[DRAFT] Lizz Truss, the SDF, and 'monetary policy is more effective in an open economy'

From The Tantri Files — verbatim writing from Prof. Tantri’s WhatsApp messages, with his blessing. The night before the September 2024 INFS final exam, Tantri stayed up answering plumbing questions in the Co25 group. The thread doubles as a complete review of the RBI’s liquidity toolkit and a real-world case study (the September 2022 UK gilt-market collapse).

How money is created — the four-line version

Tantri sent this as a four-step summary, hoping students would internalise it before the exam.

Tantri.

Money gets created through a transaction between the government and the RBI: the government issues bonds and the RBI gives reserve money in return. In other words, the government’s account with the RBI is credited.

The government spends this in the economy. Money reaches the banking system as deposits.

Banks lend a fraction of these deposits, creating new deposits. This is money multiplier in action.

Finally, the RBI manages this money supply by conducting VRR, VRRR and through MSF, SDF and other instruments. They increase money supply temporarily to cut interest rates, and vice versa. But the main source of money is step 1.

He added, dryly:

Some people are still stuck in how cash is created despite me saying it is irrelevant for the exam. I really appreciate the urge to learn at the expense of losing (maybe) all 35 marks. Salute to those people. These people will come up in life for sure.

The four windows — what each one is for

Across the same evening, in a series of short replies, he laid out the toolkit:

Variable Rate Repo (VRR). RBI buys G-secs from banks for a few days and gives them reserve money. Increases money supply temporarily, brings call rate down. Used when liquidity is tight.

Variable Rate Reverse Repo (VRRR). RBI sells G-secs to banks for a few days, takes reserve money out. Reduces money supply temporarily, pushes call rate up. Used when liquidity is flush.

Marginal Standing Facility (MSF). Emergency overnight loan from the RBI to banks at a higher rate than the repo. The ceiling of the corridor. A bank only goes here if it’s truly run out of options.

Standing Deposit Facility (SDF). The reverse — banks can park excess reserves with the RBI overnight at a lower rate than the repo. The floor of the corridor.

In Tantri’s words, when a classmate confused the directions:

Tantri. When you do SDF money supply goes down, and MSF increases it.

A classmate: But the SDF rate is the floor — banks shouldn’t be using it…

Tantri. Look at the actual data. Most of the money is in SDF. If liquidity is so deficient, then why are banks parking in SDF? (That’s where the economics comes in. The risk premium is up.)

A classmate: Can non-banks like mutual funds participate in these operations?

Tantri. Anyone can participate. Non-banks have to go through banks. Suppose a mutual fund wants to sell G-sec. The sale will be mediated through banks as mutual funds do not deal in reserve money. MF gives G-sec to bank, bank gives it to RBI, RBI passes on reserve money to banks, which in turn credits MF deposit account.

The Lizz Truss case — what happens when the plumbing breaks

A classmate asked whether VRR-style operations always work to bring rates down. Tantri’s reply was a complete case study, in two paragraphs.

A classmate: Won’t VRR always lower nominal rates?

Tantri. Exactly. All these work if inflation is constant. If inflation expectations change, then they can become counter-productive. Refer to the UK case. VRR can bring down rates only when inflation expectations are not rising.

He elaborated:

Yes — you are talking about medium and long-term issues. I am talking about that fateful Lizz Truss budget where they cut taxes without cutting expenditure.

This would have increased government deficit. Interest rates went up.

The central bank tried VRR; interest rates went up further as inflation expectations increased.

Thus, the whole thing collapsed leading to the end of the government.

The lesson, in his framing: liquidity tools fix quantity, not expectations. If you push reserve money into the system while everyone is convinced inflation is about to rip, the long end of the curve doesn’t fall — it climbs faster.

And, six months later, the inversion

A footnote from the same thread: in March 2025, on the same point but in the opposite direction.

Tantri (Mar 29, 2025, exam season). Under which of the following situations does aggregate liquidity not increase much (proportionately) despite RBI conducting repeated VRRs?

a. When the bank rate is high b. When MSF is low c. When Repo is low d. When SDF is high

The answer is D. If parking pays well, banks won’t lend out the reserves they’re being handed. The RBI has been handed money back as fast as it has injected it.

And one more, on open economies

A classmate: Does the openness of an economy change how monetary policy works?

Tantri. That is why monetary policy is more effective in an open economy than a closed one. A rate cut by the central bank doesn’t only stimulate domestic demand — it also depreciates the currency, pulls in import substitution, and boosts exports.

He set this as an exam question:

In a Keynesian world with exports and imports, which of the following is true?

a. A rate cut by the central bank has a larger stimulus than in a closed economy (where there is no international trade) b. A rate increase by the central bank has a smaller contractionary effect than in a closed economy c. Both of the above d. None of the above

Answer: A.

Editor’s notes

This post stitches together messages from two separate WhatsApp evenings: September 29, 2024 (the night before the INFS Co25 final exam) and March 28–29, 2025 (the equivalent moment for the Mohali batch). Tantri’s words are verbatim throughout; sub-headings and the brief explanatory framing for VRR/VRRR/MSF/SDF are editorial. Student questions have been paraphrased and anonymised.

For the underlying frameworks see Session 3 — Aggregate Demand & Monetary Policy, Session 3A — IS-MP Framework, and Session 4 — Fiscal Policy, Crowding Out & Transmission.

The “Lizz Truss” episode Tantri refers to is the September 23, 2022 mini-budget in the UK and the gilt-market collapse that followed it.