Monetary Policy Instruments
The RBI employs a range of monetary policy instruments (tools) to regulate liquidity and influence interest rates in the economy. These instruments can be broadly classified into quantitative (general) tools, which affect the overall money supply/credit in the economy, and qualitative (selective) tools, which channel credit to specific sectors or uses. A mix of these instruments allows the RBI to achieve its monetary policy objectives.
Quantitative Instruments (General Credit Control)
These tools influence the total volume of money and credit in the banking system:
Repo Rate (Repurchase Rate)
Repo rate is the key policy rate at which the RBI lends short-term funds to commercial banks against government securities. When the RBI raises the repo rate, borrowing from the RBI becomes costlier for banks, which translates to higher interest rates for businesses and consumers – a contractionary effect to curb inflation.
Conversely, cutting the repo rate makes loans cheaper, stimulating borrowing and investment – an expansionary effect to boost growth. The repo rate serves as the benchmark for other interest rates in the economy.
Note: As of mid-2025, the repo rate decisions are taken by the Monetary Policy Committee to maintain inflation within target.
Reverse Repo Rate
The reverse repo rate is the rate at which the RBI borrows money from banks (by lending securities to them). It is used to absorb excess liquidity from the banking system. When banks have surplus funds, they can park them with RBI at the reverse repo rate (or related facility), earning interest.
By adjusting the reverse repo rate, the RBI can encourage or discourage banks from keeping funds idle with the central bank, thus influencing liquidity. In recent times, the RBI introduced the Standing Deposit Facility (SDF) as an alternative tool for absorbing liquidity without collateral, which now serves as the effective floor rate of the interest rate corridor.
Cash Reserve Ratio (CRR)
CRR is the percentage of a bank’s total demand and time deposits that must be kept as reserves (cash) with the RBI. A higher CRR means banks have to park more funds with RBI interest-free, effectively reducing the funds available for lending. Increasing the CRR drains liquidity from the system (tightening policy), whereas reducing CRR releases funds for banks to lend (easing policy). CRR is a blunt but powerful tool to control money supply; even small changes can impact credit availability significantly.
Statutory Liquidity Ratio (SLR)
SLR is the minimum percentage of net demand and time liabilities (NDTL) that banks must maintain in the form of liquid assets (such as cash, gold, or approved government securities) within the bank (not with RBI). By raising the SLR, RBI forces banks to hold more funds in safe assets, leaving less for lending to the public (thus contracting credit). Lowering SLR frees up funds for lending (expansionary effect). SLR also serves to ensure banks invest in government securities and maintain liquidity buffers. (In recent years, SLR has been gradually reduced by RBI to align with global liquidity norms, but it remains an important instrument.)
Open Market Operations (OMO)
OMOs refer to the RBI’s outright purchase or sale of government securities in the open market. To inject liquidity (expansionary action), the RBI buys government bonds from banks and primary dealers, thereby releasing money into the system.
To absorb liquidity (contractionary action), it sells government bonds, taking money out of circulation. OMOs are a flexible day-to-day tool for managing liquidity and influencing interest rates, especially when there are transient liquidity fluctuations. A special variant, the Market Stabilization Scheme (MSS), is sometimes used by issuing special bonds to mop up excess liquidity (for example, during episodes like large capital inflows or demonetization).
Marginal Standing Facility (MSF)
MSF is a window for banks to borrow overnight funds from RBI in an emergency when inter-bank liquidity dries up. It is set slightly above the repo rate (a penal rate). Banks can dip into the MSF (typically up to a certain percentage of their net demand and time liabilities) by pledging government securities.
The MSF rate acts as the upper bound of the policy interest rate corridor, providing a safety valve against overnight liquidity shortages. If banks frequently resort to MSF, it indicates liquidity is tight in the system.
Bank Rate
The bank rate is a traditional tool, defined as the long-term rate at which RBI is ready to lend to banks (or financial institutions) without any collateral. It is often higher than the repo/MSF rates and is used as a reference for certain penalties or interest calculations (like default rates, refinance rates, or for some long-term facilities).
Changes in the bank rate generally signal the direction of long-term interest rates. While not actively used for day-to-day liquidity now, the bank rate’s value typically moves in tandem with the MSF rate and serves as an officially published rate for specific regulatory purposes.
Liquidity Adjustment Facility (LAF)
The LAF is not a single instrument but a framework under which RBI conducts daily repo and reverse repo operations to adjust short-term liquidity. Banks bid for repo (to borrow) or submit offers for reverse repo (to deposit) at these rates within the RBI’s prescribed limits.
The LAF, along with MSF and SDF, helps maintain the policy rate corridor and keep overnight market rates aligned with the repo rate. For instance, if overnight rates are too low (excess liquidity), RBI would absorb funds via reverse repo/SDF; if rates spike (liquidity tight), RBI injects funds via repo or MSF.
Qualitative Instruments (Selective Credit Control)
Qualitative tools are used to regulate credit distribution to specific sectors or to influence the purpose for which credit is extended, rather than altering the overall money supply. They include:
Credit Rationing & Sectoral Limits
RBI can impose limits on the amount of credit to certain sectors considered overheated or speculative. For example, in earlier times the RBI set ceilings on loans to the capital markets or restricted credit growth to sensitive sectors (real estate, commodities) to prevent bubbles.
By rationing credit, the RBI ensures priority sectors (like agriculture, MSMEs) are not crowded out by excessive lending to non-essential or riskier areas.
Margin Requirements
This refers to adjusting the loan-to-value ratio for certain categories of loans (especially against commodities, stocks, etc.). By raising the margin requirement, borrowers need to provide more collateral or equity for a loan, thereby dampening the demand for credit in that segment.
This tool is used to curb excessive speculative borrowing (e.g., loans against shares or for commodity trading).
Moral Suasion
Moral suasion involves the RBI persuading or advising banks to align with policy objectives through meetings, communications, or guidance. For instance, the RBI might informally urge banks to restrict lending to speculative ventures, or to pass on rate cuts to consumers.
Although not legally binding, moral suasion leverages the RBI’s authority and relationship with banks. It is often used to achieve cooperation in monetary policy (such as urging banks to cut interest rates in line with RBI’s policy rate cuts or to exercise caution in lending during asset price booms).
Directives and Administrative Measures
The RBI can issue directives under the Banking Regulation Act to control certain lending practices. Examples include prescribing higher risk weights or provisioning for specific types of loans (making them less attractive for banks), or directing banks to channel a portion of credit to desired sectors (like priority sector lending norms, though those are more structural).
The central bank can also vary supervisory norms to indirectly influence credit behavior (tightening loan classification norms in a sector can make banks more cautious to lend there).
Credit Education and Publicity
In some cases, the RBI may use public statements and reports to influence expectations. By publicly expressing concerns about, say, excessive credit growth in unsecured loans or real estate, the RBI can signal banks and borrowers to be more prudent even without formal rules – this is a softer form of persuasion.
In practice, quantitative instruments are the primary tools for routine monetary control, especially under the modern inflation-targeting regime. Qualitative instruments act as supplementary measures to fine-tune credit allocation and mitigate risks in specific areas. The RBI uses a judicious mix: for example, during an inflationary period, it may hike the repo rate and CRR (quantitative tightening) and simultaneously caution banks (moral suasion) against lending for luxury consumer credit. All instruments ultimately serve the goal of maintaining economic stability by controlling money supply, influencing interest rates, and guiding the flow of credit in line with policy objectives.