Understanding Liquidity Adjustment Facility
Liquidity Adjustment Facility (LAF) is a tool used by central banks like the Reserve Bank of India (RBI) to manage economy's liquidity and control short-term interest rates. Introduced as a result of the 1998 Narasimham Committee on Banking Sector Reforms, the LAF aims to maintain financial stability and control inflation by managing the economy's liquidity. Liquidity refers to the readily available cash that banks need to meet their operational and financial needs.
Liquidity Adjustment Facility Objectives
The LAF's main objective is to manage the economy's short-term liquidity and control its interest rates. Its key objectives include maintaining price stability, regulating short-term interest rates, ensuring financial stability, managing the money supply, and sometimes controlling the exchange rate. The ultimate goal is to maintain a stable and smoothly functioning financial system, while promoting economic growth and price stability.
Liquidity Adjustment Facility Components
The LAF primarily includes two operations: Repo Rate Operation and Reverse Repo Rate Operation. In a Repo Rate Operation, banks borrow money from the central bank using government securities as collateral, with the interest rate charged known as the repo rate. This tool is used to inject liquidity into the market. In a Reverse Repo Rate Operation, the central bank borrows money from banks, offering government securities as collateral with the interest paid known as the reverse repo rate. This tool is used to absorb liquidity from the market.