Monetary Policy

Monetary Policy

This article deals with ‘Monetary Policy .’ This is part of our series on ‘Economics’ which is an important pillar of the GS-3 syllabus. For more articles, you can click here


In any economy

Financial Intermediaries
  • The Central Bank of the nation formulates monetary policy to control the money supply in the economy.
  • Objectives of monetary policy can be (depending on economy)
    1. Control inflation 
    2. Accelerating the growth of the economy
    3. Exchange rate stabilization
    4. Balance saving & investments
    5. Generating employment 

Monetary policy can be

1. Expansionary

  • Increases total money supply in an economy.
  • E.g. in 2008, all countries, including India, used this to beat the recession.
  • Traditionally used to combat unemployment in a recession by lowering the interest rate.

2. Contractionary

  • Decreases total money supply in the economy.
  • E.g. 2010 onwards, India & many other countries used it.
  • Traditionally to combat inflation in the economy.

When Monetary policy is announced in India?

a. Till 1988-89

It was announced twice a year according  to agricultural cycles

Slack season policy April -September
Busy season policy October -March

b. After 1989

  • Since the monetary policy has become dynamic in nature, RBI reserve its right to alter it from time to time, depending upon the state of the economy.
  • Along with that, the share of credit toward industry increased, which was earlier dominated by agriculture.
  • The major policy was announced in April & reviews take place every quarter. But within a quarter at any time, RBI can make any major change in policy depending upon the need.

c. Presently

  • Changes can be done at any time when RBI feels but announced necessarily after two months.

Tools used by RBI for Monetary Policy

RBI implements it using two tools

a. Quantitative /Indirect/General Tools

  • Reserve Ratios (CRR, SLR)
  • OMO (Open Market Operation)
  • Rates (Repo, Reverse Repo, Bank rate, Marginal Standing Facility etc.)

b. Qualitative /Selective/Direct Tools

  • Margin /Loan to Value Ratio
  • Consumer Credit Control
  • Rationing
  • Moral suasion
  • Direct Action

We will discuss all this in detail.

1 . Quantitative tools

Quantitative Tools of Monetary Policy

1.1 Reserve Ratios

1.1.1 Cash Reserve Ratio (CRR)

  • CRR is the percentage of public deposits (Net Demand and Time Liabilities (NDTL)) that banks have to keep with the RBI in cash at any point in time. Usually, RBI doesn’t give any interest in this.
  • CRR provisions are applicable on Scheduled Banks, Non-Scheduled Banks & Cooperative Banks.
  • RBI get these powers from RBI Act. 
  • Present Rate (Dec 2021)- 4% of Net Demand and Time Liabilities.

1.1.2 Statutory Liquidity Ratio (SLR)

  • SLR is the percentage of NDTL that banks have to maintain with themselves in the form of specified liquid assets (like cash,  gold & government securities, or RBI approved) at any point in time. 
  • It is mandated under RBI Act.
  • SLR is applicable to all commercial banks, Cooperative Banks and NBFC deposit-taking. RBI can prescribe different levels for each.
  • Although not used as Monetary Policy Tool, but if decreased, a large amount of capital is infused into the economy.  
  • Present Rate (Dec 2021) – 18% of Net Demand and Time Liabilities.  

Trends of CRR and SLR

Note – Earlier, CRR & SLR used to be very high (53% combined). As a result, banks had significantly less money to lend. It impacted the Indian Economy because the rate of loans was high, and businesses were not expanding. It was one of (the many) reasons for the 1990 Balance of Payment Crisis. Narasimhan Committee & other experts asked the government to reduce this. As a result, it was gradually reduced.

CRR Trends

CRR Trends

SLR Trends

SLR Trends

Use of CRR and SLR 

CRR and SLR can be used to fight Inflation and Deflation

  Inflation Fight Deflation Fight
Method Tight | Dear Policy Easy | Cheap Policy
CRR,SLR Increase Decrease

They also act as security in case of bank runs.

Side Topic: CRR Exemption 

  • 2020: RBI has announced that banks will not have to maintain CRR for all the loans they have given to three sectors, namely the automobile sector, residential sector and loans to MSME industries, for the next five years. It will boost loans to these sectors. 

Side Topic: What are G-Secs?

  • Concepts like Repo, Reverse Repo and Open Market Operations involve the concept of G-Secs ( or Government Securities). Hence, we will first deal with the concept of G-Secs.
  • When Government wants extra money for their schemes, they ask RBI to print that much Government Securities (G-Secs) and give equivalent cash in return. 
  • Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. It promises that Government will pay interest of x% to the holder for y years and pay principal at the end of tenure. 
  • Now RBI can use these G-Secs for various operations. E.g. to absorb the excess liquidity from the market etc. 
  • In India, the Central Government can issue treasury bills and dated securities, while State Governments can only issue Dated Securities to raise funds. 

Types of G-Secs

1. T- Bills

  • T-bills are the short-term debt instruments issued by the Union Government. Presently, they are issued in three tenors, i.e., 91-day, 182 day and 364 days. 
  • They are zero-coupon securities, i.e. government pays no interest. Instead, they are sold at a discount on face value and redeemed at face value.

2. Dated G-Secs

  • Dated G-Secs have a fixed interest rate on the face value and have a tenor ranging from 5 years to 40 years.

1.2 Policy Rates/ Liquidity Adjustment Facility (LAF)

  • Under LAF, Central Bank tends to reduce short term fluctuations of liquidity (money supply) in the economy through Repo and Reverse Repo transactions. RBI adjusts the liquidity of the market using these tools. 
  • Official Policy rate in India is REPO RATE (i.e. RBI announces Repo Rate only).
  • LAF  includes both Repo Rate & Reverse Repo Rate
  • These are available to all the Scheduled Commercial Banks. (Update 2021: Even Regional Rural Banks can avail LAF) . 
  • Repo & Reverse Repo operations can only be done in Mumbai & in securities as approved by RBI.

1.2.1 Repo Rate

  • Repo Rate is a short form for Repurchase Rate.
  • In this, Bank borrows immediate funds from the RBI for the short term (up to 14 days) with Government Securities as collateral and simultaneously agrees to repurchase the same Securities after a specified time at a specified price. For example, when a bank borrows, it will give its securities worth, say ₹ 100 crores, & agree to repurchase it back at a rate of ₹ 104 crores ( if the repo rate is 4).
  • The amount that can be borrowed under this facility: minimum 5 crores to unlimited 
  • All Banks, Central & State Governments and Non-Banking Financial Institutions are eligible.  
  • But during the whole operation, the bank has to maintain its SLR, i.e. Collateral securities can’t be from the SLR quota. 
Repo Rate
  • Present Repo Rate is 4% (Dec 2021)

Recent Trends

  • RBI was reducing the rates before Covid to spur economic activity. Post-Covid, RBI has kept the Repo Rate at 4% for increasing the demand in the market.
Recent Trend in Repo Rate

1.2.2 Marginal Standing Facility (MSF)

  • Marginal Standing Facility was introduced in 2010. 
  • Suppose the bank is in dire need of cash but doesn’t have spare securities. Under such conditions, the bank can borrow under MSF by pledging SLR securities overnight. But they will have to pay 0.25% higher than Repo Rate (as punishment)

MSF= Repo + 0.25%

  • Only Scheduled Commercial Banks can avail this facility within a range of a minimum of one crore & Maximum of 1% of Net Time and Demand Liabilities.  
  • It helps to solve short term crunch
  • It is also necessary because Repo operations are limited to a specific period during the day.
Marginal Standing Facility (MSF)

1.2.3 Reverse Repo Rate

  • In this, RBI takes money from banks & give them securities (opposite of Repo Rate)  
  • RBI pledges securities in the form of G-Secs. 
  • All clients eligible in the Repo rate are eligible here as well. 

Reverse Repo = Repo -0.65% 

  • Current Rate : 3.35 % (i.e. Repo (4%) -0.25%).

Corridor Width

Corridor Width

Tri-Party Repo Agreement

Until now, such a facility was not available to the Corporate Houses. They can’t issue Corporate Bonds to lenders and agree to repurchase them later at a pre-determined rate. Corporate houses also wanted to use this route to raise funds.

But there is an issue of trust in this case. Hence, there is a need for an Intermediary who can assure lenders that Corporate House will surely buy back these bonds at a decided rate. If borrowers refuse to pay, the intermediary Custodian will pay the lender. Custodian will charge a fee for providing this service.

Tri-Party Repo Agreement
  • In a standard repo operation, there are two parties- borrower vs Lender (RBI). 
  • In Tri-party Repo, there are 3 parties 1) borrowers 2) lenders 3) Tri-Party Agent ( presently 2 – BSE and NSE) who acts as an intermediary between the two parties to facilitate collateral custody, payment and guaranteed settlement. 
  • RBI issued guidelines for this in 2017.
  • It is not a tool of Monetary Policy. It helps deepen the Corporate Bond market. 

Negative  Interest (Reverse Repo) Rate

In news because

  • The European Central Bank (ECB), Bank of Japan, Sweden, Switzerland and Denmark have negative interest rates.
  • 25%  of the world economy is under a negative interest rate regime. 


  • All the banks park their excess funds with the central bank from time to time. A negative interest means banks will have to pay the central bank for holding these funds.

How does this work?

  • Negative interest rates are just an extreme form of the easy money policies used by central banks to try and stimulate the economy.
  • Negative rates penalize banks for holding idle funds and force them to lend them out. 
  • A sub-zero rate should reduce borrowing costs and spur loan demand (maybe banks don’t charge negative interest, but interest would be very low). 
  • Negative rates encourage capital outflow (because they find investing abroad a better option), resulting in currency depreciation. A weaker currency will encourage exports and will also help import some inflation.


  • These types of ultra expansionary Monetary policies increase inequality because profits increase faster than wages in such a situation. Those in the financial business see more income growth than other businesses.  
  • It can lead to people not using the Banking system to store their money. 
  • Customers would either have to save more to meet long-term targets or hold cash to avoid adverse effects.

1.2.4 Bank Rate

  • Bank Rate is the interest rate at which the central bank lends for the long term to commercial banks against corporate securities.
  • The rate of interest at which Central Bank provides rediscounting facilities against their first-class securities (corporate securities like Commercial Paper and Commercial Bills).
  • No collateral is required under these operations.
  • Presently: 4.25 % (Dec 2021) ( although Bank Rate = MSF but both are declared separately)
Bank Rate

Although RBI doesn’t use this tool to control the money supply, if it does, the same theory apply here as well.

Inflation Fight Increase Bank Rate
Deflation Fight Decrease Bank Rate
  • It is not the primary tool to control money supply these days but act as a penal rate charged on banks for shortfalls in meeting their reserve requirements. How is it done? 
  • If a bank is not maintaining its SLR or CRR, the bank is fined a penalty on whatever amount is less than the amount to be maintained. Rate Charged is determined as:-
    • First time: Bank rate +3% 
    • Second Time: Bank Rate +5% and so on

1.3 Open Market Operations (OMO)

  • In Open Market Operations (OMO), the Central Bank (RBI) buys and sells the Government Securities to influence the money supply in the economy.
  • It is different from Repo and Reverse Repo Rate because there is no promise by either party to repurchase it back. RBI will pay the interest rate to the holder of the security, but there is no repurchase agreement. 
  • How government the use this to control the money supply?
    • Case 1: When there is inflation trends in the market, RBI issue these securities. Banks buy these securities & the money supply decreases.
How to fight Inflation
  • Case 2When the government wants to increase the money supply, it starts buying these securities at a high price.
How to fight Deflation

Why do banks go for OMO, although there are no compulsions on this?

  • A lot of money keep on lying idle with banks. 
  • Banks don’t earn any interest on that. Hence, it is better to invest those in govt securities & earn ~8% interest on them. 

Dollar-Rupee swap

  • To manage liquidity in the market, RBI has developed a new tool. It was started in 2019. 
  • Under this three-year currency swap scheme, RBI purchases dollars from banks in exchange for rupees.
  • RBI wants to address the issue of higher bond yield via this scheme.
  • Currently, in Repo and Reverse Repo, RBI uses G-Secs. But there is the issue of higher Bond Yields. To address this issue, Dollar-Rupee Swap comes to the scene
    • Increasing liquidity = Buy $ from Banks and giving them money
    • Decreasing liquidity = Give $ to Banks and take ₹ from them
Dollar-Rupee swap

High Quality Liquid Assets (HQLA) / Liquidity Coverage Ratio (LCR)

  • BASEL-III norms mandated that banks have to keep enough amount in High-Quality Liquid Assets (HQLA) so that banks can survive a 30-day stress-test scenario. HQLA eligible assets include:
    1. Cash, including foreign currency.
    2. Cash beyond CRR
    3. G-Sec beyond SLR
    4. High rated Marketable securities (e.g., backed by PSE, Multilateral development banks, Foreign Governments)
  • From 1/1/2019, banks have to maintain HQLA for 30 days stress scenario.

Incomplete Transmission of Rate Cut by Banks

Monetary policy transmission refers to the way in which changes in the policy rates  (such as  Repo) by the  RBI lead to commensurate changes in the rates of  Interest of the  Banks. 


When RBI decreases Repo Rate, Banks don’t reduce their interest rates proportionately.

Incomplete Transmission of Rate Cut by Banks

Why don’t banks transmit Repo Rate cuts to borrowers?

1. Banks don’t depend on RBI

  • In India (& all developing countries), RBI is not the primary source of money to banks. Ordinary people are the main supplier(mainly because people don’t have many options to invest money in alternate investment facilities, e.g. mutual funds etc.) 

2. Small saving schemes  rate not reduced

  • Transmission is limited by high small savings rates. Banks worry that if they cut their deposit rates, customers will flee to small savings instruments such as PPF, NSC etc.

3. High Statutory Liquidity Ratio

  • Significant money has to be kept idle as SLR, which banks cant lend. It reduces their ability to pass the benefit to consumers.

4. Banks increasing their Spread

  • Due to losses incurred to banks due to high NPAs & lowering of credit demand, banks are increasing their Spread to maintain their profits in absolute terms. 

5. Higher NPAs

  • Indian banks face the issue of huge NPAs, which reduces banks’ profitability.

To deal with the inadequate transfer of Repo Rate cuts by banks to borrowers, RBI Came up with MCLR and External Benchmark  Rate System. 

External Benchmark System

How Banks decide their Interest Rate: Timeline

External Benchmark System
1969 The government began nationalising private banks and ‘administered interest rates‘ on them.  
1991 M.Narsimhan suggested deregulation: Government should not dictate/administer individual banks’ interest rates & RBI should only give a methodology to banks.  
2003 RBI introduced Benchmark Prime Lending Rate (BPLR).  
2010 RBI introduced the BASE Rate + Spread system; update frequency was at individual banks’ discretion.   
2016-17 RBI introduced Marginal Cost of Funds based Lending Rate (MCLR) +Spread system
Banks to calculate the lending rate on a monthly basis. 
Lending Rate to be calculated using of CRR Cost, Operating Cost, Marginal cost of funds (calculated using Repo Rate) (don’t need to go into detail. Just remember, MCLR has Repo Rate as a component in it).

Better transmission of Monetary Policy.
Transparency & accountability to borrowers.

RBI’s Janak Raj internal study group (2017) showed MCLR did not yield all benefits. So banks keep on increasing  Spread based on their discretion.  

Hence, a new method was introduced.

External Benchmark System

  • Applicable from April 2019 (on recommendations of Dr Janak Raj Committee).
  • NEW loans to be linked with External Benchmark system. 

In this system

  • Bank have been asked to choose any of the 4 benchmarks like 
    • Repo rate   or 
    • 91-day T-bill yield  or 
    • 182-day T-bill yield   or 
    • Any other benchmarks by Financial Benchmarks India Pvt. Ltd.
  • It has to be updated at least every 3 months. 
  • Lending Rate of Bank will be External Benchmark + Spread (e.g. if Bank choose Repo Rate as External Benchmark, then Interest Rate will be Repo Rate + Spread)


  • Better transmission of Monetary Policy.
  • Better transparency and accountability.

2. Qualitative / Selective / General tools

These measures are used to regulate the money supply in specific sectors (i.e. these are sector-specific measures).

2.1 Marginal Requirements/LTV(Loan to Value)

  • If Spice Airlines wants to borrow money from SBI and pledges ₹100 crore collateral but RBI prescribe a margin (Loan to Value ratio) of say 65%, then SBI can give only a 65 crore loan.
  • It is obligatory for SBI to obey directives of RBI in this context (unlike base rate) 
  • Hence, it is a Selective direct tool.

2.2 Consumer Credit Regulation

  • In this, RBI can make various regulations on credit.
  •  Eg
    • Can increase down payment from say 10% to 30% (it will force some people to delay buying vehicles financed through bank loans).
    • Can decrease least EMI for automobile sector say from ₹ 5,000 to 3,000.

2.3 Selective Credit Control

  • In this, RBI can instruct banks not to extend loans to a particular sector (Negative / Restrictive Tools) or give a minimum %age to a particular sector (positive).
  • These are Qualitative and Direct Tools.
Selective Credit Control

2.3.1 Negative  Restrictions

a. Ceiling to big loans

  • It was operational from 1965 to 1989.
  • Under this, all Commercial Banks had to obtain prior approval of RBI before giving loans greater than ₹ 1 crore to a single borrower. 

b. Ceiling on Non-Food Loans

  • It started in 1973.
  • To boost Green Revolution
  • So that more loans go towards the agriculture sector

These tools were used before LPG Reforms, but they weren’t effective because these can be easily flouted using loopholes.

2.3.1 Positive Restrictions

a. Priority Sector Lending (PSL) / Rationing 

  • Rationing is the main feature of the communist economy. E.g. in the Soviet Union, they used to make provisions like giving a particular amount of loan to a specific sector. PSL is a form of Rationing. 
  • PSL means giving a specific minimum amount of loans to some Priority Sectors. In India, 40% of loans are given to Priority Sectors. 
  • Government can increase the supply of money to that sector by increasing its limit. 

2.4 Moral Suasion

  • Moral Suasion is “persuasion” without applying punitive measures. RBI governor tries this tactic via conferences, informal meetings, letters, seminars, convocation, panel discussion, memorial lectures. 
  • Eg 
    • Please reduce giving automobile loans instead; invest your money in government securities.
    • I have reduced the repo rate; now, you also decrease your base rate.
  • It is not obligatory on the part of the Bank to follow orders, but generally, they do follow. 

2.5 Direct Action

  • RBI can take direct action against any bank for going against the rules. RBI gets this power under the Banking Regulation Act, RBI Act, Foreign Exchange Management Act, Prevention of Money Laundering Act etc.
  • E.g.: if Bank is not maintaining CRR or SLR, RBI can scrap its license.
Direct Action

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