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Monetary Policy in India: Instruments

Published on Friday, April 28, 2017

Objectives of monetary policy:

⇒ To maintain price stability (OR control inflation) while keeping in mind the objective of Economic growth.
⇒ Price stability is a necessary precondition for a sustainable growth.
⇒ Rapid Economic Growth
⇒ Exchange Rate Stability

⇒ Balance of Payment Equilibrium
⇒ Neutrality of Money
⇒ Full Employment
⇒ Equal Income Distribution
  • In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework. 
  • INFLATION TARGET: The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years. 
  • Accordingly, the Central Government has notified in the Official Gazette 4 percent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. 
  • The Monetary Policy Committee (MPC) constituted by the Central Government under Section 45ZB of RBI ACT determines the policy interest rates required to achieve the inflation target. 

Latest RBI Monetary Policy Rates

(As per RBI’s First bi-monthly Monetary Policy Statement for 2017-18 announced on 6th April 2017)
Cash Reserve Ratio (CRR)
4.00% (CRR @ 4.00% has been unchanged since 9th February 2013)
Statutory Liquidity Ratio (SLR)
20.50% (was reduced from 20.75% w.e.f. 1st January 2017)
Bank Rate
6.50% (has been reduced by 25 basis points. Earlier it was 6.75%)
Repo Rate
6.25% (has been hunchanged since 4th October 2016)
Reverse Repo Rate
6.00% (hiked by 25 basis points. Earlier it was 5.75%)
Marginal Standing Facility (MSF) Rate
6.50% (has been reduced by 25 basis points. Earlier it was 6.75%

The next meeting of RBI’s Monetary Policy Committee (MPC) is scheduled on 5th and 6th June 2017
No limit
*(%age of Net Demand & Time Liabilities)


1. Cash Reserve Ratio

Section 42(1) of RBI Act 1934

  • Under Section 42(1) of RBI Act 1934, All Scheduled Commercial Banks/Cooperative Banks (Public Sector/Nationalised/Private Sector/ Foreign Banks/ RRBS and Coop. Banks) in India are required to deposit a certain proportion of their deposits in the form of cash with RBI. 
  • Banks don't hold these as cash with themselves. 
  • This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. 
  • At present, CRR is 4%.


  • When a bank's deposits increase by Rs.100, and if the CRR is 4%, the banks will have to deposit Rs.4 with RBI and the bank will be able to use only Rs 96 for investments and lending, credit purpose.
  • Therefore, higher the ratio, the lower is the amount that banks will be able to use for lending and investment.
  • This power of Reserve bank of India to reduce the lendable amount by increasing the CRR makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system.
  • This cash in the form of CRR deposited with RBI is considered as equivalent to holding of cash with themselves and do not carry any Rate of Interest.

Maintenance of CRR on Daily Basis

With a view to providing flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra fortnight cash flows, all SCBs are required to maintain minimum CRR balances up to 95 per cent of the average daily required reserves for a reporting fortnight on all days of the fortnight.


  • Interest is charged as under in cases of default in maintenance of CRR by SCBs:
  • In the case of default in maintenance of CRR requirement on a daily basis which is currently 95 percent of the total CRR requirement, penal interest will be recovered for that day at the rate of 3% p.a. above the Bank Rate on the amount by which the amount actually maintained falls short and if the shortfall continues on the next succeeding day/s, penal interest will be recovered at the rate of 5% p.a. above the Bank Rate.

2. Statutory Liquidity Ratio

Minimum 20.50%- Maximum: 40%

Section 24 of Banking Regulations Act 1949,

  • Under Section 24 of Banking Regulations Act 1949, Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of: cash, gold and approved securities.
  • RBI is empowered to increase this ratio up to 40%. An increase in CRR/ SLR restricts the bank's position to lend more.
  • These amounts are not to be deposited with RBI, but to be maintained with the Bank itself.

Maintained with RBI
With Bank itself
In cash form only
Can be in Cash/Gold/
Govt. securities
Controls liquidity
Controls credit growth

The purpose of CRR/SLR:

  • To control inflation by squeezing money supply.
  • To ensure the solvency of Banks.
  • To compel banks to invest in govt. securities.

Solvency of Bank (How ??)

  • In the case of any rumour in the society regarding bank’s failure, then all he deposits will go into a panic and the bank will not be in a position to repay the deposits at once.
  • To save banks from this situation of “Bank-run” also CRR and SRL are maintained.


  • Demand Liabilities: All Saving Deposits and Current Deposits/DDs
  • Time Liabilities: FD/RD/Staff Security.

Bank Rate Policy

  • Bank Rate refers to the official interest rate at which RBI will provide loans to the banking system which includes commercial/cooperative banks, development banks etc. 
  • Such loans are given out either by direct lending or by rediscounting (buying back) the bills of commercial banks and treasury bills. Thus, bank rate is also known as a discount rate.
  • Bank Rate is used by Central Bank of the Country to control and manage the supply of currency for the betterment of the national economy.

For Example: 

  • When unemployment goes up – the Central Bank reduces the Bank Rate so that the cheap funds are available to the Commercial Bank and the Commercial Banks are able to offer Loans to the unemployed Youth at Lower Rate of Interest.
  • While extending loans to the Banks at Bank Rate by RBI, no collateral security is required. 
  • Banks borrow money from RBI due to anticipated shortage of money.

Impact of Bank Rate
When RBI increases the bank rate:

  • The cost of borrowing for banks rises and this credit volume gets reduced leading to decline in the supply of money.
  • Thus, increase in Bank rate reflects a tightening of RBI monetary policy.

3. Repo Rate or Repurchase Rate

Repo rate, or repurchase rate, is the rate at which RBI lends funds to banks for short periods, generally against Govt. Securities. This is done by RBI buying government bonds from banks with an agreement to sell them back at a fixed rate.

Govt. Securities:

  • Treasury Notes (Long Term) issued by GOI ranging between 2 to 30 years.
  • Treasury Bills (Short Term): 91 days, 182 days, 364 days


  • The objective of Repo is to inject liquidity into the system. If RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
  • Reduction in Repo Rate helps the commercial Banks to get money a Cheaper Rates and vice versa.

Difference between Bank Rate and Repo Rate

  • Bank Rate and Repo Rate seem to be similar terms because in both of them RBI lends to the banks.
  • Repo Rate is a short-term measure and it refers to short-term loans and used for controlling the amount of money in the market.
  • Bank Rate is a long-term measure RBI uses this tool to control the money supply.
  • Bank Rate borrowing – No Collateral Security
  • Repo Rate borrowing – Against securities.
  • Bank Rate is Higher than Repo Rate.

4. Reverse Repo Rate

  • Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. This is done by RBI selling government bonds/securities to banks with the commitment to buy them back at a future date.
  • The banks use the reverse repo facility to deposit their short-term excess funds with the RBI and earn interest on it. RBI can reduce liquidity in the banking system by hiking reverse repo rate.
  • RBI uses this tool when it feels that there is too much money floating in the Banking System.
  • An increase in Reverse Repo Rate means – Banks will get a higher Rate of Interest from RBI. Banks will prefer to lend money to RBI which is always safe.

Repo Rate v/s Reverse Repo Rate

Repo Rate: Borrowing by Banks from RBI. Means RBI injects money/liquidity in the Banking System.
Reverse Repo Rate: Borrowing by RBI from Banks – Means absorption of liquidity from the Banking System.

Reverse Repo (Borrowing by RBI)

RBI Generally Is Never In A Situation To Borrow Funds From The Banking System. But This Tool Is Used Whenever Rbi Feels That There Is Enuogh Surplus Money Floating In The Banking System.
Or Whenever There Is Any Borrowing Requirement By The Central Govt. This Tool Is Used.

5. Marginal Standing Facility

Marginal Standing Facility is a new Liquidity Adjustment Facility (LAF) window created by Reserve Bank of India in its credit policy of May 2011.
MSF is the rate at which the banks are able to borrow overnight funds from RBI against the approved government securities.

The question is– when Banks are already able to borrow from RBI via Bank Rate or Repo Rate, then why MSF is needed?
The answer is that - this window has been created for commercial banks to borrow from RBI in certain emergency conditions:

  • When inter-bank liquidity dries up completely and there is a volatility in the overnight interest rates.
  • To curb this volatility, RBI allowed them to pledge G-secs and get more funds from RBI at a rate higher than the repo rate.
  • Thus, overall idea behind the MSF is to contain volatility in the overnight inter-bank rates.

The rate of Interest: The rate of interest on MSF is above 100 bps above the Repo Rate.
Max. Borrowing Limit: The banks can borrow up to 1 percent of their net demand and time liabilities (NDTL) from this facility.
Minimum Amount: Min. Rs. 1 crore and multiples thereof.

6. Open Market Operations

  • Open Market Operations refer to the purchase and sale of the Government securities (G-Secs) by RBI from/to market.
  • The objective of Open Market Operations is to adjust the rupee liquidity conditions in the economy.
  • When RBI sells government security in the markets, the banks purchase them. When the banks purchase Government securities, they have a reduced ability to lend to the industrial houses or other commercial sectors. This reduced surplus cash, contracts the rupee liquidity and consequently credit creation/credit supply.
  • When RBI purchases the securities, the commercial banks find them with more surplus cash and this would create more credit in the system.
  • Thus, in the case of excess liquidity, RBI resorts to sale of G-secs to suck out rupee from the system. Similarly, when there is a liquidity crunch in the economy, RBI buys securities from the market, thereby releasing liquidity.
  • It’s worth note here that the market for government securities is not well developed in India but still OMO plays very important role.

Qualitative Methods of Credit Control

  • Margin Requirement
  • Credit Rationing
  • Direct Action
  • Moral Persuasion

By Quality we mean the uses to which bank credit is directed.
For example-
The bank may feel that spectators or the big capitalists are getting a disproportionately large share in the total credit, causing various disturbances and inequality in the economy, while the small-scale industries, consumer goods industries and agriculture are starved of credit.

Marginal Requirement

The marginal requirement of loan: current value of security offered for loan-value of loans granted. The marginal requirement is increased for those business activities, the flow of whose credit is to be restricted in the economy.


  • A person mortgages his property worth Rs. 100,000 against the loan. The bank will give a loan of Rs. 80,000 only. The marginal requirement here is 20%.
  • In case the flow of credit has to be increased, the marginal requirement will be lowered. Reserve Bank of India has been using this method since 1956.

Rationing of Credit

Under this method, there is a maximum limit to loans and advances that can be made, which the commercial banks cannot exceed. RBI fixes a ceiling for specific categories. Such rationing is used for situations when credit flow is to be checked, particularly for speculative activities. Minimum of "capital: total assets" (ratio between capital and total asset) can also be prescribed by Reserve Bank of India

Direct Action

Under the Banking Regulation Act, the central bank has the authority to take strict action against any of the commercial banks that refuses to obey the directions given by Reserve Bank of India. There can be a restriction on advancing of loans imposed by Reserve Bank of India on such banks.


RBI had put up certain restrictions on the working of the Metropolitan co-operative banks. Also the 'Bank of Karad' had to come to an end in 1992.

Moral Persuasion

This method is also known as "moral persuasion" as the method that the Reserve Bank of India, being the apex bank uses here, is that of persuading the commercial banks to follow its directions/orders on the flow of credit. RBI puts a pressure on the commercial banks to put a ceiling on credit flow during inflation and be liberal in lending during deflation
The Central Government notified the following as factors that constitute the failure to achieve the inflation target:
  • (a) the average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters; or 
  • (b) the average inflation is less than the lower tolerance level for any three consecutive quarters.
Prior to the amendment in the RBI Act in May 2016, the flexible inflation targeting framework was governed by an Agreement on Monetary Policy Framework between the Government and the Reserve Bank of India of February 20, 2015.

Written By: J. K Gupta
(Retired Senior Manager from Punjab National Bank)
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