The money markets see bouts of surplus liquidity and shortfalls of liquidity at various points of time. For example, currently the money markets are facing a shortage because a lot of liquidity was sucked out of the system in the last few months due to payment of year-end tax, advance tax and for election spending. On June 20th, the RBI is infusing liquidity of Rs.12,500 crore into the money markets. There are broadly two ways in which the RBI infuses liquidity into the system.

· The first method is called the Open Market Operations (OMO). When the RBI wants to infuse liquidity, it will buy bonds to that extent and when it pays for these bonds, the liquidity gets infused in the system. OMOs work both ways. RBI buys bonds to infuse liquidity and sells bonds to suck out liquidity.

· The second method is through dollar swap auctions. The government has done two rounds of dollar swap auctions in April worth $5 billion. In this method, the RBI absorbs the dollar deposits with the banks and gives them rupee funds instead. This helps banks monetize their dollar deposits and also enables the banks to buy it back at a future date (normally 3 years). Dollar swaps not only infuse liquidity into the money markets but also create demand for dollars and prevent the rupee from appreciating beyond a point.

When there is liquidity shortfall in the system, the short term rates go up and that also pushes up interest rates and cost of funds across the board. RBI uses the above two measures to regulate the liquidity in the system.