverse repo rate it disincentives banks to lend to RBI and hence they 'might' use that to increase lending to businesses & individuals (10/n)

So if RBI wants to increase liquidity and/or incentivize banks to lend, RBI will reduce repo & reverse repo rates & that’s what you call as increasing liquidity in the system as well (11/n)

(ii) To increase liquidity, RBI also does Bond buying (Open market operations - OMO) / GSAP or Quantitative Easing like popularly called in the western world. GSAP is government security acquisition program, let me explain, (12/n)

Indian government like most other governments run a fiscal deficit. Income is less than expense. So if income is 100 & expense is 105, the 5 rupees is borrowed & a bond is issued vs that promising a fixed return for a fixed time like in an FD (13/n)

When RBI wants to increase liquidity in the market, RBI buys back the bonds issued earlier for fiscal deficit before its maturity. So when RBI buys back the bonds, it has to pay the banks & that’s how liquidity is infused in the banking system. (14/n)

(Q3) What are the side effects of liquidity?

Rates across time frame falls as there is more supply of money in the system. This can be discomforting for RBI after a point in time because this liquidity increases the demand & hence liquidity lead inflation (15/n)

(4Q) What did RBI do to control liquidity so far?

(4a) - They stopped GSAP: If RBI stops GSAP (buying bonds), demand for bonds will reduce & hence bond prices will drop & yield/rates will go up (16/n)

- They also introduced 14 days long-term variable reverse repo: Unlike over night reverse repo @3.35%, RBI took money 4m banks for 14 days & the rate will be decided by an auction. FYI, in auction, instead of 3.35%, the money was lent by banks to RBI at close to 4% (17/n)

(4b) Lately RBI Introduced something called as SDF. Generally, RBI uses reverse repo to absorb liquidity. In reverse repo, RBI takes liquidity from the banks & gives reverse repo rate of interest to the banks + keeps government securities (GSec, SDL, Tbills) as collateral (18/n)

But, when a huge amount of liquidity needs 2b absorbed, it's difficult in many ways 4 the RBI to give so much collateral in return. SDF is the perfect tool then. U can take liquidity & don't have 2 give the collateral as well. Another tool 2 suck liquidity out of the system(19/n)

(4c) In the latest move RBI increased the CRR by 0.50% & increased the repo rate by 0.40% both will suck liquidity out of the system. CRR is the amount of money banks have to keep with RBI on which RBI pays no interest to the bank. (20/n)

So if the banks have a total deposit of 100 & CRR is 4%, banks have to keep 4 rupees with the RBI. When it is increased by 0.50%, banks have to now keep 4.5% with RBI & hence 0.50% more gets absorbed by the RBI which cant be lent. (21/n)

RBI will keep increases rates till it becomes comfortable with the inflation. That’s how Demand (Liquidity) has been controlled by the RBI so far (22/n)

Summary so far,
- COVID situation prompted RBI to reduce liquidity to save businesses & job
- They reduces rates & also bought back bonds to infuse liquidity
- Excess liquidity in the system gave rise to liquidity demand & hence inflation (23/n)

- To control the same RBI has already Stopped GSAP & Operations twist, introduced 14 days variable reverse repo, introduced SDF & now increased CRR & Repo (24/25)

Can do only 25 tweets at a go & hence have attached the screen shot of the remaining content. This is my 55th thread. You can access the earlier threads as a pinned post to my wall. Dont forget to follow me @KirtanShahCFP for some interesting content on #investing (END)