Monetary policy transmission

Also called: Monetary transmission, Pass-through, Interest rate channel, Credit channel, Exchange rate channel · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Beyond NCERT

Meaning

Monetary policy transmission is the process by which a change in the RBI's policy repo rate (the interest rate at which the RBI lends money to banks for a short time) passes on to other interest rates, then to people's spending and firms' investment, and finally to output (GDP) and inflation.

It matters because the RBI controls only one short-term rate directly. Its fight against inflation works only if banks, bond markets and borrowers actually follow that rate. How strong the transmission is can be measured:

Pass-through (%) = (Change in lending or deposit rate ÷ Change in repo rate) × 100

Explanation

How it works: the five stages

• Stage 1: the money market (very short-term borrowing between banks and other institutions). A repo change first moves:
• WACR (Weighted Average Call Rate, the average rate on overnight loans between banks). This is the RBI's operating target.

• TREPS (Tri-party Repo, overnight lending against collateral, settled through CCIL) and the market repo rate.

• Stage 2: short and long bonds. Next come:

• T-bill yields (Treasury bills, government debt of up to 1 year)
• CP/CD rates (Commercial Paper issued by companies; Certificates of Deposit issued by banks)

• G-sec yields (longer-term government bonds)

• Stage 3: bank rates. Then banks change their deposit and loan rates:

• WADTDR (Weighted Average Domestic Term Deposit Rate, the average rate banks pay on fixed deposits)
• WALR (Weighted Average Lending Rate, the average rate banks charge on loans)

• Both are measured separately for fresh (new) and outstanding (all existing) amounts.

• Stage 4: spending and asset prices. Consumption changes through EMIs (Equated Monthly Instalments). Investment by firms changes too, along with share and property prices and the exchange rate.

• Stage 5: the final goals. Output and inflation change.
• Worked example: a 50 bps hike (1 basis point = 0.01 percentage point, so 100 bps = 1%)
• The same day, the repo rate goes up and WACR rises with it.
• After weeks, T-bill and CD rates rise, and banks raise their fixed deposit and loan rates.
• After months, home and car loans cost more. People buy less, demand cools and prices rise more slowly.

The channels of transmission

The table uses a rate cut as the example.

Channel	How it works
Interest rate channel	Loans get cheaper → firms invest more → households borrow for houses and cars
Credit channel	Banks get cheaper funds and more cash to lend → they give more loans, especially to small firms that depend on banks
Asset price / wealth channel	Lower rates → share and bond prices rise → people feel richer → they spend more
Exchange rate channel	Lower Indian rates → foreign investors take money out → the rupee weakens → exports get cheaper and imports get costlier (imported inflation)
Expectations channel	People trust the RBI to keep inflation low → they ask for smaller wage and price increases

• Worked example: EMI (interest rate channel)
• Formula: EMI = P × r × (1+r)ⁿ / [(1+r)ⁿ − 1]. Here P = loan amount, r = monthly rate (annual rate ÷ 12) and n = number of months.
• Take a ₹30 lakh home loan for 20 years (n = 240):
  • At 9.0%, the EMI is about ₹26,992.
  • At 8.5%, after a 50 bps cut is fully passed on, the EMI is about ₹26,035.

• The borrower saves about ₹957 a month. They can spend this money on other things, so consumption rises.

• Forward guidance (the expectations channel in action)

• The central bank tells markets how it is likely to set rates in future.
• Long-term rates such as G-sec and corporate bond yields then move before the RBI actually acts.
• Time-based guidance is linked to a period of time. In October 2020, the RBI said it would stay accommodative "at least during the current financial year and into the next".
• State-based guidance is linked to conditions being met, for example "rates stay low until inflation is durably at target".
• If a trusted central bank promises to keep rates lower for longer, the economy gets extra support and inflation returns to target faster [7].

Lags and what makes transmission stronger or weaker

• Transmission lag is the time between a policy change and its effect.
• A rough guide is 2-3 quarters to reach output and 3-4 quarters to reach inflation. RBI studies give different figures, so treat these only as ranges.

• Research on emerging markets measures the effects over 1 to 12 quarters [5].

• State of the economy (IMF, 2026) [5]:

• Policy has a strong effect on output during recessions and after a period of loose policy.
• It has little effect in booms or when policy is already tight.

• The effect on prices is weak in both cases.

• Trend inflation (IMF, 2023) [6]:

• When trend inflation is low, policy has a bigger effect on output and a smaller effect on prices.

• When trend inflation is high, the output effect is small and the price effect is larger.

• Direction of the change. Pass-through is stronger when rates are rising than when they are falling [1].

• Why transmission is slow in India:
• Fixed-rate term deposits. Banks have promised rates to depositors for 1-5 years. After a repo cut they still pay these old high rates, so their cost of funds (what they pay for the money they lend) falls slowly.
• Administered small-savings rates. The government sets rates on PPF, NSC and post office deposits and revises them every quarter. If banks cut deposit rates below these, savers move their money away. So banks cannot cut deposit rates freely, and this in turn holds up loan rate cuts.
• CRR/SLR pre-emptions. Under CRR (Cash Reserve Ratio), banks keep cash with the RBI and earn no interest on it. Under SLR (Statutory Liquidity Ratio), they must hold government securities and similar safe assets. Money locked up this way cannot be lent, which raises the cost of the funds that are lent.
• High NPAs. An NPA (Non-Performing Asset) is a loan on which interest or principal has been unpaid for more than 90 days. Banks with many NPAs keep loan rates high and lend cautiously.
• Heavy government borrowing. The government competes with firms for savings, so G-sec yields stay high and all long-term rates stay high.
• Informal lenders such as moneylenders and traders. Their rates do not follow the repo rate at all.

In India

• Who manages it: the RBI's Monetary Policy Committee (MPC) sets the repo rate. The RBI steers the WACR as its operating target, inside a policy corridor (the band that keeps overnight rates close to the repo rate).
• The corridor in 2026 [2][3]:
• SDF (Standing Deposit Facility) 5.00%. This is the floor, the rate the RBI pays when banks park extra cash with it.
• Repo 5.25%. This rate was left unchanged at the April, June and August 2026 meetings.
• MSF (Marginal Standing Facility) and Bank Rate 5.50%. This is the ceiling, the emergency borrowing rate for banks.

• The stance is neutral. The 62nd MPC meeting (3-5 August 2026) held the rate on a unanimous vote [3].

• Recent path of the repo rate:

• It rose by 250 bps from May 2022 to 6.50% [1].
• A 25 bps cut in April 2025 took it to 6.00% [4].

• It stood at 5.25% by April 2026 [2]. That is a total cut of 125 bps from the 6.50% peak.

• The record in the 2022-23 tightening cycle (bank rates measured from May 2022 to September 2023) [1]:

• WALR on fresh loans rose by +187 bps, so pass-through = 187 ÷ 250 × 100 = 75%.
• WALR on outstanding loans rose by +111 bps, only 44%, because old loans reprice slowly.
• The 1-year MCLR rose by +152 bps. WADTDR on fresh bulk deposits rose by +269 bps.

• The RBI's long-run estimate is 69 bps for every 100 bps change in repo over the full sample. In the EBLR period (2019 Q3 to 2022 Q4) it was 82 bps [1].

• Lending benchmarks: the fix on the loan side

• The order was BPLR → Base Rate (2010) → MCLR (2016) → External Benchmark Lending Rate (EBLR) from 1 October 2019.
• EBLR is compulsory for new floating-rate retail loans and loans to MSMEs. Most banks chose the repo rate as their external benchmark [1].

• Example: with repo at 5.25% and a bank spread of 2.75%, the loan rate is 8.00%. If repo falls by 25 bps, the loan rate falls to 7.75% at the next reset. Loans must reset at least once every 3 months.

• Uneven adoption. Share of floating-rate loans linked to an external benchmark in June 2023: foreign banks 87.6%, private banks 73.2%, public sector banks only 36.1% [1].

• Using projections, because of the lags. In April 2026, the RBI projected CPI inflation for 2026-27 at 4.6% and real GDP growth at 6.9%. The quarterly CPI path was 4.0% → 4.4% → 5.2% → 4.7% [2].

Don't confuse with

• Repo rate vs "Base Rate": the repo rate is the RBI's policy rate. The Base Rate (2010-16) was each bank's own minimum lending rate. Class 7 NCERT calls the repo rate the "base interest rate", which is a common trap.
• Operating target vs policy rate: the RBI sets the repo rate, but the rate it aims to steer day to day is the WACR.
• Fresh vs outstanding pass-through: fresh loans reprice quickly (75% in 2022-23), while outstanding loans reprice slowly (44%) [1]. A question on "transmission" may refer to either one.
• Interest rate channel vs credit channel: the interest rate channel works through the price of loans (cheaper EMIs). The credit channel works through the quantity of loans (banks lending more, especially to small firms that depend on banks).

Prelims Hooks

• The WACR is the operating target of RBI monetary policy. The repo rate is the policy (benchmark) rate.
• Corridor in 2026: SDF 5.00% (floor) < Repo 5.25% < MSF = Bank Rate 5.50% (ceiling) [2][3].
• Order of lending benchmarks: BPLR → Base Rate (2010) → MCLR (2016) → EBLR (1 October 2019). Most banks linked EBLR to the repo rate [1].
• WALR = Weighted Average Lending Rate. WADTDR = Weighted Average Domestic Term Deposit Rate. Both are published for fresh and outstanding amounts.
• Transmission is stronger in tightening than in easing phases. EBLR share of floating-rate loans was lowest in public sector banks (36.1%, June 2023) [1].
• Time-based guidance: RBI in October 2020 ("at least during the current financial year and into the next"). State-based guidance is linked to conditions, not dates.

Mains Points

• Deposit-side rigidity is the core problem.
• Fixed-rate deposits and administered small-savings rates slow the fall in banks' cost of funds.
• EBLR fixed the loan side, but it squeezes banks' net interest margins (the gap between what they earn on loans and pay on deposits).

• This is a trade-off between faster transmission and bank profitability.

• Fiscal-monetary link.

• Heavy government borrowing keeps G-sec yields high and weakens RBI rate cuts.

• Sticking to the fiscal deficit path would make RBI action more effective. So would aligning small-savings rates with market rates.

• Transmission depends on the state of the economy and on financial inclusion [5][6].

• Rate cuts work better in downturns, so the RBI should act early using projections. Forward guidance, MPC minutes and a clear stance should support these decisions.
• Borrowers who depend on moneylenders are untouched by the repo rate. Formal credit (SHGs, MUDRA, priority sector lending) widens monetary policy's reach.

Related concepts

• Benchmark interest rate
• Forward guidance

Read more

• Transmission: from the repo rate to the real economy