Banking, Credit Creation and Monetary Policy

1. The financial system: banks and other institutions

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What the financial system is

• Financial infrastructure is the network of banks, payment systems, stock markets and other financial institutions. It moves money among households, firms and government (Class 7, Banks and the Magic of Finance).
• It works alongside physical infrastructure (roads, railways, telecom). Physical projects need funds, and the financial system raises and channels those funds.
• The financial sector means the institutions and markets that collect and allocate funds: commercial and investment banks, stock exchanges, the foreign exchange market.
• Regulators in India:
• RBI: banks, NBFCs, payment systems
• SEBI: securities markets
• IRDAI: insurance
• PFRDA: pensions
• IFSCA (2020): the GIFT City international financial services centre

Financial intermediation

• Financial intermediation: banks stand between savers and borrowers. They pool depositors' surplus funds and use most of these deposits to give loans.
• NCERT example: Navdeep deposits his spare money. Rima's bamboo business needs funds that friends and family cannot fully give. The bank lends Navdeep's pooled money to Rima.
• The bank also removes risk and search costs. Navdeep does not need to judge whether Rima can repay.
• Joseph Schumpeter said the banker is "not only a middleman". The banker is a "producer" of credit who helps entrepreneurs "transform ideas into reality".
• Ancient precedent: temples worked like banks. They did not take public deposits, but they lent to artisans, merchants and local governments for infrastructure. Contracts were cut on copper plates (Pandya kingdom plates). A 13th-century inscription from Kodumbalur (Tamil Nadu) records communities that borrowed from the Tirumudukunramudaiya-Nayanar temple and agreed to pay interest.

Institutions

• Commercial banks take deposits from the public and lend part of them. They are part of the money-creating system (section 3).

• Types: public sector, private sector, foreign, Regional Rural Banks, small finance banks and payments banks (structure → banking-regulation-npas).

• Private sector banks are majority-owned by private shareholders.

• New private banks were licensed after the 1991 reforms (1993 guidelines).
• On-tap universal bank licensing started in 2016.

• Foreign investment of up to 74% is allowed.

• Post offices offer savings schemes such as National Savings Certificates (NSC), Kisan Vikas Patra and Sukanya Samriddhi. Their network reaches remote areas.

• A development finance institution (DFI) funds a specific sector with long-term credit.

Institution	Year	Role
IFCI	1948	First DFI. Funds industry such as power and textiles
NABARD	1982	Refinances banks that lend for farming, village industries and rural infrastructure (roads, irrigation)
EXIM Bank	1982	Export-import finance
NHB	1988	Housing finance
SIDBI	1990	Small industries (MSMEs)
NaBFID	2021	Infrastructure financing

• NABARD, EXIM Bank, NHB, SIDBI and NaBFID are RBI-regulated all-India financial institutions.

2. How a bank works: deposits, interest, spread and terms of credit

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Deposits

• Deposits are money placed in a bank account. You can withdraw them as per the bank's terms, and they often earn interest.

Account	Who uses it	Interest	Withdrawals
Savings account	Individuals who save regularly	Yes	Minimum balance; limits on how often you can withdraw each month
Current deposit account	Businesses and traders	No	Generally no limit on transactions
Fixed deposit	One-time deposit for a fixed period (e.g. 3-5 years)	Higher than savings	Early withdrawal only with a penalty

• A fixed deposit pays more because the depositor gives up liquidity. The bank can lend that money for longer.
• Demand deposits are savings and current balances payable on demand. They can be used through cheques.
• They count as money: currency plus demand deposits make up the money stock (Class 10, Money and Credit).

• They are not legal tender. Anyone can refuse a cheque.

• Time deposits (fixed deposits) enter M3, not M1.

• A cheque is a paper that tells the bank to pay a set amount from the payer's account to the named person. Example: Salim pays his leather supplier by cheque. The money moves between accounts in a couple of days without any cash.
• Passbook: a diary-like bank document that records every receipt and payment in an account.
• Debit and credit: a debit takes money out of an account. A credit puts money into it.

Interest and compounding

• Interest is the price charged for borrowing money, or earned for lending it. It is usually a percentage.
• Compound interest means earning interest on interest you earned earlier. Worked example (Class 7):
• ₹1,000 at 6% becomes ₹1,060 after year 1.
• Year 2 interest is 6% of ₹1,060 = ₹63.60, so the total is ₹1,123.60.
• After 12 years it becomes ₹2,012.20. Formula: A = P(1 + r)ⁿ.

• Rule of 72: 72 ÷ 6 = 12 years to double.

• Ambalappuzha chessboard story: a sage asks a king for 1 grain of rice on the first square, doubling on each square. The 16th square holds 32,768 grains. The 32nd square holds over 210 crore (2³¹).

Spread

• Interest rate spread is the lending rate minus the deposit rate. It is a bank's main source of income.
• Example: Anand deposits ₹200 at 2% and gets ₹4. The bank lends the ₹200 to Shreya at 5% and collects ₹10. The bank keeps ₹6.
• Banks keep reserves and lend the rest.
• (NCERT outdated: Class 10 says banks keep "about 5 per cent of deposits as cash". Now the CRR is 3% of NDTL, held with RBI, not as vault cash. Verify current.)

Loans and terms of credit

• Terms of credit are four things together: interest rate, collateral, documentation and mode of repayment.
• Collateral is an asset the borrower owns and pledges, such as land, a building, a vehicle, livestock or bank deposits. If the borrower defaults, the lender can sell it.
• Example: Megha takes a ₹5 lakh home loan at 12% for 10 years, repaid in monthly instalments. She shows employment and salary records. The bank keeps the house papers as collateral.
• Credit has two faces:
• Salim borrows working capital for a 3,000-pair shoe order. He delivers, earns more and repays. Credit helps.
• Swapna's groundnut crop fails from pests. Her moneylender loan grows, and she must sell part of her land. This is a debt trap.

• Whether credit helps depends on the risk and on whether there is support if things go wrong.

• Cost contrast in Sonpur village:

• Moneylender: 5% a month (60% a year).
• Trader: 3% a month, plus the farmer must sell the crop to the trader at a low post-harvest price.
• Landowner lending to Rama: 5% a month, repaid through labour.

• Bank: 8.5% a year, repayable within 3 years.

• Cheap formal credit leaves borrowers more income and encourages enterprise. That is why it matters for development. (Sources of credit, AIDIS data and SHGs → financial-inclusion-rural-credit. Deposit insurance → banking-regulation-npas.)

3. Credit creation, high-powered money and the money supply

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Lala the goldsmith (Class 12)

• Villagers keep 100 kg of gold with Lala, and his paper receipts start to circulate as money.
• Lala lends 25 kg to Ramu, betting that not all depositors will withdraw at once. Ramu pays Ali, who deposits the gold back with Lala for a receipt.
• "Money" (receipts) rises from 100 to 125 kg. This is fractional-reserve banking.
• The risk is a bank run: many depositors withdraw together out of fear, and the bank cannot pay because it holds only a fraction of deposits as cash. Class 10 asks: "What would happen if all the depositors went to ask for their money at the same time?" This is why we need a lender of last resort and deposit insurance.

Bank balance sheet

• A bank balance sheet records a bank's assets and liabilities. Both sides must balance.
• Assets = Reserves + Loans
• Liabilities = Deposits

• Net worth = Assets − Liabilities

• Bank reserves are vault cash plus a bank's deposits with the central bank. They are kept against deposits, not lent. The CRR sets the legal minimum.

Credit creation, one-bank example (CRR 20%)

• Credit creation: banks lend deposits, the loans come back as new deposits, and money supply grows to a multiple of reserves.
• Leela deposits ₹100.
• The bank keeps ₹20 and lends ₹80 to Jaspal Kaur. That loan comes back as a deposit, so deposits are now ₹180.
• Required reserves become ₹36, so the bank can lend ₹64 more (to Junaid).
• The process continues until deposits reach ₹500.

Round	Deposits	Required reserve	Loan
1	100	20	80
2	180	36	64
Last	500	100	400 (total)

• M1 rises from 100 to 500.
• Money multiplier = 1/CRR = 1/0.2 = 5.

• If CRR rises to 25%, the multiplier becomes 4. Lending falls to ₹300, and banks must call back loans.

• Fuller formula: m = (1 + cdr)/(cdr + rdr)

• The currency deposit ratio (cdr) is currency held by the public ÷ their bank deposits.
• The reserve deposit ratio (rdr) is the share of deposits banks hold as reserves.
• A wider banking habit lowers cdr and raises m. With cdr = 0, m = 1/rdr.

NCERT errors (Class 12, Money and Banking)

• It defines CRR as reserves kept "with the bank". CRR balances are actually kept with RBI.
• It says reserves include bonds and T-bills "issued by the RBI". Reserves are actually vault cash plus deposits with RBI. Government securities count toward SLR, not CRR.
• The appendix sums the series with r = 0.4 to get 5/3. This does not match the 20% CRR example. There, r = 0.8, so 1/(1 − 0.8) = 5.

High-powered money

• High-powered money (reserve money, monetary base, M0) is the central bank's total monetary liability. It is the base for credit creation.

• M0 = currency in circulation + bankers' deposits with RBI + other deposits with RBI.

• Currency in circulation = currency with the public + cash with banks.

• Table 3.5, 2024-25 figures:
• Currency in circulation: ₹37,24,448 crore (₹37.24 lakh crore)
• Bankers' deposits with RBI: ₹9,91,488 crore (₹9.91 lakh crore)
• Other deposits with RBI: ₹1,13,307 crore

• M0 ≈ ₹48.3 lakh crore

• NCERT errors in Table 3.5:

• Cash with banks for 2024-25 is printed as 9396. It should be about ₹93,697 crore (37,24,448 − 36,30,751).

• Currency with the public for 2016-17 is printed as 124124. It should be about ₹12,64,124 crore.

• Sources of M0: RBI's net credit to government, RBI's credit to banks, and net foreign exchange assets.

Money supply

• Money supply is the total stock of money held by the public at a point of time. It is created by RBI together with the banks.
• Money supply = m × H.

• For 2024-25: M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore gives m ≈ 5.6.

• Measures of money:

• M1 = currency with the public + net demand deposits + other deposits with RBI (most liquid)
• M2 = M1 + Post Office savings bank deposits
• M3 = M1 + net time deposits of banks. This is the most-used measure, also called "aggregate monetary resources".

• M4 = M3 + total Post Office savings deposits (excluding NSC)

• Narrow money = M1, M2. Broad money = M3, M4. They are listed in decreasing order of liquidity.

• Growth example: M3 grew from ₹11.24 lakh crore (1999-2000) to ₹272.87 lakh crore (2024-25). Full treatment of the measures → money-evolution-functions.
• Class 12 exam question: "Is a commercial bank a creator of money?"
• Yes: its loans create deposits, which are money.
• But only within limits: RBI's high-powered money, CRR, the public's cash habit and the demand for loans.

4. Demand for money and the interest rate

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Interest as the price of holding money

• Liquidity is how easily an asset can be exchanged for other goods. Money is the most liquid asset.
• The opportunity cost of holding money is the interest you give up by holding cash instead of, say, a fixed deposit. So the interest rate is the "price" of holding money.
• The interest rate is also the cost of borrowed funds. Higher rates lower money demand and investment.
• Demand for money (liquidity preference) is a trade-off between the benefit of liquidity and the interest you lose.
• It rises with income, because there are more transactions.
• It falls as the interest rate rises.

Transaction motive

• Income arrives at points in time but is spent continuously. So people hold money balances.
• Example: you earn ₹100 on day 1 and spend it evenly. Average holding = (100 + 0) ÷ 2 = ₹50.
• Two-person economy: transactions worth ₹200 per month need only ₹100 of money.
• Formulas: Mᵀd = kT, and in terms of GDP, Mᵀd = kPY. Transaction demand rises with real income (Y) and the price level (P).
• Velocity of circulation: the number of times one unit of money changes hands in a period. v = 1/k, and v·Md = T. In the example, v = 2.

Speculative motive

• The speculative motive is holding money instead of bonds to avoid capital losses when interest rates are expected to rise.
• Bond prices move opposite to interest rates. Example: a 2-year bond (face value ₹100, 10% coupon):
• Price at 5% = 10/1.05 + 110/1.05² ≈ ₹109.29

• Price at 6% ≈ ₹107.33

• When r is high, people expect it to fall, buy bonds and hold little money. When r is low, people expect it to rise, sell bonds and hold money.

• Formula: Msd = (rₘₐₓ − r)/(r − rₘᵢₙ).
• Total money demand: Md = kPY + (rₘₐₓ − r)/(r − rₘᵢₙ). (Derivations → money-evolution-functions.)

Money-market equilibrium

• The interest rate settles where money demand (depending on Y and r) equals money supply.
• How more money lowers r (Box 3.1 logic):
• People use the extra money to buy bonds.
• Bond prices rise.

• r falls.

• This is the channel through which RBI's liquidity operations move market rates.

• Liquidity trap: at a very low rate (rₘᵢₙ), everyone expects rates to rise. They hold any extra money instead of buying bonds, so r cannot fall further. Money demand is infinitely elastic here. This is why policy at the zero lower bound turns unconventional (section 12).
• Nominal vs real rate: real rate ≈ nominal rate − expected inflation. Debates about a "real policy rate" (e.g. a repo rate of 5.25% against about 4% inflation gives a real rate near 1.25%) rest on this. See also the neutral rate (section 10).

5. The Reserve Bank of India: origin, functions and balance sheet

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Origin

• The Hilton Young Commission (1926) recommended a central bank.
• The RBI Act 1934 set up RBI on 1 April 1935 as a shareholders' bank. Its head office was in Calcutta and moved to Bombay in 1937.
• RBI was nationalised on 1 January 1949.
• (NCERT simplification: Class 7 says RBI has worked as "banker of banks" since 1949. In fact it did central-banking work from 1935. 1949 was only the move to public ownership.)

Functions of a central bank

• A central bank is the apex institution. It issues currency, controls money supply, acts as banker to government and banks, and holds forex reserves.
• Currency issue monopoly: RBI alone issues banknotes. The Government of India issues coins and ₹1 notes.
• Notes carry the Governor's promise to pay. They are fiat money and legal tender.

• RBI also manages currency distribution.

• Banker to government: for the Centre by law, and for states by agreement. RBI gives ways and means advances (short-term overdrafts) and manages public debt.

• Banker to banks: RBI holds banks' accounts and reserves, settles interbank payments and lends to banks.
• Lender of last resort: RBI stands ready to lend to banks in a liquidity crisis when they cannot raise funds elsewhere. This prevents panic and bank runs (Class 12, Money and Banking).
• Custodian of forex reserves.
• Bank supervision: RBI checks banks' cash balances and makes sure they lend to small cultivators, small industries and small borrowers. Banks report how much they lend, to whom and at what rate (Class 10, Money and Credit).
• Payment-system regulator (UPI, RTGS, NEFT) and a developmental role (e.g. financial inclusion).
• Symbol: the statues of a yaksha and yakshi at RBI's Delhi office. In mythology they guard Kubera's treasure, just as RBI guards the currency and is banker to banks.

RBI's balance sheet and surplus

• Income comes from interest on forex assets and G-secs, liquidity operations and seigniorage (profit from issuing currency).
• The Economic Capital Framework (ECF) is RBI's method for deciding how much risk capital, including a contingent risk buffer (CRB), it keeps. This fixes the surplus it transfers to the government.
• Bimal Jalan Committee (2019):
• CRB of 5.5-6.5% of the balance sheet.

• Record transfer of ₹1.76 lakh crore.

• 2025 review:

• CRB band widened to 4.5-7.5%.
• ₹2.69 lakh crore transferred for 2024-25.
• Latest transfer: verify current.

Central Bank Digital Currency (e₹)

• A Central Bank Digital Currency is legal tender in digital form. It is a direct liability of RBI and exchanges one-to-one with cash. It extends the note-issue monopoly into digital form.
• The Finance Act 2022 amended the RBI Act so that "bank note" includes digital form. RBI released its Concept Note in Oct 2022.
• Wholesale CBDC (e₹-W) is limited to banks and financial institutions for interbank settlement.

• Pilot started 1 Nov 2022, for settling secondary-market G-sec trades.

• Retail CBDC (e₹-R) is for individuals and businesses in everyday payments, through bank wallets.

• Pilot started 1 Dec 2022.
• It is token-based and supports person-to-person and person-to-merchant payments.

• It works with UPI QR codes, and later added offline and programmable features.

• Motives: lower cost of cash, programmability, faster cross-border payments, a sovereign alternative to private crypto.

• Risks:
• Bank disintermediation: deposits may shift out of banks. This is why e₹ pays no interest.
• Privacy concerns.

6. Monetary policy and its quantitative instruments

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Meaning and objective

• Monetary policy is the central bank's control of money supply and credit through quantitative and qualitative tools.
• The objective is set in the RBI Act preamble (amended 2016): price stability "while keeping in mind the objective of growth".
• Expansionary monetary policy means cutting rates or adding liquidity. This makes credit cheaper and boosts demand.
• 2019-20 easing: repo cut to 4% by May 2020.

• 2025 easing cycle: repo cut from 6.5% to 5.25% by Dec 2025.

• Contractionary monetary policy means raising rates or absorbing liquidity to curb inflation.

• May 2022-Feb 2023: +250 bps, taking repo from 4% to 6.5%.

• Quantitative tools are general tools. They act on the overall volume and cost of credit.

The tools

• Net Demand and Time Liabilities (NDTL): a bank's demand and time liabilities (mainly deposits) minus interbank assets. CRR and SLR are calculated on NDTL.
• Cash Reserve Ratio (CRR) (RBI Act s.42):
• The share of NDTL a bank must keep as balances with RBI. It earns no interest.
• A higher CRR means a lower multiplier and less credit.

• It is 3% after the 2025 cuts (verify current).

• Statutory Liquidity Ratio (SLR) (BR Act s.24):

• The share of NDTL a bank keeps itself in cash, gold or unencumbered government securities.
• It is 18% (verify current). Its peak was 38.5% in 1990.

• It is also a captive channel of government borrowing, because banks must hold G-secs.

• Bank rate: the rate at which RBI lends to or rediscounts bills of banks without repo collateral.

• It is now aligned with the MSF rate and used for penal charges.

• (NCERT outdated: Class 12 presents it as an active lending-rate lever.)

• Open market operations (OMO): RBI buys or sells government bonds.

• Buying adds reserves (injection). Selling absorbs them.

• Outright open market operations are permanent purchases or sales with no promise to reverse them.

• Repo rate: RBI lends by buying securities with an agreement to sell them back at a set date and price. This is a reversible injection, done overnight, for 7 days or for 14 days.

• Repo has been the single policy rate since 2011.

• Reverse repo rate: RBI absorbs money by selling securities with an agreement to buy them back.

• (NCERT outdated: the SDF replaced the fixed-rate reverse repo as the floor in April 2022. See section 8.)

Revision table

Tool	Move	Liquidity	Money supply
CRR	Cut	Rises	Rises (multiplier up)
SLR	Cut	More lendable funds	Rises
Repo	Cut	Cheaper borrowing	Rises
Bank rate/MSF	Raise	Costlier emergency funds	Falls
OMO	Purchase	Injects	Rises
OMO	Sale	Absorbs	Falls
Reverse repo/SDF	Raise	Absorbs more	Falls

7. Selective credit control, directed credit and macroprudential policy

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Qualitative tools

• Qualitative tools of monetary policy steer the direction and purpose of credit, not its total volume.
• Margin requirement: the share of a security's value that cannot be lent against.
• If the margin is 40%, a bank lends only ₹60 against ₹100 of shares.

• Higher margins curb speculative lending against shares or commodities.

• Credit ceilings: limits on lending to certain sectors.

• Selective credit controls: controls on lending against sensitive commodities (foodgrains, sugar, oilseeds).
• Used from 1956 under BR Act s.21.

• Largely dismantled after the 1990s.

• Moral suasion: persuading banks through letters and meetings. Examples: pressing for faster rate pass-through, or urging caution on unsecured loans.

• Direct action: penalties or business restrictions on banks that do not comply.

Directed credit: priority sector lending

• Class 10 notes that RBI "sees that banks give loans … to small cultivators, small scale industries, to small borrowers". This is the root of priority sector lending (PSL).
• PSL requires banks to lend a set share of credit to agriculture, MSMEs, weaker sections, education and housing.
• Began in 1974.
• Target reached 40% of adjusted net bank credit (ANBC) for domestic commercial banks by 1985.
• Sub-targets: agriculture 18% (including a small and marginal farmer sub-target), micro enterprises 7.5%, weaker sections.

• RRBs and small finance banks have higher targets (verify current).

• PSL certificates and co-lending → banking-regulation-npas.

Macroprudential policy

• Macroprudential policy uses regulatory tools to limit risk to the whole financial system, not just one bank.
• Tools:
• Countercyclical capital buffer: framework from 2015 (not yet activated). Banks build extra capital in good times.
• Sectoral risk weights: Nov 2023, +25 percentage points on unsecured consumer credit and on bank loans to NBFCs. Partly rolled back in Feb 2025.
• Loan-to-value caps on housing and gold loans.

• Provisioning norms.

• Financial stability means banks, markets and payment systems work smoothly and can absorb shocks without disrupting credit and payments.

• RBI publishes a Financial Stability Report every six months (June, December).

• The FSDC (2010) coordinates regulators and is chaired by the Finance Minister.

• Tinbergen logic: one instrument per goal.

• The policy rate targets price stability.
• Macroprudential tools target financial stability.

8. The operating framework: LAF, the corridor and WACR

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Liquidity Adjustment Facility (LAF)

• Started in June 2000, following the Narasimham Committee II.
• The Liquidity Adjustment Facility is RBI's system of repo, reverse repo and standing facilities, at fixed and variable rates, for managing day-to-day liquidity in the banking system.

• Repo injects liquidity. Reverse repo/SDF absorbs it.

• Variable Rate Repo (VRR): an auction where banks bid for RBI funds at or above the repo rate.

• Variable Rate Reverse Repo (VRRR): an auction where banks bid to park surplus funds with RBI.
• Tenors range from overnight to 14 days.
• The Feb 2020 framework made the 14-day VRR/VRRR the main operation.
• A later review changed the main operation (verify current).

Standing facilities

• Marginal Standing Facility (MSF) (May 2011):
• An overnight emergency window at a penal rate of repo + 25 bps.

• Banks can dip into their SLR holdings up to 2% of NDTL.

• Standing Deposit Facility (SDF) (April 2022):

• A collateral-free window where banks park surplus funds with RBI at repo − 25 bps.
• Enabled by s.17(2A), inserted into the RBI Act by the Finance Act 2018.
• Because it needs no collateral, RBI is not limited by its own bond holdings when absorbing large surpluses.
• It replaced the fixed-rate reverse repo (3.35%, now used only at RBI's discretion) as the floor.

The corridor

• The policy rate corridor is the band within which overnight rates move:

Floor	Policy rate	Ceiling
SDF 5.00%	Repo 5.25%	MSF = Bank rate 5.50%

• The corridor is 50 bps wide. Rates shown are after Dec 2025 (verify current).
• Weighted Average Call Rate (WACR): the volume-weighted average rate in the overnight interbank call money market. It is RBI's operating target, kept close to repo.

Banking system liquidity

• Banking system liquidity is measured by the net LAF position.
• A surplus pulls WACR toward the SDF rate.

• A deficit pushes it toward the MSF rate.

• What changes liquidity on its own (autonomous drivers):

• Currency demand: festivals and elections pull cash out of banks.
• Government cash balances: tax dates drain liquidity, spending adds it.

• RBI forex intervention: selling dollars drains rupees, buying dollars adds them.

• Money-market instruments (call money, TREPS, T-bills, CP, CDs) → financial-markets-instruments.

9. Durable liquidity, sterilisation and currency shocks

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Durable tools beyond daily LAF

• OMO purchases and sales.
• CRR changes:
• Dec 2024: cut from 4.5% to 4%.

• 2025: cut to 3% in tranches (verify current).

• Long-Term Repo Operations (LTRO) (Feb 2020): 1-3 year funds for banks at the repo rate.

• Targeted LTROs (2020), including on-tap TLTRO, require the money to be used in specified or stressed sectors.

• Forex swap auction: RBI buys dollars from banks and agrees to sell them back later. This injects rupees for the swap period.

• March 2019: $5 bn for 3 years.
• 2025 series (e.g. $10 bn for 3 years in Feb 2025; verify amounts).

Sterilisation

• Sterilisation means protecting domestic money supply from external shocks such as forex inflows.
• Example: RBI buys dollars (adding rupees), then sells bonds (absorbing those rupees).
• Class 12, Money and Banking: RBI "sterilises the money supply … against external shocks".
• Market Stabilisation Scheme (MSS) (2004 MoU):
• GoI issues T-bills and dated securities to absorb surplus liquidity.
• The proceeds are parked in a separate account and not spent.

• The budget bears the interest cost.

• Incremental Cash Reserve Ratio (ICRR): a temporary extra CRR on the increase in deposits over a period. It absorbs sudden surplus liquidity.

• Impossible trinity → balance-of-payments-exchange-rate.

Case: demonetisation 2016

• Demonetisation is withdrawing legal tender status from currency notes.
• November 2016:
• ₹15.41 lakh crore of old ₹500 and ₹1,000 notes (about 86% of currency) lost legal tender status.

• About 99.3% came back as bank deposits.

• Why it was a liquidity shock:

• Deposits surged and banks were flooded with funds.
• RBI absorbed the surplus through reverse repo.
• It imposed a 100% ICRR on NDTL added between 16 Sept and 11 Nov 2016. The ICRR was imposed on 26 Nov and withdrawn on 10 Dec 2016.

• The MSS ceiling was raised to ₹6 lakh crore.

• Remonetisation continued through 2017.

• Class 12 Box 3.2 claims these benefits: savings moved into the formal system, banks got more resources, lending rates fell and tax compliance improved.
• Critics point to the cash crunch and losses in the informal sector (Economic Survey 2016-17).
• ₹2,000 withdrawal (May 2023): a 10% ICRR on NDTL added between 19 May and 28 July 2023, unwound by Oct 2023.
• Legal-tender history → money-evolution-functions. Digital push → payment-systems-digital-finance.

10. MPC and flexible inflation targeting

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Evolution of the framework

• Credit planning (1950s-80s).
• Monetary targeting with feedback: Chakravarty Committee 1985, targeting M3 growth.
• Multiple-indicator approach (1998).
• Inflation targeting: the central bank publicly commits to a numerical inflation target and uses the policy rate as its main instrument. New Zealand was first (1990).
• Steps in India:
• Urjit Patel Committee (Jan 2014).
• Monetary Policy Framework Agreement (Feb 2015).
• Finance Act 2016 inserted Chapter IIIF (ss.45Z-45ZO) into the RBI Act.

The target

• GoI sets the target every five years, in consultation with RBI.
• It is CPI-Combined 4%, within a 2-6% band.
• Aug 2016-Mar 2021, renewed for Apr 2021-Mar 2026.
• Target for 2026-31: verify current.

• RBI's Aug 2025 discussion paper reviewed headline vs core inflation, the 4% level and the band.

• Failure: average inflation outside the band for three consecutive quarters.

• RBI must then report to GoI the reasons, the remedial actions and the time needed to return to target.

• First invoked in Nov 2022.

• Flexible inflation targeting means RBI also weighs growth and output volatility, bringing inflation back to target along a glide path.

Monetary Policy Committee (MPC)

• The Monetary Policy Committee (s.45ZB) was constituted in Sept 2016.
• Members (six):
• Governor (chair, with a casting vote)
• Deputy Governor in charge of monetary policy
• One RBI officer nominated by the Central Board

• Three external experts appointed by GoI on a search-cum-selection committee's advice, for 4 years, not eligible for reappointment

• Quorum is four.

• It must meet at least four times a year. In practice it meets six times (bimonthly).
• Communication:
• A resolution after each meeting.
• Minutes on the 14th day, with each member's vote and statement.

• A Monetary Policy Report every six months.

• The MPC sets the repo rate and the stance. CRR and SLR stay with RBI.

• Monetary policy stance signals the direction of policy:
• Accommodative: ready to ease.
• Neutral: can move either way.
• Withdrawal of accommodation: tightening (2022 to Oct 2024).
• "Hawkish" means a tightening bias. "Dovish" means an easing bias.

Autonomy and fiscal pressure

• Central bank independence is freedom from political interference in monetary policy. It builds credibility.
• India has instrument independence (RBI chooses how to hit the target), not goal independence (GoI sets the target).

• RBI Act s.7 lets the government issue directions. Consultations under it in the 2018 RBI-government standoff were widely reported.

• Fiscal dominance is when large deficits push the central bank to keep rates low or finance the deficit.

• Before 1997: ad hoc T-bills meant automatic monetisation. The 1994 and 1997 agreements ended this and brought in ways and means advances.
• FRBM: from 2006 RBI is barred from buying primary G-sec issues, except under an escape clause.
• Large deficits still press for low rates.

Decision benchmarks

• Taylor rule: a rule of thumb for the policy rate.

• i = r + π + 0.5(π − π) + 0.5 × output gap

• Neutral rate of interest: the real rate at which output stays at potential with stable inflation. It neither stimulates nor restrains the economy. RBI estimates it at about 1.4-1.9% (verify current).

11. Transmission: from the repo rate to the real economy

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Benchmark rate

• A benchmark interest rate is the reference rate to which other rates are linked. In India this is RBI's policy repo rate.
• Class 7 calls it "the base interest rate that the RBI fixes for lending money to commercial banks".
• Trap: this is not the 2010-16 "Base Rate" lending regime of banks.

Stages of transmission

• Monetary policy transmission is how a policy rate change passes through to the economy:
• Repo moves WACR, TREPS and market repo.
• These move T-bill, CP/CD and G-sec yields.
• These move deposit and lending rates: WADTDR (weighted average domestic term deposit rate) and WALR (weighted average lending rate).
• These change consumption (EMIs), investment, asset prices, and the exchange rate through capital flows.

• Finally, output and inflation change.

• Lags: roughly 2-3 quarters to output and 3-4 quarters to inflation (verify RBI estimates).

• Channels: interest rate, credit, asset price/wealth, exchange rate, expectations.

Why transmission is slow and partial in India

• Fixed-rate term deposits dominate bank liabilities, so banks' cost of funds adjusts slowly.
• Administered small-savings rates compete for deposits, so banks cannot cut deposit rates freely.
• CRR/SLR pre-emptions lock up part of bank funds.
• Stressed bank balance sheets (NPAs) make banks cautious.
• Heavy government borrowing keeps yields high.
• Informal lenders are beyond RBI's reach. Class 10 notes "there is no organisation which supervises" them.

Fixes

• BPLR → Base Rate (2010) → MCLR (2016) → external-benchmark lending rate (Oct 2019). Details → banking-regulation-npas.

Forward guidance

• Forward guidance means telling markets about the likely future path of policy to shape expectations and longer-term rates.
• Time-based guidance: RBI in Oct 2020 said it would stay accommodative "at least during the current financial year and into the next". The Fed used "extended period".
• State-based guidance: tied to conditions being met.
• Draghi's "whatever it takes" (2012) worked mainly through expectations.
• MPC statements and minutes are also communication tools.

12. Unconventional monetary policy: the global toolkit and India's use of it

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Why it is needed

• Policy rates at the zero lower bound or in a liquidity trap (section 4) cannot be cut further.
• Frozen markets (2008, 2020) block normal transmission.
• Unconventional monetary policy means tools beyond changing the short-term policy rate.

The global toolkit

• Quantitative easing (QE): large-scale purchases of bonds and other assets to inject money and lower long-term rates.

• BoJ 2001-06; Fed QE1-3 (2008-14) and 2020; ECB 2015; Bank of England.

• Quantitative tightening (QT): shrinking the central bank's balance sheet by selling assets or letting them mature without reinvesting.

• Fed 2017-19 and 2022-25 (verify end).

• Negative interest rate policy: policy rates below zero, so banks pay to hold reserves and are nudged to lend.

• ECB 2014, BoJ 2016-24, Switzerland, Sweden, Denmark.

• Yield curve control: targeting a specific long-term bond yield and buying as many bonds as needed to hold it.

• BoJ 2016-24 on the 10-year JGB; Reserve Bank of Australia 2020-21.

• Operation Twist: buying long-term and selling short-term securities at the same time. This lowers long yields without changing overall liquidity.

• Fed 1961 and 2011-12.

• Helicopter money (Friedman 1969): new central bank money given directly to the public, or permanently financing government spending.

• Unlike QE, it is not reversed.

• Targeted lending schemes: cheap central bank funds tied to lending to specified sectors.

India's use

• Special OMOs (Dec 2019-2020): Operation Twist-style simultaneous buying and selling of G-secs.
• G-SAP 1.0 and 2.0 (2021): ₹2.2 lakh crore of pre-committed G-sec purchases, often called India's "QE-lite".
• TLTROs (2020).
• 2020 debate on deficit monetisation.

Taper tantrum and spillovers

• Taper tantrum: a sharp rise in bond yields and capital outflows from emerging markets in 2013.
• Trigger: in May 2013 Fed Chair Bernanke hinted the Fed would slow (taper) its QE purchases.
• The rupee fell to about 68.8/$ (Aug 2013).

• India was named among the "Fragile Five".

• RBI's response:

• MSF raised to 10.25% (July 2013) to tighten rupee liquidity.

• FCNR(B) swap window (Sept 2013) to draw in dollar deposits.

• Lesson: Fed policy spills over to India. Adequate forex reserve buffers and sterilisation capacity matter.

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Exam angles

Prelims — high-yield facts and traps

• CRR vs SLR:
• CRR is kept with RBI and earns nothing.
• SLR assets (cash, gold, approved securities) are held by the bank itself.
• Both are percentages of NDTL.
• CRR is set by RBI, not the MPC.

• "CRR is kept as cash in the bank's vault": FALSE.

• Rate matching:

• Repo: injection; the policy rate set by the MPC.
• SDF: absorption; the floor; no collateral.
• MSF: penal ceiling; SLR dip up to 2% of NDTL.
• Bank rate = MSF (used for penal charges).
• Fixed-rate reverse repo 3.35% is now discretionary.

• Corridor = repo ± 25 bps.

• Expansionary policy means cutting CRR, SLR, repo and bank rate, and OMO purchases. "Raising MSF is expansionary": FALSE.

• Money multiplier:
• Simple form: 1/CRR (20% gives 5; 25% gives 4).
• Full form: m = (1 + cdr)/(cdr + rdr).

• A lower cdr or rdr raises m.

• M0 = currency in circulation + bankers' deposits with RBI + other deposits with RBI.

• M1-M4: M3 = M1 + net time deposits. M1 and M2 are narrow money; M3 and M4 are broad money.
• Demand deposits are money but not legal tender. Coins and ₹1 notes are issued by GoI, not RBI.
• MPC facts:
• Six members; three external members appointed by GoI.
• Governor has a casting vote; quorum is four.
• External members serve 4 years and cannot be reappointed.
• Minutes come out on the 14th day.
• GoI (not RBI) sets the target: CPI-Combined 4% ± 2%.

• Failure = three consecutive quarters outside the band.

• Chronology:

• RBI 1935; nationalised 1949; PSL 1974; Chakravarty Committee 1985.
• LAF 2000; MSS 2004; MSF and repo as single policy rate 2011.
• Taper tantrum 2013; Urjit Patel Committee 2014; MPC 2016.
• EBLR 2019; SDF 2022; e₹ pilots Nov/Dec 2022.

• ICRR 2016 and 2023.

• Classification:

• Qualitative tools: margin requirement, moral suasion, credit ceilings, direct action.
• Quantitative tools: CRR, SLR, OMO, bank rate, repo.

• PSL is 40% of ANBC.

• DFI founding years: IFCI 1948, NABARD 1982, EXIM 1982, NHB 1988, SIDBI 1990, NaBFID 2021.

• Match pairs: Jalan Committee = ECF. Retail vs wholesale CBDC. QE (buys assets, adds liquidity) vs Operation Twist (liquidity-neutral) vs YCC (targets a yield) vs helicopter money (permanent, not reversed).
• Bond price and interest rate move inversely. A liquidity trap means infinitely elastic money demand at rₘᵢₙ.
• Trap: "RBI became central bank only in 1949": FALSE. 1949 was nationalisation.

Mains — GS-III themes

1. "Is a commercial bank a creator of money?" Cover credit creation, its limits (CRR, cash habit, loan demand) and the role of high-powered money.
2. Why monetary transmission is weak in India. Cover deposit-rate rigidity, small-savings rates, the external benchmark, liquidity-framework reforms and informal credit.
3. Ten years of flexible inflation targeting. Cover the record, headline vs core CPI, the 4% target and band, food and supply shocks, the 2022 failure and the 2026 target review.
4. RBI autonomy vs government. Cover surplus transfers and the ECF, s.7, fiscal dominance, and the MPC as a depoliticising device (GS-II/III).
5. Price stability vs growth vs financial stability. Cover macroprudential tools (risk weights, CCyB) and PSL as directed credit.
6. Monetary consequences of demonetisation (liquidity surge, ICRR, MSS); CBDC's promise and risks; Fed tightening, the taper tantrum and the costs of sterilisation for India.
7. Credit and development. Contrast cheap formal credit with the informal debt trap (Salim vs Swapna, Sonpur rates).

Current-affairs hooks

• Bimonthly MPC meetings: repo, stance, CRR moves, GDP and CPI projections, developmental and regulatory policy statements; the half-yearly Monetary Policy Report.
• Notification of the inflation target for 2026-31; RBI's framework-review discussion paper; CPI base revision (→ inflation-price-indices).
• RBI Annual Report and surplus transfer (May) under the ECF; Financial Stability Report (June, December); liquidity-framework reviews, OMO and forex-swap announcements.
• Economic Survey chapter on monetary management; Union Budget borrowing programme; US Fed FOMC decisions and QT; e₹ expansion; PSL and risk-weight revisions.