Monetary policy

Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 11, Ch 6 "Correlation"; Class 11, Ch 7 "Index Numbers"; Class 12, Ch 3 "Money and Banking"

Meaning

Monetary policy is how the central bank controls the money supply (the total money in the economy) and credit (loans), including how much credit costs. It uses quantitative (general) tools and qualitative (selective) tools. In India, the Reserve Bank of India (RBI) runs it.

It matters because interest rates and the amount of money affect inflation, borrowing, spending and growth. In India, the legal goal is "to maintain price stability while keeping in mind the objective of growth" [5].

Key formula: simple money multiplier = 1 / CRR (this ignores SLR and the cash people hold).

Explanation

How it works: the transmission chain

• The RBI changes the policy rate or the amount of liquidity. Liquidity means ready cash in the banking system.
• Repo rate (the interest rate at which the RBI lends money to banks for a short time) goes down → banks borrow more cheaply → loan rates fall → people and firms borrow and spend more → demand rises.

• Repo rate goes up → loans cost more → people borrow and spend less → demand and prices cool.

• Operating target: the RBI tries to keep the weighted average call rate (WACR) close to the repo rate. WACR is the average interest rate at which banks lend to each other overnight [5].

• It does this by adding liquidity to the system or taking it out [5].

• Basis point (bp): 1 bp = 0.01 percentage point. So 100 bps = 1 percentage point.

Types of stance: expansionary vs contractionary

• Expansionary (easy) policy: the RBI cuts rates or adds liquidity to push growth.
• Example: the repo rate was cut to 4% by May 2020 because of the COVID shock.

• Example: in 2025 the repo rate was cut from 6.5% to 5.25% by December 2025, a total cut of 125 bps.

• Contractionary (tight) policy: the RBI raises rates or takes liquidity out to control inflation.

• Example: from May 2022 to February 2023 the repo rate was raised by 250 bps, from 4% to 6.5%.

• Neutral stance: the RBI does not lean either way. It is ready to move in either direction depending on the data.

Components: the tools

• Quantitative tools are general. They change the total amount and cost of credit in the whole economy. They do not target any one sector.
• CRR (Cash Reserve Ratio): the share of NDTL that a bank must keep as cash with the RBI. It earns no interest. It is kept as an average daily balance [5].
• SLR (Statutory Liquidity Ratio): the share of NDTL that a bank must keep itself in liquid assets, i.e. things that can quickly become cash: cash, gold and unencumbered government securities (G-secs not already pledged for a loan) [5].
• Repo / Reverse repo / SDF / MSF: the RBI lends or absorbs money for short periods through the Liquidity Adjustment Facility (LAF), its daily system for adding and taking out liquidity [2].
• Bank rate: the rate at which the RBI lends to banks, or rediscounts their bills, without repo collateral.

• Open market operations (OMO): the RBI buys or sells government bonds. A purchase injects cash and a sale absorbs it.

• Qualitative tools are selective. They push credit towards some sectors or away from others. Examples are margin requirements and moral suasion (the RBI persuading banks through advice and pressure).

• NDTL (Net Demand and Time Liabilities) is the base for CRR and SLR.
• NDTL = (Demand liabilities + Time liabilities) − interbank assets.
• Demand liabilities are money a bank must pay whenever the customer asks, e.g. savings and current accounts.
• Time liabilities are money a bank must pay only after a fixed period, e.g. fixed deposits.

Worked example (₹ crore)

• Step 1: NDTL. Demand liabilities 600 + time liabilities 400 = 1,000. Minus interbank assets of 50 → NDTL = 950.
• Step 2: CRR at 3%. 950 × 3% = ₹28.5 crore kept with the RBI, earning no interest.
• Step 3: SLR at 18%. 950 × 18% = ₹171 crore kept in SLR assets.
• Step 4: Money left to lend. 950 − 171 − 28.5 = ₹750.5 crore.
• Step 5: Money multiplier.
• With CRR at 4%, the multiplier is 1/0.04 = 25, so ₹100 of fresh reserves supports ₹2,500 of deposits.

• With CRR at 3%, the multiplier is 1/0.03 ≈ 33.3, so the same ₹100 supports about ₹3,333.

• Step 6: Repo cost. A bank borrows ₹1,000 crore overnight at 5.25%.

• Interest = 1,000 × 0.0525 ÷ 365 ≈ ₹0.144 crore ≈ ₹14.4 lakh.

In India

• Institution: the Reserve Bank of India, set up in 1935, runs monetary policy.
• Legal objective: the preamble of the RBI Act, amended in 2016, sets the goal of price stability while keeping growth in mind [5].
• Inflation target (RBI Act s.45ZA): the Central Government, after consulting the RBI, fixes a CPI inflation target once every 5 years [5].
• The target is 4%, with an upper limit of 6% and a lower limit of 2% [5].
• First period: 5 August 2016 to 31 March 2021 [5].
• First renewal: 1 April 2021 to 31 March 2026 [5].
• Second renewal, on 25 March 2026: 1 April 2026 to 31 March 2031 [5].

• The target counts as failed if average inflation stays above 6% or below 2% for three quarters in a row [5].

• Monetary Policy Committee (MPC) (RBI Act s.45ZB): a 6-member committee sets the repo rate [5].

• 3 RBI members: the Governor (Chair), the Deputy Governor in charge of monetary policy, and one RBI officer nominated by the Central Board [5].

• 3 external members, each serving a 4-year term [5].

• Legal base of the tools:

• CRR comes from RBI Act s.42.

• SLR comes from Banking Regulation Act s.24.

• Latest stance (August 2026): the MPC voted unanimously to keep the repo rate at 5.25%, with a neutral stance [2].

• It had also held the rate at its 60th meeting (6-8 April 2026) and its 61st meeting (3-5 June 2026) [3].

• LAF corridor (August 2026): the band that keeps short-term market rates near the repo rate [2].

Rate	Level
SDF (floor) = repo − 25 bps	5.00%
Repo (policy rate)	5.25%
MSF / Bank rate (ceiling) = repo + 25 bps	5.50%

• CRR cut of 2025: announced in June 2025. It cut the CRR by 100 bps, from 4% to 3% of NDTL, in four steps of 25 bps [4].
• 3.75% from 6 September 2025 [4].
• 3.5% from 4 October 2025 [4].
• 3.25% from 1 November 2025 [4].

• 3.0% from 29 November 2025 [4].

• SLR: 18% now, down from a peak of 38.5% in 1990.

• SDF (Standing Deposit Facility): since April 2022 it has replaced the fixed-rate reverse repo as the floor of the corridor.
• Repo has been the single policy rate since 2011.

Don't confuse with

• Fiscal policy: this is the government using taxes and spending through the Budget. Monetary policy is run by the RBI through money supply, credit and interest rates.
• Quantitative vs qualitative tools: quantitative tools (CRR, SLR, repo, OMO) change the total amount of credit. Qualitative tools (margin requirements, moral suasion) change where credit goes.
• Repo vs outright OMO: repo is a temporary injection (overnight, 7-day or 14-day) that reverses when the term ends. Outright OMO changes durable (long-lasting) liquidity permanently [5].
• CRR vs SLR: CRR is kept with the RBI as cash, earns no interest, and comes from RBI Act s.42. SLR is kept by the bank itself in cash, gold and G-secs, and comes from Banking Regulation Act s.24.

Prelims Hooks

• The CPI inflation target of 4% ± 2% is set by the Central Government in consultation with the RBI, not by the RBI alone, under s.45ZA. It was renewed on 25 March 2026 for 2026-2031 [5].
• MPC (s.45ZB): 6 members, with the Governor as Chair and 3 external members serving 4-year terms [5].
• The RBI's operating target is the WACR, not the repo rate itself [5].
• August 2026 corridor: SDF 5.00% < Repo 5.25% < MSF = Bank rate 5.50% [2]. The SDF replaced the reverse repo as the floor in April 2022.
• Both CRR and SLR are calculated on NDTL, not on total deposits. The CRR fell to 3% of NDTL from the fortnight starting 29 November 2025 [4].
• Simple money multiplier = 1/CRR. Cutting the CRR from 4% to 3% raises it from 25 to about 33.3.

Mains Points

• Inflation targeting vs growth: the law asks for price stability while "keeping in mind" growth.
• After a 250 bps rise in 2022-23, the RBI cut the repo rate by 125 bps in 2025. It then held it at 5.25% with a neutral stance in 2026 [2][3].

• This shows the trade-off. Cutting too early can bring inflation back. Holding high rates for too long can slow growth.

• Slow transmission: a repo cut works only if banks pass it on to borrowers.

• Banks have already promised fixed rates to their depositors, so they are slow to cut loan rates.

• This is why the RBI also cut the CRR by 100 bps in 2025, which freed cheap funds for banks to lend [4].

• Rule-based framework and SLR reform (GS-II / GS-III):

• The MPC, together with a legal target and a legal meaning of "failure", makes the RBI accountable. It also protects monetary policy from fiscal pressure [5].
• The SLR gives the government a captive channel of borrowing, meaning banks must buy its bonds. But it locks up bank money that could go to private firms, a form of financial repression. Cutting the SLR from 38.5% (1990) to 18% was a key banking reform.

Related concepts

• Expansionary monetary policy
• Contractionary monetary policy
• Quantitative tools of monetary policy
• Cash Reserve Ratio
• Net Demand and Time Liabilities
• Statutory Liquidity Ratio
• Bank rate
• Open market operations
• Outright open market operations
• Repo rate

Read more

• Monetary policy and its quantitative instruments