Monetary policy and its quantitative instruments

Detail

1. What monetary policy means

• Monetary policy is how the central bank controls the money supply (the total money in the economy) and credit (loans).
• In India the central bank is the Reserve Bank of India (RBI), set up in 1935.

• It uses two kinds of tools: quantitative and qualitative.

• Quantitative tools are general tools. They change the total amount and the cost of credit in the whole economy. They do not target any one sector.

• Examples: CRR, SLR, repo rate, reverse repo/SDF, bank rate/MSF, OMO.

• Qualitative tools are selective tools. They guide credit towards some sectors or away from others, e.g. margin requirements and moral suasion. They are covered in another section.

2. The legal objective

• The objective is written in the preamble of the RBI Act, which was amended in 2016: keep price stability "while keeping in mind the objective of growth".

• RBI's own wording: "the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth" [5].

• Inflation target (RBI Act s.45ZA): the Central Government, after talking with the RBI, fixes a target for CPI inflation once every 5 years [5].

• Target: 4%. Upper limit 6%, lower limit 2%, i.e. a band of ±2% [5].
• First period: 5 August 2016 to 31 March 2021 [5].
• First renewal (31 March 2021): same target kept for 1 April 2021 to 31 March 2026 [5].

• Second renewal (25 March 2026): same target kept for 1 April 2026 to 31 March 2031 [5].

• When the target counts as missed: 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 members from the RBI: 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 with a 4-year term [5].

• Operating target: the RBI tries to keep the weighted average call rate (WACR) close to the repo rate [5].

• WACR is the average interest rate at which banks lend to each other overnight.
• The RBI keeps it close to the repo rate by adding or taking out liquidity [5].

3. Expansionary vs contractionary policy

• Basis point (bp): 1 bp = 0.01 percentage point. So 100 bps = 1 percentage point.
• Expansionary monetary policy means the RBI cuts rates or adds liquidity (ready cash in the banking system).
• Repo rate cut → banks borrow more cheaply → loan rates fall → people and firms borrow and spend more → demand rises.
• 2019-20 easing: the repo rate was cut to 4% by May 2020 (COVID shock).
• 2025 easing cycle: the repo rate was cut from 6.5% to 5.25% by December 2025. That is a total cut of 125 bps.

• Latest (August 2026): the MPC voted unanimously to keep the repo rate at 5.25%, with a neutral stance [2]. It had also kept the rate unchanged at its 60th meeting (6-8 April 2026) and 61st meeting (3-5 June 2026) [3].

• Contractionary monetary policy means the RBI raises rates or takes liquidity out to control inflation.

• Repo rate up → loans cost more → people borrow and spend less → demand and prices cool.
• May 2022 to February 2023: the repo rate was raised by 250 bps, from 4% to 6.5%.

4. Net Demand and Time Liabilities (NDTL): the base for CRR and SLR

• Demand liabilities: money a bank must pay whenever the customer asks, e.g. savings and current account deposits.
• Time liabilities: money a bank must pay only after a fixed period, e.g. fixed deposits.
• NDTL = (Demand liabilities + Time liabilities) − assets held with other banks (interbank assets).
• Worked example (₹ crore):
• Demand liabilities 600 + time liabilities 400 = 1,000.
• Minus interbank assets of 50 → NDTL = 950.

5. Cash Reserve Ratio (CRR): RBI Act s.42

• Definition: the share of NDTL that a bank must keep as a cash balance with the RBI.
• It earns no interest.

• It is kept as an average daily balance [5].

• Effect on credit: a higher CRR means less money to lend, a smaller money multiplier and less credit.

• Simple money multiplier (ignoring SLR and cash held by the public) = 1 / CRR.
• CRR 4% → multiplier = 1/0.04 = 25.
• CRR 3% → multiplier = 1/0.03 ≈ 33.3.

• So a cut from 4% to 3% lets ₹100 of fresh reserves support about ₹3,333 of deposits instead of ₹2,500.

• The 2025 cut: announced in June 2025. The CRR was cut by 100 bps in four steps of 25 bps, from 4% down to 3% of NDTL [4].

• 3.75% from the fortnight starting 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].

• (NCERT scaffold: "3% after the 2025 cuts". This matches.)

• Example: a bank's NDTL is ₹950 crore and the CRR is 3%. It must keep ₹28.5 crore with the RBI, and this money earns no interest.

6. Statutory Liquidity Ratio (SLR): Banking Regulation Act s.24

• Definition: the share of NDTL that a bank must keep itself as liquid assets, i.e. things that can be turned into cash quickly [5]:
• cash,
• gold,

• unencumbered government securities (G-secs), meaning bonds that are not already pledged as security for a loan.

• Current level: 18% (verify current). Peak: 38.5% in 1990.

• Link to government borrowing: banks must hold G-secs, so the SLR gives the government a captive channel of borrowing (a fixed group of buyers who must buy its bonds).
• Example: NDTL ₹950 crore × 18% = ₹171 crore kept in SLR assets.
• With CRR (₹28.5 crore) also set aside, about ₹950 − 171 − 28.5 = ₹750.5 crore is left for lending.

7. Bank rate

• Definition: the rate at which the RBI lends to banks, or rediscounts their bills (buys their bills of exchange before they are due), without repo collateral.
• Today: it is aligned with the MSF rate and is used mainly for penal charges (fines when banks fall short on reserves).

• Bank rate = MSF = 5.50% (August 2026) [2].

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

8. Repo rate: the policy rate

• Repo (repurchase agreement): the RBI lends money to a bank by buying its securities, and the bank promises to buy them back at a fixed date and price.
• It is a reversible injection of liquidity.

• Tenors: overnight, 7-day or 14-day.

• Repo rate = the interest rate on this loan. It has been the single policy rate since 2011.

• It is 5.25% (August 2026) [2].

• Worked example: a bank borrows ₹1,000 crore overnight at 5.25%.

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

• The repo rate sits inside the Liquidity Adjustment Facility (LAF), the RBI's daily system for adding and taking out liquidity [2].

9. Reverse repo, SDF and the LAF corridor

• Reverse repo: the RBI takes money out of the system. It sells securities to banks and promises to buy them back later.
• Standing Deposit Facility (SDF): since April 2022 it has replaced the fixed-rate reverse repo as the floor of the corridor. (NCERT outdated: the book still shows the reverse repo as the floor.)
• The corridor: the band that keeps short-term market rates close to the repo rate.
• Floor = SDF = repo − 25 bps [5].
• Ceiling = MSF = repo + 25 bps [5].

• The Marginal Standing Facility (MSF) is emergency overnight borrowing for banks at a penal (higher) rate.

• August 2026 corridor [2]:

Rate	Level
SDF (floor)	5.00%
Repo (policy rate)	5.25%
MSF / Bank rate (ceiling)	5.50%

• Width of the corridor = 5.50 − 5.00 = 50 bps.

10. Open market operations (OMO)

• Definition: the RBI buys or sells government bonds in the open market.
• OMO purchase → the RBI pays banks cash → bank reserves rise → injection of liquidity.

• OMO sale → banks pay the RBI cash → bank reserves fall → absorption of liquidity.

• Outright OMO: a permanent purchase or sale, with no promise to reverse it. The RBI describes it as "outright purchase/sale of government securities… for injection/absorption of durable liquidity" [5].

• Durable liquidity means long-lasting liquidity.

• OMO vs repo:

• OMO changes liquidity permanently.
• Repo changes it temporarily, because it reverses when the term ends.

11. 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

Prelims Hooks

• CRR comes from RBI Act s.42 and is kept with the RBI, earning no interest. SLR comes from Banking Regulation Act s.24 and is kept by the bank itself. A common trap is to swap the Acts.
• Both CRR and SLR are calculated on NDTL, not on total deposits.
• CRR was cut to 3% of NDTL in four 25-bp steps. It took effect from the fortnight starting 29 November 2025 [4].
• Corridor as of August 2026: SDF 5.00% < Repo 5.25% < MSF = Bank rate 5.50% [2].
• SDF replaced the fixed-rate reverse repo as the floor of the LAF corridor in April 2022.
• Inflation target: CPI 4% ± 2%. It 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 (weighted average call rate), not the repo rate itself [5].
• Outright OMO = a permanent change in durable liquidity. Repo = a temporary injection for overnight, 7 or 14 days.
• Simple money multiplier = 1/CRR. Cutting CRR from 4% to 3% raises it from 25 to about 33.3.

Mains Points

• Inflation targeting vs growth: the RBI Act asks for price stability "keeping in mind" growth. After raising rates by 250 bps in 2022-23, the RBI cut them by 125 bps in 2025 and then held at 5.25% with a neutral stance in 2026 [2][3]. This shows the trade-off: cutting too early can bring inflation back, and holding rates too long can slow growth.
• Slow transmission: a repo cut only works if banks pass it on to borrowers.
• Banks have already promised fixed rates to their deposit holders, so they are slow to cut loan rates.

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

• The SLR and captive government borrowing:

• The SLR guarantees buyers for G-secs and keeps government borrowing cheaper. But it also locks up bank money, so less is lent to private firms (a form of financial repression).

• Cutting the SLR from 38.5% (1990) to 18% was a key part of banking reform.

• Rule-based framework: the MPC and the s.45ZA target, with a legal definition of "failure", make the RBI accountable [5]. They also keep monetary policy separate from fiscal pressure, which links to GS-II (statutory bodies and their independence).