Monetary Policy and Its Tools: In our “Daily News Explainer” series, today we bring you a very important and relevant topic that has been making headlines. This article will not only update you on current affairs but will also help students preparing for various competitive exams such as UPSC, Banking, SSC, CLAT, CUET, and other state-level examinations. Stay informed and boost your exam readiness with this detailed analysis.
In Short (Quick Summary):
- RBI slashed repo rate to 50 basis points to 5.50 per cent
- The MPC, headed by RBI Governor Sanjay Malhotra
What is Monetary Policy?
Monetary policy is a critical framework through which the Reserve Bank of India (RBI), India’s central bank, manages the economy’s money supply and interest rates to achieve macroeconomic objectives such as price stability, economic growth, and financial stability.
Enacted under the Reserve Bank of India Act, 1934, the RBI’s monetary policy influences the availability of credit, interest rates, and liquidity in the economy, impacting inflation, employment, and overall economic activity.
Since 2016, the RBI has adopted a Flexible Inflation Targeting Framework (FITF), emphasizing price stability while supporting growth.
Objectives of RBI’s Monetary Policy
The primary objective of the RBI’s monetary policy, as outlined in the preamble to the Reserve Bank of India Act, 1934, is to maintain price stability while keeping economic growth in mind. Price stability ensures the purchasing power of the Indian rupee is preserved, fostering sustainable economic development. Secondary objectives include:
- Economic Growth: Ensuring adequate credit availability to productive sectors like agriculture, industry, and small-scale enterprises to stimulate growth.
- Financial Stability: Managing systemic risks in the financial sector to maintain a robust banking system.
- Employment Generation: Supporting policies that indirectly promote job creation through economic expansion.
- Exchange Rate Stability: Balancing domestic currency value to support trade and investment.
- Priority Sector Development: Allocating credit at concessional rates to critical sectors such as agriculture and small-scale industries to promote inclusive growth.
| The Flexible Inflation Targeting Framework, formalized in 2016, sets a target inflation rate of 4% with a tolerance band of ±2% (2–6%) for the Consumer Price Index (CPI)-based inflation, reviewed every five years in consultation with the Government of India. If inflation breaches this band for three consecutive quarters, the RBI must submit a report to the government explaining the reasons and corrective measures. |
Monetary Policy Framework
The RBI’s monetary policy operates through a structured framework, with the Monetary Policy Committee (MPC) playing a central role since its establishment under the Finance Act, 2016.
- The MPC, comprising six members (three from the RBI, including the Governor as chairperson, and three external members appointed by the government), meets bimonthly to set the policy repo rate based on macroeconomic conditions.
- The framework aims to anchor the weighted average call rate (WACR) around the repo rate through liquidity management, ensuring effective transmission of policy changes across the financial system.
The RBI employs two types of monetary policies:
1. Expansionary Monetary Policy: Increases money supply and reduces interest rates to stimulate economic activity during slowdowns or recessions. Tools include lowering the repo rate, reducing reserve requirements, and purchasing government securities.
2. Contractionary Monetary Policy: Decreases money supply and raises interest rates to curb inflation during overheated economic conditions. Tools include increasing the repo rate, raising reserve requirements, and selling government securities.
Monetary Policy Tools
The RBI uses a combination of quantitative and qualitative tools to regulate money supply, liquidity, and credit availability. These tools are categorized as follows: Quantitative Tools
Quantitative tools directly influence the money supply and liquidity in the banking system. They include:
1. Repo Rate
Definition: The interest rate at which the RBI lends short-term funds to commercial banks against government securities under the Liquidity Adjustment Facility (LAF).
Impact: A lower repo rate reduces borrowing costs for banks, encouraging lending and increasing money supply, which supports economic growth. A higher repo rate increases borrowing costs, reducing money supply to control inflation.
Recent Update: On June 6, 2025, RBI in latest Monetary Policy Committee (MPC) meet, has cut down the repo rate to 50 basis points to 5.50 per cent to boost economic activity. The panel retained GDP growth projected at 6.5% for FY 2025-26.
Earlier, on April June 9, 2025, the repo rate was reduced by 25 basis points to 6.00% by RBI.
2. Reverse Repo Rate
- Definition: The rate at which the RBI borrows from commercial banks against government securities, absorbing excess liquidity under the LAF.
- Impact: A higher reverse repo rate incentivizes banks to park funds with the RBI, reducing liquidity in the market. A lower rate discourages such parking, increasing liquidity.
- Current Rate: as per official RBI website – the fixed reverse repo rate stands at 3.35%.
3. Cash Reserve Ratio (CRR)
- Definition: The percentage of a bank’s net demand and time liabilities (NDTL) that must be maintained as cash reserves with the RBI.
- Impact: Increasing the CRR reduces the funds available for lending, contracting money supply. Decreasing the CRR increases lendable funds, expanding money supply.
- Example: In 2023, the RBI introduced an incremental CRR (I-CRR) of 10% to absorb excess liquidity of over ₹1 lakh crore.
- Current CRR is 4.00%
4. Statutory Liquidity Ratio (SLR)
- Definition: The percentage of NDTL that banks must maintain in liquid assets such as cash, gold, or government securities.
- Impact: A higher SLR restricts lending capacity, reducing money supply. A lower SLR frees up resources for lending, increasing money supply.
- Role: Ensures banks maintain a buffer of safe assets, promoting financial stability.
- Current SLR rate is 18%.
5. Open Market Operations (OMOs)
- Definition: The RBI’s buying or selling of government securities in the open market to regulate liquidity.
- Impact: Buying securities injects money into the system (expansionary), while selling securities absorbs money (contractionary).
- Example: During the COVID-19 pandemic, the RBI used OMOs to inject liquidity and support economic recovery.
6. Bank Rate
- Definition: The rate at which the RBI lends to commercial banks without collateral, typically for longer terms, and used as a penal rate for reserve requirement shortfalls.
- Impact: Aligned with the Marginal Standing Facility (MSF) rate, an increase in the bank rate raises borrowing costs, reducing money supply, while a decrease encourages borrowing.
- Current Rate: As of June 6, 2025, the bank rate is 5.75%.
7. Marginal Standing Facility (MSF)
- Definition: A facility allowing banks to borrow overnight from the RBI by dipping into their SLR portfolio at a penal rate higher than the repo rate.
- Impact: Provides emergency liquidity during interbank liquidity shortages, ensuring financial stability.
- Current Rate: As of June 6, 2025, the MSF rate is 5.25 %.
8. Market Stabilisation Scheme (MSS)
- Definition: Introduced in 2004, this tool involves the sale of short-dated government securities and treasury bills to absorb excess liquidity from large capital inflows.
- Impact: Helps manage durable liquidity, particularly during capital surges, to stabilize the economy.
Qualitative Tools: Qualitative tools indirectly influence credit allocation and economic behavior. They include:
- Credit Ceiling
- Definition: The RBI sets limits on the amount of credit commercial banks can extend to specific sectors or borrowers.
- Impact: Controls credit flow to prevent speculative lending or overexposure to certain sectors.
- Moral Suasion
- Definition: The RBI uses persuasion or guidelines to influence banks’ lending practices without formal regulation.
- Impact: Encourages banks to align lending with national priorities, such as supporting agriculture or small-scale industries.
- Selective Credit Controls
- Definition: Directives to regulate credit to specific sectors, such as restricting loans for speculative activities or prioritizing credit for agriculture.
- Impact: Ensures equitable distribution of credit to promote inclusive growth.
- Forward Guidance
- Definition: The RBI communicates its future policy intentions to guide market expectations, introduced prominently during the 2019 non-banking financial company crisis and the COVID-19 pandemic.
- Impact: Enhances policy predictability, influencing asset prices and market behavior. For example, in April 2021, the RBI provided forward guidance on its Government Securities Acquisition Programme.
Conclusion
The RBI’s monetary policy is a cornerstone of India’s economic management, balancing the dual objectives of price stability and growth. Through a mix of quantitative tools (repo rate, CRR, SLR, OMOs) and qualitative measures (credit ceilings, moral suasion), the RBI regulates money supply and credit to foster a stable and inclusive economy. The adoption of the Flexible Inflation Targeting Framework and the Monetary Policy Committee has enhanced transparency and accountability, aligning India’s monetary policy with global best practices. As the RBI navigates evolving economic challenges, its strategic use of conventional and unconventional tools ensures resilience and adaptability in promoting sustainable growth.
