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CA Foundation · Business Economics · Money Market

Which of the following best describes the primary function of the Liquidity Adjustment Facility (LAF) in India's monetary framework?

The LAF is the RBI's daily liquidity management tool, enabling the central bank to inject or absorb rupees from the banking system through repo and reverse repo operations, thereby smoothing short-term liquidity mismatches and supporting the implementation of monetary policy.

  1. ATo provide long-term credit to commercial banks for capital expenditure projects
  2. BTo allow the RBI to inject or absorb liquidity from the banking system on a daily basis through repo and reverse repo operationsCorrect
  3. CTo set the minimum cash reserve requirements that all banks must maintain
  4. DTo regulate the interest rates charged by banks on retail deposits and loans

Explanation

The LAF is RBI's operational tool for day-to-day liquidity management in the money market. Through repo (RBI lends to banks) and reverse repo (RBI borrows from banks) operations, the RBI manages short-term liquidity fluctuations and supports monetary transmission. Option 0 confuses LAF with long-term refinancing schemes. Option 2 refers to CRR policy, which is separate. Option 3 is incorrect—RBI does not directly regulate retail rates; LAF influences wholesale money market rates which then affect retail pricing indirectly.

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