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Monetary policy: objectives, instruments and transmission

RBI and monetary policy · Part 2 / 1 · Fact-checked on 20 October 2026 · how we check

Written with AI from the sources listed at the bottom of this page, then fact-checked by a separate AI.

What monetary policy aims at under the amended RBI Act, the policy stance, and every instrument the RBI uses: the liquidity adjustment facility (repo, reverse repo, variable rate operations), the corridor formed by the standing deposit facility and the marginal standing facility, the bank rate, open market operations, the Market Stabilisation Scheme, CRR and SLR, qualitative and prudential tools; how a rate change reaches borrowers (MCLR, external benchmarks) and where monetary policy falls short.

monetary policy is the RBI's use of interest rates and of the amount of money in the banking system to steer inflation and growth. The Monetary Policy Committee meets at least four times a year (in practice usually six) and fixes the policy repo rate; the RBI then uses a set of tools to make sure that the rates banks charge one another, and in time the rates they charge borrowers, follow that decision. The inflation chapter explained why India targets inflation and how the committee is formed. This part focuses on the instruments: the liquidity adjustment facility and its corridor, open market operations, reserve ratios and qualitative tools, and on how a policy decision finally reaches a household or a firm.

What is monetary policy for? The RBI Act's preamble, as amended by the Finance Act, 2016, states: 'the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth'. Price stability comes first because high and unpredictable inflation erodes savings, hurts the poor most and makes planning hard; growth still matters, since rates can be cut to support output when inflation is under control. The policy stance tells markets which way the RBI is leaning: 'accommodative' signals readiness to cut rates or add money, 'neutral' keeps both directions open, and wording such as 'withdrawal of accommodation' signals tightening. Expansionary, or easy, policy lowers rates and adds liquidity to support demand; contractionary, or tight, policy raises rates and absorbs liquidity to cool inflation.

The main channel is the liquidity adjustment facility (LAF), introduced in June 2000. In a repo, a bank sells government securities to the RBI and agrees to buy them back after a day or a few days; in effect it borrows cash against them, and the interest it pays is the repo rate. In a reverse repo the direction is reversed: the RBI takes surplus cash from banks against securities and pays the reverse repo rate. The policy repo rate set by the MPC anchors the whole interest rate structure. Besides overnight operations at that fixed rate, the RBI holds variable rate repo and reverse repo auctions of different maturities, where the bidding decides the rate, to add or drain money more finely. The aim is to keep the weighted average call rate, at which banks lend to each other overnight without collateral, close to the repo rate; the RBI's revised liquidity management framework of 2025 kept this call rate as the operating target.

Around the repo rate sits a corridor that limits how far the overnight rate can stray. Its ceiling is the marginal standing facility (MSF), introduced in May 2011: a bank short of funds can borrow overnight from the RBI at a rate above repo, even by using part of its required SLR holdings up to a limit the RBI sets. Its floor, since 8 April 2022, is the standing deposit facility (SDF) under section 17(2B) of the RBI Act, inserted by the Finance Act, 2018: banks park surplus cash with the RBI at a rate below repo, and unlike a reverse repo the RBI need not give securities in return, which matters when surplus cash is too large for the RBI's stock of securities. Since April 2022 the SDF rate has been 25 basis points below repo and the MSF rate 25 basis points above it. The bank rate (section 49), the rate at which the RBI buys or rediscounts eligible bills, is kept equal to the MSF rate and is used mainly to set penal rates, for example on banks that fall short of reserve requirements.

Repo operations move money in and out for days or weeks. To change the amount of money for longer, the RBI uses open market operations (OMOs): outright purchases or sales of government securities in the market. When it buys bonds from banks it pays with fresh reserves, adding durable liquidity; when it sells bonds, reserves flow back and liquidity shrinks. OMOs also move bond yields. In an 'operation twist', first carried out in December 2019, the RBI bought long-term securities and sold short-term ones at the same time, to lower long-term yields without much change in total liquidity. Under the G-sec Acquisition Programme (G-SAP) of 2021, it committed in advance to buying a stated amount of government bonds, to steady the bond market during the pandemic. The RBI also uses foreign exchange swaps: in a buy/sell swap it buys dollars from banks now and agrees to sell them back later, which injects rupees for the life of the swap.

Sometimes the problem is extra money the RBI did not set out to create. When large foreign capital flows in, the RBI often buys dollars to stop the rupee rising too fast and pays in rupees, which swells banks' cash; absorbing all of it through OMO sales could exhaust the RBI's own securities. The Market Stabilisation Scheme (MSS), set up under a Memorandum of Understanding between the Government and the RBI in 2004, offers another route. The Government issues additional treasury bills and dated securities, not to spend the money but to soak up liquidity, and the proceeds are held in a separate account with the RBI, so the only cost to the budget is the interest. The scheme was used on a large scale after the November 2016 withdrawal of the old ₹500 and ₹1,000 notes, when deposits poured into banks. Buying foreign currency and then mopping up the rupees it creates is called sterilisation.

The reserve requirements studied in the money and banking chapter are monetary tools too. A higher cash reserve ratio (CRR) locks more of every deposit with the RBI, leaving banks less to lend; a cut releases funds at once. Because it hits the whole system in one stroke and earns banks nothing, the RBI changes it less often than the repo rate. In August 2023, after the withdrawal of ₹2,000 notes from circulation brought a rush of deposits, the RBI temporarily required banks to keep an incremental CRR of 10 per cent on the growth in their deposit liabilities between 19 May and 28 July 2023, and released it in phases later that year. The statutory liquidity ratio (SLR), set under section 24 of the Banking Regulation Act, works more slowly: it fixes how much of a bank's deposits must be kept in cash, gold or approved securities, which also ensures steady demand for government bonds. A change in either ratio alters the money multiplier and so the money supply.

The tools so far are quantitative: they change the overall cost or quantity of credit. Qualitative, or selective, tools steer credit towards or away from particular uses. Margin requirements decide how much of the value of the pledged security a borrower must cover from own funds; raising the margin on loans against shares or stocks of sensitive commodities makes speculative borrowing harder. Selective credit controls have been used in India to stop traders hoarding essential commodities with bank money. moral suasion is persuasion: the Governor meets or writes to bank chiefs to urge them, say, to pass on a rate cut or go slow on risky lending, without any formal order. Direct action, such as restrictions on a bank that keeps ignoring the RBI's advice, is the stronger form. Prudential tools now work in a similar targeted way: in November 2023 the RBI raised risk weights on unsecured consumer credit, so banks had to set aside more capital for such loans.

A cut in the policy rate helps the economy only if it reaches borrowers. This passage is called monetary policy transmission: from the policy rate to the overnight money market, then to bond yields and banks' deposit and lending rates, and finally to spending, investment and prices, with lags of many months. In India transmission to bank loans has often been slow, because banks raise most of their funds through fixed-rate term deposits and used to price loans on internal formulas. The RBI has therefore changed the loan pricing system several times: the benchmark prime lending rate (2003), the base rate (July 2010) and the marginal cost of funds based lending rate, or MCLR (April 2016), each meant to tie loan rates more closely to banks' costs. The biggest step came on 1 October 2019, when banks had to link new floating-rate retail loans and loans to micro and small enterprises to an external benchmark, such as the policy repo rate, and reset the rate at least once every three months.

Monetary policy is powerful but not all-powerful. It works mainly on demand, so it can do little directly about supply shocks such as a failed monsoon that pushes up vegetable prices or a jump in world oil prices; raising rates then may slow growth without bringing those prices down. Its effects arrive with long lags, so the RBI must act on forecasts. Large government deficits can push up interest rates and press the central bank to keep government borrowing cheap, which economists call fiscal dominance. And where people borrow from moneylenders or other informal sources, a repo change barely reaches them. Suppose the RBI raises the repo rate while vegetable prices climb because floods have damaged crops: urban home-loan rates may rise within months, yet vegetables become cheaper only when the next harvest arrives. That is why government supply-side steps, such as releasing buffer stocks or easing imports, must work alongside monetary policy.

Taken together, the RBI's toolkit works in layers. The MPC sets the repo rate; LAF operations, the SDF floor and the MSF ceiling keep the overnight call rate close to it; OMOs, foreign exchange swaps and the MSS manage longer-lasting liquidity; CRR and SLR change how much banks can lend from each deposit; and qualitative and prudential tools aim credit at, or away from, particular uses. Loan pricing rules, above all the external benchmark system, then carry the decision to households and firms. The table shows which way each tool moves when the RBI wants to ease or tighten. Any monetary policy statement can then be read with three questions: did the repo rate change, did the stance change, and what is the RBI doing about liquidity?

Exam traps

• In a repo the RBI lends to banks; in a reverse repo and under the SDF, banks park money with the RBI.
• The SDF needs no collateral and, since 8 April 2022, it (not the fixed rate reverse repo) is the floor of the LAF corridor.
• The MSF is the ceiling of the corridor (repo + 25 basis points); the bank rate is aligned with the MSF rate, not with the repo rate.
• An OMO purchase of government securities injects liquidity; an OMO sale absorbs it.
• Money raised under the Market Stabilisation Scheme is not spent by the government; it sits in a separate account with the RBI, and the budget bears only the interest.
• The operating target of monetary policy is the weighted average call rate; the repo rate is the policy rate that signals the stance.
• The external benchmark system (1 October 2019) covers new floating-rate retail loans and loans to micro and small enterprises, with a reset at least every three months; MCLR dates from April 2016 and the base rate from July 2010.
• Moral suasion is persuasion without any legal order; margin requirements and selective credit controls are qualitative tools that target particular uses of credit.

Recap

• Objective (RBI Act preamble, 2016): price stability while keeping in mind the objective of growth; the stance signals the direction of policy.
• LAF (2000): repo = RBI lends to banks against securities; reverse repo = RBI absorbs cash; variable rate auctions fine-tune liquidity.
• Corridor since April 2022: SDF floor (repo − 25 bp, no collateral, s.17(2B)) and MSF ceiling (repo + 25 bp, 2011); bank rate (s.49) = MSF rate.
• Operating target: weighted average call rate, kept in the 2025 revised liquidity framework.
• OMOs: buying bonds injects durable liquidity, selling absorbs it; operation twist (2019), G-SAP (2021), forex swaps.
• MSS (2004 MoU): extra government securities to sterilise inflows; proceeds kept in a separate account, not spent.
• CRR and SLR as tools; incremental CRR of 10% in August 2023 after the ₹2,000 note withdrawal.
• Qualitative tools: margins, selective credit controls, moral suasion, direct action; risk weights raised on unsecured consumer credit in November 2023.
• Transmission: BPLR (2003) → base rate (2010) → MCLR (2016) → external benchmark (1 October 2019, reset at least every three months).
• Limits: supply shocks, lags, fiscal dominance and informal credit, so supply-side measures must work alongside.

Practice questions

Sources

• Reserve Bank of India Act, 1934 (Preamble as amended by the Finance Act, 2016; ss.17(2B), 42, 45ZA, 45ZB and 49) — https://www.indiacode.nic.in
• Banking Regulation Act, 1949 (s.24) — https://www.indiacode.nic.in
• Reserve Bank of India: monetary policy statements and statements on developmental and regulatory policies (2000, 2011, 2019, 2021, 2022); press release on operationalising the Standing Deposit Facility (April 2022); Revised Liquidity Management Framework (September 2025); notification on the incremental CRR (August 2023); circular on risk weights for consumer credit (November 2023) — https://www.rbi.org.in
• Reserve Bank of India: circulars on the base rate (2010), the marginal cost of funds based lending rate (2016) and external benchmark-based lending (September 2019); Memorandum of Understanding on the Market Stabilisation Scheme (2004) — https://www.rbi.org.in