Monetary Policy

What is Monetary
Policy?

It is a macroeconomic policy tool used by

the Central Bank to influence the money
supply in the economy to achieve certain
macroeconomic goals.
It involves the use of monetary
instruments by the central bank to
regulate the availability of credit in the
market to achieve the ultimate objective of
economic policy.
Types of Monetary Policy

Expansionary Monetary Policy

Contractionary Monetary Policy

What is Expansionary Monetary Policy?

• It is also called Accommodative Monetary Policy.

• Its primary purpose is to increase the money supply in the economy through
measures such as:
• Decreasing interest rates – It makes it less expensive for consumers to borrow money,
thus increasing the money supply in the market.
• Lowering reserve requirements for banks – It leaves commercial banks with more
money to lend to the public, thus infusing more money into the economy.
• Purchasing government securities by central banks – The RBI buys government
securities by paying cash. This means that money available in the market increases.
• It is aimed at fueling economic growth by stimulating business activities and consumer
spending and also helps to lower unemployment rates.
• However, it may have an adverse effect of occasional hyperinflation.
What is Contractionary Monetary Policy?

It is used to decrease the amount of money supply in

the economy through measures such as:
Increasing the reserve Selling government bonds – The
Raising interest rates – It makes it
requirements for banks – It leaves buyers of government securities pay
more expensive for consumers to
commercial banks with less money cash to the RBI. This means that
borrow money, thus reducing the
to lend to the public, thus reducing money available in the market
money supply in the market.
the money supply in the economy. decreases.

It is aimed at reducing inflation.

 Monetary
Policy
Committee

1official
RBI Governor Deputy 3 Members by
nominated by
(Chairperson) Governor selection Com.
RBI Board

Cabinet
Secretary
COMPOSITION OF MPC

Secretary DEA

RBI Governor

3 Experts
 Bank Rate
Cash Reserve Ratio (CRR)
Reserve Requirements
Statutory Liquidity Ratio (SLR)

Repo Rate
Quantitative Tools Liquidity Adjustment Facility
Reverse Repo Rate
MSF
Monetary

OMO
Policy
Tools

MSS

Margin Requirements

Consumer Credit Regulation

Moral Suasion
Qualitative Tools
Rationing of Credit

Direct Action

Priority Sector Lending

Quantitative Tools (Bank Rate)

The Bank Rate is the interest rate at which a country’s central bank (like the Reserve Bank of India, RBI) lends
money to commercial banks for long-term purposes, without requiring any collateral. It is a key monetary
policy tool used to control the money supply and inflation in the economy.
Key Points:
1. No Collateral: Banks can borrow from the central bank without providing any security or collateral.
2. Long-term Borrowing: It is typically used for long-term loans, unlike the Repo Rate, which is for short-term
borrowing.
3. Monetary Policy Tool: The central bank can increase or decrease the Bank Rate to either tighten or loosen
the money supply:
1. Higher Bank Rate: Makes borrowing more expensive for banks, which leads to higher interest rates for
loans to customers, reducing money supply and controlling inflation.
2. Lower Bank Rate: Makes borrowing cheaper for banks, encouraging lending to customers and
increasing money supply, boosting economic activity.
Reserve Requirements

• Reserve requirements refer to the regulations set by a central bank (like

the RBI in India) that require commercial banks to hold a certain
percentage of their deposits as reserves. These reserves are not
available for lending or investment and are usually kept as cash in the
bank’s vault or deposited with the central bank.
• The purpose of reserve requirements is to ensure that banks have
enough liquidity to meet customer withdrawals and to control the
money supply in the economy.
Types of Reserve Requirements

1. Cash Reserve Ratio (CRR):

• Definition: The Cash Reserve Ratio is the minimum percentage of a commercial bank’s total deposits
that must be kept as reserves with the central bank (like the RBI) in the form of cash.
• Purpose: This amount cannot be lent out or used for investments. It is a tool to control the money
supply in the economy.
• Effect:
• If CRR is increased: Banks are required to hold more cash in reserve, leaving them with less
money to lend, which reduces the money supply in the economy.
• If CRR is decreased: Banks can hold less cash in reserve, allowing them to lend more, which
increases the money supply.
• Example:
• If CRR is 4%, and a bank has ₹1,00,000 in deposits, it must hold ₹4,000 as reserves with the RBI
and can lend out the remaining ₹96,000.
2. Statutory Liquidity Ratio (SLR):
• Definition: The Statutory Liquidity Ratio is the percentage of a bank’s Net Demand and Time
Liabilities (NDTL) that must be maintained as liquid assets like cash, gold, or government-approved
securities.
• Purpose: Unlike the CRR, SLR is held by the bank itself and not with the central bank. SLR helps
ensure the solvency of banks and control credit expansion.
• Effect:
• If SLR is increased: Banks have to keep a larger portion of their deposits in the form of liquid
assets, reducing their ability to lend.
• If SLR is decreased: Banks can use more of their funds for lending, which increases the money
supply.
• Example:
• If the SLR is 18%, and a bank has ₹1,00,000 in deposits, it must hold ₹18,000 in the form of cash,
gold, or government securities, and can lend out the remaining ₹82,000.
Liquidity Adjustment Facility (LAF)

• Liquidity Adjustment Facility (LAF) is a monetary policy tool used by

the central bank (like the RBI) to manage liquidity and control short-term
interest rates in the economy. Through LAF, the central bank allows
commercial banks to borrow money from or lend money to the central
bank on a short-term basis, usually overnight. It primarily helps in
managing temporary mismatches in the liquidity of banks.
Types of Liquidity Adjustment Facility

1. Repo Rate (Repurchase Agreement Rate):

• Definition: The Repo Rate is the rate at which the RBI lends short-term money to commercial banks
against the collateral of government securities, with an agreement to repurchase those securities at a
future date.
• Purpose: It is used to inject liquidity into the banking system. When banks face a short-term shortage
of funds, they borrow from the RBI at the Repo Rate.
• Effect:
• If Repo Rate is increased: Borrowing from the RBI becomes more expensive for banks, reducing
their ability to lend and decreasing liquidity in the economy.
• If Repo Rate is decreased: Borrowing from the RBI becomes cheaper, encouraging banks to
borrow more and lend more, increasing liquidity in the economy.
• Example:
• Suppose ABC Bank needs ₹1 crore for short-term needs. The RBI offers to lend this amount at a
Repo Rate of 4%. ABC Bank provides government securities as collateral and agrees to buy
them back from the RBI after a certain period (usually overnight) with an interest rate of 4%.
Aspect Repo Rate LTRO (Long-Term Repo Operations)
Full Form Repurchase Agreement Long-Term Repo Operations
Banks borrow short-term funds Banks borrow long-term funds (1 to 3
Meaning from RBI by giving govt. securities as years) from RBI using govt. securities as
collateral. collateral.
Tenure 1 to 14 days (short-term) 1 year and 3 years (long-term)
Manage short-term liquidity needs Infuse durable long-term liquidity into
Objective
of banks. the banking system.
Rate
At the current Repo Rate Also at the current Repo Rate
Applied
Collateral Govt. Securities Govt. Securities
Reduces long-term borrowing costs,
Impact Controls daily liquidity fluctuations. encourages lending to businesses &
growth.
Interest Banks pay interest to RBI (same repo
Banks pay interest to RBI.
Paid By rate).
Key Long duration, structural liquidity tool
Short duration, routine liquidity tool.
Difference introduced in 2020.
2. Reverse Repo Rate:
• Definition: The Reverse Repo Rate is the rate at which the RBI borrows money from commercial
banks by offering them government securities. In other words, it is the rate at which banks park their
excess funds with the RBI.
• Purpose: It is used by the RBI to absorb liquidity from the banking system. When banks have excess
funds, they can deposit these funds with the RBI at the Reverse Repo Rate and earn interest.
• Effect:
• If Reverse Repo Rate is increased: Banks are more likely to park their excess funds with the RBI,
reducing the amount of money available for lending in the economy.
• If Reverse Repo Rate is decreased: Banks are less likely to deposit excess funds with the RBI,
and instead lend more to customers, increasing liquidity in the economy.
• Example:
• If XYZ Bank has excess cash reserves, it can deposit ₹50 crore with the RBI at a Reverse Repo
Rate of 3%. The bank earns 3% interest on this amount while temporarily parking its funds with
the RBI.
SDF (INTRODUCED IN 2022)
It is a tool used by RBI to absorb excess liquidity from the banking system without giving
any collateral in return.
Banks park their surplus funds with RBI and earn interest on it through SDF.

Why SDF was Introduced?

• Earlier, RBI used Reverse Repo Rate for this purpose, but it required RBI to provide
collateral (like government securities).
• SDF allows RBI to absorb excess liquidity without collateral.
Marginal Standing Facility (MSF)

• Marginal Standing Facility (MSF) is a monetary policy tool introduced by the Reserve Bank of India
(RBI) in 2011. It allows commercial banks to borrow funds from the central bank (RBI) overnight, but
only in emergency situations when they have exhausted all other borrowing options, such as the
Liquidity Adjustment Facility (LAF). The interest rate charged for borrowing under the MSF is usually
higher than the Repo Rate, making it a last-resort option for banks.
Key Features of MSF:
• Collateral Requirement: Banks can borrow funds under MSF by pledging government securities as
collateral.
• Overnight Borrowing: MSF is used for very short-term needs, usually overnight.
• Borrowing Limit: Banks can borrow up to 1% of their Net Demand and Time Liabilities (NDTL)
through MSF.
• Penal Rate: MSF is considered a penal rate, which is typically higher than the Repo Rate (usually by 25
basis points or 0.25%).
Difference Between Bank Rate, Repo Rate and MSF

Marginal Standing
Feature Bank Rate Repo Rate
Facility (MSF)
Long-term
Short-term borrowing by Emergency overnight
Purpose borrowing by
banks from RBI borrowing for banks
banks from RBI
No collateral Requires government Requires government
Collateral
required securities as collateral securities as collateral
Higher than Repo Rate
Typically higher Lower than Bank Rate and
Interest Rate (usually 25 basis points
than Repo Rate MSF
more)

Long-term (not
Short-term (typically Very short-term, usually
Borrowing Period specifically
overnight or short duration) overnight
overnight)
Open Market Operations (OMO)

• Open Market Operations (OMOs) refer to the buying and selling of government
securities by the central bank (like the RBI) in the open market to control the money
supply in the economy. OMOs are primarily used to manage short-term liquidity and
influence interest rates.
• Key Features of OMO:
• Buying Government Securities: When the central bank buys government securities, it
injects liquidity into the banking system, increasing the money supply.
• Selling Government Securities: When the central bank sells government securities, it
absorbs liquidity from the banking system, reducing the money supply.
• Impact on Interest Rates: OMOs help regulate short-term interest rates and influence
overall monetary conditions in the economy.
Market Stabilization Scheme (MSS)

What is MSS?
• MSS is a tool used by RBI to absorb excess liquidity (extra money in the system)
through the sale of Government securities (like Treasury Bills, Bonds).
• Introduced in 2004, mainly to manage liquidity caused by foreign exchange inflows.
 MSS :Sometimes, too much money enters India (through foreign
investments, exports, etc.).When RBI buys dollars to stop the rupee from
becoming too strong, it gives out rupees into the Indian market.
This creates excess money (extra liquidity) in the economy → which can
cause inflation.

Problem:Too much money → Prices go up → Inflation risk.

MSS = RBI’s Solution:

RBI asks the government to issue special bonds (MSS Bonds).People
(banks, investors) buy these bonds → They give their extra rupees to
RBI.This way, RBI sucks back the excess money from the market.Inflation
is controlled, money supply is balanced.
 Simple Trick to Remember:
Anything that brings foreign money INTO India → Increases demand for
Rupee.

What happens when demand for Rupee increases?

• Rupee becomes stronger.
• Good for importers (cheaper oil, gadgets).
• Bad for exporters (makes Indian goods expensive abroad).

When RBI Buys Dollar RBI Sells Dollar

To stop rupee from becoming To stop rupee from becoming
Why?
too strong too weak
Huge foreign inflows, rising Capital outflows, rising imports,
When does it happen?
exports, strong rupee weak rupee
Increases dollar demand, Increases dollar supply,
Effect
weakens rupee slightly strengthens rupee
Adds rupees to the market (can Takes rupees out of the market
Impact on Liquidity
cause liquidity surplus) (reduces liquidity)
 Difference Between OMO and MSS

Feature Market Stabilization Scheme (MSS) Open Market Operations (OMO)

Absorb excess liquidity specifically to sterilize Manage day-to-day liquidity in the banking system
Purpose
capital inflows and manage inflation. and influence short-term interest rates.
Type of Market Stabilization Bonds (MSBs) are issued
Regular government securities (like treasury bills
Securities specifically for liquidity absorption. These bonds
or bonds) are bought or sold.
Issued do not finance government expenditure.
Funds raised through MSS are kept in a separate Funds from OMOs are part of regular government
Funds Usage account and are not used for government operations and are used in managing the
spending. government’s financial needs.
Primarily used when there is excess liquidity due Used on a regular basis to manage short-term
Time of Use to large foreign exchange inflows. It is more liquidity in the banking system and to ensure
targeted for sterilization. smooth functioning of the financial markets.
MSS is explicitly designed for sterilizing excess
OMO is not specifically for sterilization but to
Sterilization liquidity and preventing inflation due to capital
adjust overall liquidity in the market.
inflows.
Frequency of MSS is used selectively, typically in periods of high OMOs are used frequently by the RBI to manage
Use capital inflows and excess liquidity. daily liquidity needs and short-term interest rates.
Primarily used to absorb excess liquidity in a more Used to either inject or absorb liquidity based on
Monetary Impact
controlled and targeted manner. the prevailing market conditions.
Qualitative Credit
Control Tools
Tool Meaning How it Works Purpose / Objective Example
Increasing margin for
Margin is the difference RBI increases margin %
To control speculative loans against shares
1. Margin between the loan to reduce loan amount
lending in stocks, real from 30% to 50% to
Requirements amount & value of banks can give against
estate, etc. discourage stock
security pledged. assets.
market speculation.
Prevents over-lending to
RBI imposes ceilings on Limiting bank loans to
Limiting the amount of non-priority/risky
bank credit to real estate sector while
2. Credit Rationing credit to certain sectors, ensures credit
overheated or risky prioritizing MSMEs &
sectors. flow to productive
sectors. agriculture.
sectors.
Through meetings, RBI requests banks to
RBI uses persuasion letters, press To encourage voluntary avoid aggressive
3. Moral Suasion without legal force to statements, RBI advises compliance with RBI’s lending to personal
guide banks. banks to follow policy measures. loans during
policies. inflationary trends.
Restricting bank’s
RBI takes punitive access to RBI facilities, Ensures banks adhere Penalizing a bank for
4. Direct Action actions against imposing penalties, to RBI regulations violating priority sector
defaulting banks. even license strictly. lending targets.
cancellation.
RBI regulates credit Fixes minimum down Limiting EMIs for
Controls demand for
5. Regulation of given for consumer payment and maximum purchase of cars or TVs
consumer goods,
Consumer Credit durables & installment number of installments to control excessive
manages inflation.
purchases. (EMIs). consumer spending.
Publishing warnings
Educates public &
RBI spreads awareness Builds public pressure about risky lending
banks about risks,
6. Publicity through reports, media, for compliance, practices in
policies, and desired
and public statements. ensures transparency. newspapers and
lending practices.
reports.