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Introduction to Economics
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National Income
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Inclusive growth
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Inflation
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Monetary Policy
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Investment Models
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Chapter 7: Monetary Policy
Chapter Test15 topics•Estimated reading: 45 minutes
Monetary Policy
Key Point
Monetary policy is the use of tools by a country’s central bank (in India, the RBI) to regulate money supply, control inflation, promote growth, and ensure economic stability. It works alongside fiscal policy, but is independent in nature.
Monetary policy is the use of tools by a country’s central bank (in India, the RBI) to regulate money supply, control inflation, promote growth, and ensure economic stability. It works alongside fiscal policy, but is independent in nature.
Detailed Notes (18 points)
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Introduction
Monetary policy = actions by RBI to manage money supply, inflation, credit, and growth.
Fiscal policy = actions by Government through taxation, spending, and borrowing.
Both affect the money supply but in different ways.
Goals of Monetary Policy
# 1. Controlling Inflation
Inflation = rise in general price level.
RBI uses contractionary monetary policy to control high inflation by reducing money supply.
Example: RBI increases repo rate (rate at which RBI lends to banks) → borrowing becomes costlier → less demand → inflation falls.
# 2. Promoting Economic Growth
RBI ensures stable conditions for investment, productivity, and employment.
Example: During slowdown, RBI reduces interest rates → loans cheaper → businesses invest more → jobs increase → demand rises.
# 3. Reducing Unemployment
Expansionary monetary policy increases money supply.
Lower interest rates encourage borrowing → more business activity → more jobs → unemployment decreases.
# 4. Managing Exchange Rates
RBI intervenes in forex market to stabilize rupee value.
Example: RBI sells dollars → dollar supply in market rises → rupee strengthens (as demand for rupee increases).
Goals of Monetary Policy
| Goal | Explanation | Example |
|---|---|---|
| Control Inflation | Reduce money supply when prices rise | Raise repo rate to reduce borrowing |
| Economic Growth | Stimulate demand and investment | Lower repo rate during slowdown |
| Reduce Unemployment | More jobs via expansionary credit policies | Cheaper loans encourage hiring |
| Exchange Rate Stability | RBI intervenes in forex market | Selling dollars to strengthen rupee |
Mains Key Points
Monetary policy balances inflation control with growth promotion.
RBI uses repo, reverse repo, CRR, SLR, OMOs as tools.
Acts as stabilizer against unemployment and external shocks.
Helps in maintaining currency stability in forex markets.
Needs coordination with fiscal policy for maximum impact.
Prelims Strategy Tips
Repo rate = RBI lending rate to commercial banks.
Contractionary monetary policy → controls inflation.
Expansionary monetary policy → reduces unemployment and boosts growth.
RBI intervenes in forex market to stabilize rupee.
Types of Monetary Policy
Key Point
There are two main types of monetary policy: Expansionary and Contractionary. Expansionary policy increases money supply to boost growth during slowdowns, while Contractionary policy reduces money supply to control inflation during overheating of the economy.
There are two main types of monetary policy: Expansionary and Contractionary. Expansionary policy increases money supply to boost growth during slowdowns, while Contractionary policy reduces money supply to control inflation during overheating of the economy.
Detailed Notes (16 points)
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Expansionary Monetary Policy
Meaning: Injecting more money into the economy to encourage growth.
Objective: To fight recession, depression, or periods of low economic growth.
Tools used: Lowering interest rates, reducing reserve requirements, and purchasing government securities.
# How it Works
1. Lowering Interest Rates: Makes loans cheaper → more borrowing and spending → boosts investment and demand.
2. Purchasing Govt Securities (Quantitative Easing): RBI buys securities in open market → injects money into the system → increases liquidity → stimulates growth.
3. Lowering Reserve Requirements: Banks hold less in reserve (lower CRR/SLR) → more money available to lend → higher spending and demand.
Contractionary Monetary Policy
Meaning: Reducing money supply in the economy to curb spending and inflation.
Objective: To fight high inflation or hyperinflation.
Tools used: Raising interest rates, increasing reserve requirements, and selling government securities.
# How it Works
1. Raising Interest Rates: Loans become costlier → borrowing reduces → less spending and investment → controls inflation.
2. Selling Govt Securities: RBI sells securities → money absorbed from market → reduces liquidity → slows demand.
3. Increasing Reserve Requirements: Higher CRR/SLR → banks must hold more reserves → less lending to public → reduced money supply.
Types of Monetary Policy – Comparison
| Aspect | Expansionary Policy | Contractionary Policy |
|---|---|---|
| Purpose | Boost growth during slowdown | Control inflation during overheating |
| Money Supply | Increases | Decreases |
| Interest Rates | Lowered | Raised |
| Reserve Requirements | Reduced (Lower CRR/SLR) | Increased (Higher CRR/SLR) |
| Govt Securities | Purchased (injects money) | Sold (absorbs money) |
Mains Key Points
Expansionary policy helps fight unemployment and low growth but may risk higher inflation.
Contractionary policy controls inflation but may slow growth and increase unemployment.
RBI balances both policies depending on economic conditions.
Both use tools like repo, reverse repo, CRR, SLR, and OMOs.
Choice depends on macroeconomic goals – stability vs. growth.
Prelims Strategy Tips
Expansionary = more money supply, lower interest rates.
Contractionary = less money supply, higher interest rates.
Quantitative Easing = RBI buying govt securities.
OMOs (Open Market Operations) = buying/selling govt securities.
Monetary Policy Framework in India
Key Point
The Monetary Policy Framework is the system through which the Reserve Bank of India (RBI) manages money supply, credit, and inflation in the economy. Its main goal is to keep inflation under control while also ensuring enough money is available for economic growth. Since 2016, India follows a Flexible Inflation Targeting (FIT) framework where the inflation target is set for 5 years.
The Monetary Policy Framework is the system through which the Reserve Bank of India (RBI) manages money supply, credit, and inflation in the economy. Its main goal is to keep inflation under control while also ensuring enough money is available for economic growth. Since 2016, India follows a Flexible Inflation Targeting (FIT) framework where the inflation target is set for 5 years.
Detailed Notes (16 points)
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Broad Objectives of Monetary Policy (as explained by former RBI Governor C. Rangarajan)
To regulate the amount of money in the economy so that prices do not rise too quickly (price stability).
To make sure there is enough credit (loans from banks) available for businesses and people to support growth in jobs and income.
Evolution of Framework
Earlier system: RBI tried to balance inflation (rise in prices) and growth, but there was no fixed or legal target for inflation.
Problem: Without a clear target, inflation sometimes went too high or too low, creating uncertainty.
Solution in 2016: The RBI Act was amended to introduce a new system called the Flexible Inflation Targeting (FIT) framework.
Under this, the Government of India, in consultation with RBI, sets an official inflation target once every 5 years.
Present Monetary Policy Framework
Inflation in India is measured using the Consumer Price Index (CPI), which shows the average price change of goods and services consumed by households.
In August 2016, the Govt fixed the inflation target at 4% CPI with an upper tolerance of 6% and a lower tolerance of 2%.
This means inflation should ideally stay close to 4%. But if it stays between 2% and 6%, it is still acceptable.
First 5-year period: Aug 2016 – March 2021.
Second 5-year period: April 2021 – March 2026 (target retained at 4% ± 2%).
RBI uses this target to decide monetary tools like repo rate, reverse repo, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open Market Operations (OMO).
Importance: This framework makes RBI more accountable and helps people and businesses trust that inflation will stay under control.
Inflation Target Framework in India
| Period | Target Inflation | Tolerance Band | Remarks |
|---|---|---|---|
| 2016–2021 | 4% CPI | ±2% (2-6%) | First official inflation target under FIT framework |
| 2021–2026 | 4% CPI | ±2% (2-6%) | Target retained for next 5 years |
Mains Key Points
Monetary Policy Framework creates balance between price stability and growth.
Flexible Inflation Targeting makes RBI more accountable and transparent.
Helps in anchoring inflation expectations among people and businesses.
Ensures inflation measured through CPI remains central to policy decisions.
Challenges remain: supply-side factors like fuel and food prices are beyond RBI’s control.
Prelims Strategy Tips
2016 amendment to RBI Act introduced Flexible Inflation Targeting (FIT).
Inflation target = 4% CPI with 2–6% tolerance band.
Target is set once every 5 years by Govt in consultation with RBI.
Current validity: April 2021 – March 2026.
Monetary Policy Committee (MPC)
Key Point
The Monetary Policy Committee (MPC) is a six-member body formed under Section 45ZB of the amended RBI Act, 1934. It was first set up in September 2016. The MPC decides the policy repo rate needed to achieve the inflation target (currently 4% CPI within 2-6% band). It meets at least 4 times a year, usually once every two months.
The Monetary Policy Committee (MPC) is a six-member body formed under Section 45ZB of the amended RBI Act, 1934. It was first set up in September 2016. The MPC decides the policy repo rate needed to achieve the inflation target (currently 4% CPI within 2-6% band). It meets at least 4 times a year, usually once every two months.
Detailed Notes (29 points)
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About MPC
Established under RBI Act amendment, 2016 to give collective decision-making power in monetary policy.
Ensures transparency, accountability, and reduces sole dependency on RBI Governor.
Decides the repo rate to achieve inflation target under Flexible Inflation Targeting framework.
Composition of MPC
Total Members: 6.
3 from RBI:
RBI Governor (Chairperson, ex-officio).
RBI Deputy Governor (ex-officio).
One member nominated by RBI Central Board.
3 nominated by Central Government:
Selected by a Search-cum-Selection Committee headed by Cabinet Secretary (RBI Governor is also part of this committee).
Hold office for 4 years.
Not eligible for reappointment.
Working of MPC
Quorum: Minimum 4 members required for a meeting.
Voting: Each member has one vote. In case of tie, RBI Governor has casting vote.
Frequency: Meets at least 4 times a year, usually every 2 months.
RBI publishes a Monetary Policy Report (every 6 months) covering:
Past 6 months’ inflation trends.
Inflation and growth projections.
Economic assessment and risks.
Failure to Maintain Inflation Target
Section 45ZN of RBI Act: If inflation stays outside 2-6% band for 3 consecutive quarters (9 months), RBI must:
Call a special MPC meeting.
Submit report to Central Govt explaining reasons for failure.
Suggest corrective actions.
Provide timeline for bringing inflation back within target.
Example: In November 2022, RBI had to submit such a report as inflation stayed above 6% for 3 consecutive quarters.
Monetary Policy Committee (MPC) Composition
| Member | Nominated By | Details |
|---|---|---|
| RBI Governor | RBI | Chairperson, ex-officio |
| RBI Deputy Governor | RBI | Ex-officio member |
| One member from RBI Central Board | RBI | Nominated by RBI Board |
| Three external members | Central Govt | Selected for 4 years, no reappointment |
Mains Key Points
MPC institutionalizes monetary policy decisions, ensuring collective wisdom instead of one-person discretion.
Brings transparency, accountability, and predictability in RBI’s decisions.
Supports the inflation targeting regime (FIT) by setting repo rate accordingly.
Failure clause ensures RBI explains its actions, increasing credibility.
November 2022 was first instance RBI submitted a report after failing inflation target.
Prelims Strategy Tips
MPC established under Section 45ZB of RBI Act, 1934 (amended in 2016).
Total 6 members: 3 RBI + 3 Govt nominated.
Repo rate is decided by MPC to achieve inflation target (4% ± 2%).
Governor has casting vote in case of tie.
Special report required if inflation outside 2–6% for 3 consecutive quarters (Sec 45ZN).
Instruments of Monetary Policy – Quantitative Tools
Key Point
Quantitative tools of monetary policy are used by the RBI to control the overall supply of money and credit in the economy. The most important among them are Repo Rate, Reverse Repo Rate, Bank Rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open Market Operations (OMO).
Quantitative tools of monetary policy are used by the RBI to control the overall supply of money and credit in the economy. The most important among them are Repo Rate, Reverse Repo Rate, Bank Rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Open Market Operations (OMO).
Detailed Notes (17 points)
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Quantitative Tools
These tools regulate the total volume of money and credit in the economy, without focusing on any specific sector.
Examples: Repo rate, Reverse repo rate, Bank rate, CRR, SLR, OMO.
Cash Reserve Ratio (CRR)
CRR is the percentage of a commercial bank’s Net Demand and Time Liabilities (NDTL) that must be kept in cash with RBI.
This money cannot be used by banks for lending or investment and RBI does not pay any interest on it.
Applies only to scheduled commercial banks (not RRBs or NBFCs).
Example: If CRR = 4% and a bank has deposits worth ₹100 crore, it must keep ₹4 crore with RBI.
Recent Changes: During COVID (2020) it was reduced to 3%. In 2022, increased to 4.5%.
Statutory Liquidity Ratio (SLR)
SLR is the percentage of a commercial bank’s NDTL that must be kept in the form of liquid assets like cash, gold, or approved government securities.
Unlike CRR, SLR is not kept with RBI but maintained by the banks themselves.
It acts as a safety net against excessive withdrawals and maintains public confidence in banks.
Example: If SLR = 18% and a bank has ₹100 crore in deposits, it must keep ₹18 crore in liquid assets.
As per Banking Regulation Act, 1949, maximum SLR can be up to 40% (presently 18%).
CRR vs. SLR
Both are statutory reserve ratios that reduce lending capacity of banks, but differ in form and purpose.
Comparison: CRR vs. SLR
| Aspect | CRR | SLR |
|---|---|---|
| Definition | Minimum cash % of deposits kept with RBI | Minimum % of deposits in cash, gold, or approved securities kept by banks themselves |
| Legal Basis | RBI Act, 1934 | Banking Regulation Act, 1949 |
| Where Held | With RBI | With Banks themselves |
| Interest | No interest paid by RBI | Banks can earn some interest on securities |
| Current Rate | 4.5% of NDTL | 18% of NDTL |
| Limit | No fixed maximum, but not 100% | Cannot exceed 40% |
Mains Key Points
CRR and SLR are key tools to control inflation and liquidity in the economy.
Higher CRR/SLR = less money for lending = contractionary effect.
Lower CRR/SLR = more money for lending = expansionary effect.
They ensure financial discipline and protect depositors’ money.
CRR directly affects bank liquidity; SLR provides a buffer for financial stability.
Prelims Strategy Tips
CRR is maintained with RBI in cash form; SLR is maintained with banks themselves in cash/gold/securities.
CRR = 4.5% (2022), SLR = 18%.
CRR governed by RBI Act, 1934; SLR governed by Banking Regulation Act, 1949.
Both CRR and SLR reduce lending capacity of banks.
CRR, SLR, SDF and LAF in Monetary Policy
Key Point
CRR and SLR are statutory reserve requirements that directly affect money supply, interest rates, and economic activity. RBI also uses new tools like the Standing Deposit Facility (SDF) and Liquidity Adjustment Facility (LAF) to manage liquidity, inflation, and stability in the financial system.
CRR and SLR are statutory reserve requirements that directly affect money supply, interest rates, and economic activity. RBI also uses new tools like the Standing Deposit Facility (SDF) and Liquidity Adjustment Facility (LAF) to manage liquidity, inflation, and stability in the financial system.
Detailed Notes (36 points)
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Impact of Increasing or Decreasing CRR/SLR
When CRR/SLR increases:
Banks must keep more money with RBI (CRR) or in liquid assets (SLR).
Less loanable money remains with banks → they raise interest rates.
Borrowing decreases → investments and consumption reduce.
This reduces demand → lowers inflation (but may slow down growth).
When CRR/SLR decreases:
Banks have more loanable funds available.
They reduce lending rates → more borrowing.
Investments and consumption rise → boosts production and growth.
But excessive credit can cause inflation.
Recent CRR Changes
2019: CRR was 4%.
2020: Reduced to 3% after lockdown to support economy during GDP contraction.
2021: Raised back to 4% due to inflation from supply chain disruptions (COVID).
May 2022: Increased from 4% to 4.5% (absorbed ₹87,000 crore liquidity) due to inflation from post-pandemic effects and Russia-Ukraine war.
Standing Deposit Facility (SDF)
Introduced by RBI in April 2022.
Replaced fixed Reverse Repo Rate as floor of Liquidity Adjustment Facility (LAF) corridor.
Proposed by Urjit Patel Committee (2014), enabled by RBI Act amendment (2018).
Difference from Reverse Repo: Banks park excess funds with RBI without RBI giving collateral (no need for RBI to provide G-Secs).
Reverse Repo Rate remains in toolkit, used as per RBI discretion.
Currently: SDF is 25 basis points (0.25%) below Repo Rate.
Significance:
Helps RBI absorb large liquidity during extraordinary times (e.g., post-2008 financial crisis, 2016 demonetisation).
Banks can voluntarily park excess liquidity with RBI under SDF.
Liquidity Adjustment Facility (LAF)
Introduced in 2000 (Narasimham Committee, 1998).
Facility for scheduled commercial banks (except RRBs) and Primary Dealers.
Purpose: Manage day-to-day liquidity.
Mechanism:
Repo Rate → Banks borrow from RBI against G-Secs (adds liquidity).
Reverse Repo Rate → Banks lend to RBI by parking funds (absorbs liquidity).
Benefits:
Helps control inflation by adjusting liquidity.
Provides short-term liquidity support to banks during shocks or instability.
Effect of CRR/SLR on Inflation & Growth
| Condition | Impact on Banks | Impact on Economy |
|---|---|---|
| CRR/SLR Increases | Less money to lend, higher interest rates | Reduced borrowing, demand falls, inflation decreases |
| CRR/SLR Decreases | More money to lend, lower interest rates | More borrowing, demand rises, growth increases (but risk of inflation) |
Comparison: SDF vs Reverse Repo vs LAF
| Aspect | SDF | Reverse Repo | LAF |
|---|---|---|---|
| Introduced | 2022 | 2000 (LAF toolkit) | 2000 |
| Collateral | No collateral required | RBI provides collateral (G-Secs) | G-Secs required |
| Position | Floor of LAF corridor | Part of LAF toolkit | Umbrella facility |
| Purpose | Absorb large liquidity quickly | Absorb day-to-day liquidity | Daily liquidity adjustment |
Mains Key Points
Changes in CRR/SLR directly impact liquidity, inflation, and growth trade-offs.
SDF strengthens RBI’s ability to absorb liquidity without collateral.
LAF provides a flexible mechanism to handle daily liquidity needs of banks.
These tools together enhance RBI’s effectiveness in monetary management.
Global events (like COVID, Ukraine war) show why CRR, SLR, SDF, and LAF must be dynamic.
Prelims Strategy Tips
CRR ↑ = contractionary, inflation ↓. CRR ↓ = expansionary, growth ↑.
SLR maintained in cash/gold/securities with banks, CRR in cash with RBI.
SDF introduced in April 2022, no collateral required.
LAF = Repo + Reverse Repo, introduced in 2000 (Narasimham Committee).
Liquidity Adjustment Facility (LAF) and Inflation Control
Key Point
LAF is a mechanism used by RBI to manage short-term liquidity in the economy through Repo and Reverse Repo rates. By adjusting these rates, RBI influences the cost of borrowing for banks, which directly affects lending rates, demand for credit, and ultimately inflation or growth.
LAF is a mechanism used by RBI to manage short-term liquidity in the economy through Repo and Reverse Repo rates. By adjusting these rates, RBI influences the cost of borrowing for banks, which directly affects lending rates, demand for credit, and ultimately inflation or growth.
Detailed Notes (29 points)
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How LAF Controls Inflation
When inflation is high:
RBI increases Repo Rate → borrowing for banks becomes costlier.
Banks raise loan interest rates for people and businesses.
Borrowing decreases → demand for goods/services falls → inflation reduces.
When economy slows down:
RBI reduces Repo Rate → borrowing becomes cheaper.
Banks lower lending rates → people and businesses borrow more.
Higher demand boosts investment, consumption, and growth.
Reverse Repo Rate and Inflation
During high inflation:
RBI increases Reverse Repo Rate → banks prefer to park money with RBI for safe returns.
Loanable funds reduce → lending becomes expensive → demand falls → inflation cools down.
During slowdown:
RBI reduces Reverse Repo Rate → banks earn less by parking funds with RBI.
Banks lend more to public → demand rises → economy revives.
Repo Rate – Mechanism
Repo Rate = rate at which commercial banks borrow short-term funds from RBI against government securities.
When repo increases: borrowing for banks costly → banks raise interest rates → less borrowing by public → inflation reduces.
When repo decreases: borrowing for banks cheap → banks lower interest rates → more borrowing → boosts demand and growth.
Reverse Repo Rate – Mechanism
Reverse Repo Rate = interest paid by RBI to banks when they park surplus funds with RBI.
Higher reverse repo: attractive for banks → they keep funds with RBI instead of lending → liquidity reduces → inflation falls.
Lower reverse repo: unattractive for banks → they lend more → increases liquidity → supports growth.
Examples of RBI Actions
Feb 2019–May 2020: Repo reduced by 225 bps (6.25% → 4%) due to slowdown after GST and Demonetisation.
May 2020–Apr 2022: Repo kept at 4% during COVID lockdown to support economy.
May 2022–Feb 2023: Repo increased by 250 bps (4% → 6.5%) due to inflation above 6% from supply disruptions & Russia-Ukraine war.
COVID Example: Demand for loans was low, so banks parked money in RBI via reverse repo. RBI reduced reverse repo drastically to 3.35% to discourage parking and push banks to lend.
Repo vs Reverse Repo – Impact on Inflation
| Tool | When Increased | When Decreased |
|---|---|---|
| Repo Rate | Borrowing costly → demand falls → inflation reduces | Borrowing cheap → demand rises → growth increases |
| Reverse Repo Rate | Banks park more funds with RBI → less lending → inflation reduces | Banks park less with RBI → more lending → growth increases |
Repo Rate Changes (2019–2023)
| Period | Change in Repo Rate | Reason |
|---|---|---|
| Feb 2019 – May 2020 | Reduced from 6.25% → 4% (225 bps cut) | Economic slowdown after GST & Demonetisation |
| May 2020 – Apr 2022 | Maintained at 4% | COVID lockdown and negative GDP growth |
| May 2022 – Feb 2023 | Increased from 4% → 6.5% (250 bps hike) | High inflation due to supply chain issues & Ukraine-Russia war |
Mains Key Points
LAF provides a flexible framework to manage daily liquidity and inflation control.
Repo rate is RBI’s primary tool to influence borrowing costs and demand.
Reverse Repo complements repo by absorbing excess liquidity when needed.
RBI adjusts repo/reverse repo based on economic cycles – slowdown vs inflationary pressure.
Real examples (COVID, Ukraine war) show how repo/reverse repo changes directly impact inflation and growth.
Prelims Strategy Tips
Repo Rate = banks borrow from RBI; Reverse Repo Rate = banks lend to RBI.
Repo ↑ → contractionary → inflation ↓; Repo ↓ → expansionary → growth ↑.
Reverse Repo ↑ → banks park funds with RBI → inflation ↓.
Reverse Repo ↓ → banks lend more → growth ↑.
LAF introduced in 2000 on Narasimham Committee recommendation.
Reverse Repo Rate, MSF and Open Market Operations (OMO)
Key Point
Reverse Repo, MSF, and OMO are important instruments of RBI’s monetary policy to control liquidity and inflation. They influence how much money is available in the market, thereby affecting inflation, growth, and stability of the financial system.
Reverse Repo, MSF, and OMO are important instruments of RBI’s monetary policy to control liquidity and inflation. They influence how much money is available in the market, thereby affecting inflation, growth, and stability of the financial system.
Detailed Notes (26 points)
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Mechanism of Reverse Repo Rate
When RBI increases Reverse Repo Rate:
Banks get higher interest from RBI.
Banks prefer lending to RBI instead of public/businesses.
Market money supply reduces → controls inflation.
When RBI decreases Reverse Repo Rate:
Parking money with RBI becomes unattractive.
Banks lend more to public and businesses.
Increases liquidity → boosts growth.
COVID-19 Example (Reverse Repo)
During COVID slowdown, loan demand decreased.
By March 2020: Banks parked ~₹3 lakh crore with RBI via Reverse Repo.
RBI reduced Reverse Repo to 3.35% to discourage parking and force banks to lend.
Example: If SBI gives 5.9% FD interest to depositors but earns only 3.35% from RBI, it makes losses. Hence, SBI would prefer lending to customers.
Marginal Standing Facility (MSF)
Introduced in 2011.
Penal interest rate at which banks borrow overnight from RBI by pledging G-Secs (up to 2% of SLR quota).
Acts as safety valve when interbank liquidity dries up.
Last resort borrowing option after LAF and other sources are exhausted.
MSF = Upper bound of LAF corridor (25 bps above Repo Rate).
Purpose: Provides emergency liquidity support to banking system.
Open Market Operations (OMO)
OMO = RBI buys and sells Government Securities (G-Secs) in the open market.
RBI buys G-Secs → injects money → increases liquidity → boosts growth (used in slowdown).
RBI sells G-Secs → absorbs money → reduces liquidity → controls inflation (used in high inflation periods).
OMO is a flexible tool used frequently along with Repo/Reverse Repo.
Comparison: Reverse Repo vs MSF vs OMO
| Instrument | Meaning | Purpose | Position in LAF Corridor |
|---|---|---|---|
| Reverse Repo | Rate RBI pays to banks when they park funds | Absorb excess liquidity, control inflation | Floor (lower bound) |
| MSF | Penal overnight borrowing from RBI against G-Secs (up to 2%) | Emergency liquidity support | Ceiling (upper bound) |
| OMO | Buying & selling of Govt. Securities in open market | Inject or absorb liquidity as per need | Not part of corridor but used flexibly |
Mains Key Points
Reverse Repo influences banks’ preference between lending to RBI vs public, thus controlling liquidity.
MSF acts as an emergency support tool to prevent liquidity shocks in the banking system.
OMO provides RBI with flexibility to adjust liquidity depending on inflation or slowdown.
Together, these instruments ensure stability of financial markets and effective inflation control.
Examples: COVID slowdown (reverse repo reduction), inflationary periods (OMO selling).
Prelims Strategy Tips
Reverse Repo = floor of LAF corridor, MSF = ceiling of LAF corridor.
MSF introduced in 2011, last resort borrowing option.
OMO = RBI buys (injects liquidity) / sells (absorbs liquidity) G-Secs.
During COVID (2020), RBI reduced reverse repo to 3.35% to discourage banks from parking funds.
Other Monetary Policy Measures by RBI
Key Point
Apart from Repo, Reverse Repo, CRR, and SLR, RBI uses additional instruments like Variable Rate Reverse Repo (VRRR), Bank Rate, and Operation Twist to manage liquidity, inflation, and interest rates in the economy. These tools help in fine-tuning monetary policy and ensuring better transmission to markets and banks.
Apart from Repo, Reverse Repo, CRR, and SLR, RBI uses additional instruments like Variable Rate Reverse Repo (VRRR), Bank Rate, and Operation Twist to manage liquidity, inflation, and interest rates in the economy. These tools help in fine-tuning monetary policy and ensuring better transmission to markets and banks.
Detailed Notes (30 points)
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Variable Rate Reverse Repo (VRRR)
Introduced in 2021 due to inflationary pressures after global supply chain disruptions.
Unlike fixed reverse repo (at RBI-decided rate), VRRR is conducted through auctions on RBI’s e-KUBER platform.
Banks bid interest rates at which they want to park funds with RBI.
Key Features:
Minimum bid: ₹1 crore (multiples only).
Bids at or above Repo Rate are rejected.
Accepted bids are those below Repo Rate and below the cut-off rate.
Purpose: To absorb excess liquidity from the banking system more efficiently.
Bank Rate
Published under Section 49 of RBI Act, 1934.
Earlier: Rate at which RBI lent long-term funds to commercial banks (influenced lending rates).
Now: Functions mainly as a penal rate charged on banks for shortfalls in CRR/SLR requirements.
Aligned with MSF: Changes automatically when MSF changes.
Less important today as Repo/Reverse Repo are the main policy tools.
Operation Twist
Unconventional monetary policy used first by US Federal Reserve in 1961.
Adopted by RBI in 2019–2020 to manage bond yields and stimulate growth.
Mechanism: Simultaneous buying & selling of government securities (short-term vs long-term) via OMOs.
RBI buys long-term G-Secs → demand ↑ → price ↑ → yield ↓.
RBI sells short-term G-Secs → supply ↑ → price ↓ → yield ↑.
Why RBI introduced it in India:
Indian economy slowdown in 2019; banks reluctant to lend due to high NPAs & low demand.
Aim: Reduce yields on long-term G-Secs to make corporate bonds more attractive.
This helped companies raise money through bonds and pushed banks to lower lending rates.
Important: Operation Twist was not aimed at inflation control but at reducing borrowing costs for companies and government.
Outcome:
Improved monetary policy transmission.
Deepened corporate bond market as an alternative to bank loans.
Lowered interest rates indirectly in the economy.
Comparison of VRRR, Bank Rate, and Operation Twist
| Instrument | Year Introduced | Purpose | Key Feature |
|---|---|---|---|
| VRRR | 2021 | Absorb excess liquidity via auctions | Banks bid rates below repo rate on e-KUBER |
| Bank Rate | 1934 (RBI Act) | Earlier – long-term lending rate; Now – penal rate | Aligned with MSF, automatic change |
| Operation Twist | 1961 (US), 2019 (India) | Reduce long-term G-Sec yields, deepen bond market | Simultaneous buying (long-term) & selling (short-term) of G-Secs |
Mains Key Points
VRRR is a market-based tool ensuring efficient liquidity absorption compared to fixed reverse repo.
Bank Rate has lost prominence but continues as penal mechanism linked with MSF.
Operation Twist shows RBI’s shift towards unconventional monetary policies to improve monetary transmission.
Helps corporate sector raise funds via bonds, easing stress on banks.
These measures complement traditional tools like Repo/CRR/SLR for better monetary management.
Prelims Strategy Tips
VRRR introduced in 2021; conducted via e-KUBER auction; bids must be below Repo Rate.
Bank Rate under Sec 49 of RBI Act, 1934; now acts as penal rate; aligned with MSF.
Operation Twist first by US Fed (1961), RBI adopted in 2019–2020.
Operation Twist aimed at reducing long-term bond yields, not inflation control.
Retail Direct Scheme, G-SAP, Special Repo Windows & LAF Corridor
Key Point
RBI has recently introduced innovative measures like Retail Direct Scheme (direct G-Sec access for retail investors), Government Securities Acquisition Programme (G-SAP), Long Term Repo Operations (LTRO variants), and special On-Tap liquidity windows during COVID. Alongside, the LAF Corridor framework ensures stability in liquidity management by defining the relationship between Repo, MSF, and SDF.
RBI has recently introduced innovative measures like Retail Direct Scheme (direct G-Sec access for retail investors), Government Securities Acquisition Programme (G-SAP), Long Term Repo Operations (LTRO variants), and special On-Tap liquidity windows during COVID. Alongside, the LAF Corridor framework ensures stability in liquidity management by defining the relationship between Repo, MSF, and SDF.
Detailed Notes (41 points)
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Retail Direct Scheme (2021)
Allows retail investors to directly buy government securities (G-Sec, T-Bills, State bonds, and Sovereign Gold Bonds) from RBI’s e-KUBER platform.
Investors must open a Retail Direct Gilt (RDG) account.
No application fee to open the account.
Both resident Indians and NRIs can participate.
Investors can buy in primary issues and trade in secondary market via RBI’s NDS-OM system.
Earlier: Retail investors could only access G-Secs indirectly through mutual funds.
Government Securities Acquisition Programme (G-SAP) – 2021
RBI buys G-Secs from the secondary market to infuse liquidity (special type of OMO).
Unique: RBI announces the entire schedule (amount + dates) in advance, making it transparent.
Benefits:
Increases money supply and supports post-COVID economic revival.
Investors selling G-Secs to RBI get cash to invest elsewhere (shares, bonds).
Helps reduce gap between Repo Rate and 10-year G-Sec yield.
Difference from Operation Twist:
Operation Twist: simultaneous buy/sell (short-term vs long-term G-Secs).
G-SAP: only buying G-Secs with pre-declared schedule.
Special Repo Windows during COVID
# Long Term Repo Operations (LTRO)
Introduced to provide 1–3 year loans at Repo Rate instead of overnight loans.
Goal: Inject liquidity and support productive sectors.
# Targeted LTRO (TLTRO)
RBI gave 3-year loans at Repo Rate, but banks had to invest part of the money in corporate bonds, debentures, and commercial papers.
Aim: Push credit into stressed sectors.
# Special LTRO (SLTRO)
RBI gave 3-year repo loans to Small Finance Banks (SFBs).
Goal: Support micro and small industries and unorganised sector entities.
# On-Tap Liquidity Windows
Healthcare: 3-year loans at Repo Rate for hospitals, vaccine makers, oxygen suppliers, etc.
Contact-Intensive Sectors: Hotels, restaurants, transport, salons, etc. – severely hit by COVID.
LAF Corridor
Framework with three key rates:
Standing Deposit Facility (SDF): Lower bound/floor.
Repo Rate: Middle (benchmark rate).
Marginal Standing Facility (MSF): Upper bound/ceiling.
Example (Feb 2023):
Repo Rate = 6.5%.
SDF = 6.25% (Repo – 0.25%).
MSF = 6.75% (Repo + 0.25%).
Width of corridor = Difference between MSF & SDF = 0.5% (50 basis points).
Significance: Provides structure to monetary policy operations, guiding liquidity absorption and injection.
Comparison of OMO, Operation Twist, and G-SAP
| Instrument | Mechanism | Purpose | Schedule |
|---|---|---|---|
| OMO | RBI buys/sells G-Secs | Control inflation/deflation | Not pre-announced |
| Operation Twist | Buy long-term, Sell short-term G-Secs | Reduce long-term yields, make borrowing cheaper | Not fixed, tactical |
| G-SAP | RBI buys G-Secs only | Infuse liquidity post-COVID revival | Pre-announced schedule |
Mains Key Points
Retail Direct democratizes access to government securities for small investors.
G-SAP shows RBI’s use of forward guidance and transparency in liquidity injection.
LTRO/TLTRO/SLTRO highlight RBI’s targeted approach during crisis (COVID).
On-Tap windows show flexibility in addressing sector-specific shocks.
LAF Corridor provides structure, stability, and predictability to monetary policy operations.
Prelims Strategy Tips
Retail Direct Scheme launched in 2021; RDG account required.
G-SAP = special OMO with pre-announced schedule; started in 2021.
LTRO/TLTRO/SLTRO introduced during COVID for long-term liquidity support.
LAF Corridor = MSF (ceiling), Repo (middle), SDF (floor). Width = MSF – SDF.
Marginal Standing Facility (MSF) and Open Market Operations (OMO)
Key Point
MSF is an emergency borrowing facility for banks at a penal interest rate, introduced in 2011 as the ceiling of the LAF corridor. OMO is RBI’s regular tool to inject or absorb liquidity by buying/selling government securities in the market.
MSF is an emergency borrowing facility for banks at a penal interest rate, introduced in 2011 as the ceiling of the LAF corridor. OMO is RBI’s regular tool to inject or absorb liquidity by buying/selling government securities in the market.
Detailed Notes (21 points)
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Marginal Standing Facility (MSF)
Introduced in 2011 as part of RBI’s monetary policy toolkit.
It is the rate at which banks can borrow short-term (overnight) funds from RBI when they face acute liquidity shortages.
Banks pledge Government Securities (G-Secs) from their Statutory Liquidity Ratio (SLR) quota as collateral (up to 2% of NDTL).
MSF is always set 25 basis points (bps) above Repo Rate (penal rate).
Example: If Repo Rate = 6.50%, MSF = 6.75%.
Purpose:
Provides a ‘safety valve’ when interbank lending dries up.
Prevents panic during sudden liquidity shocks.
Last resort: Used only after exhausting other options like borrowing from market or using LAF.
Open Market Operations (OMO)
RBI buys or sells G-Secs in the open market to control liquidity.
Mechanism:
RBI Buys G-Secs → Gives money to banks/investors → Injects liquidity → Stimulates economy (done in slowdown/recession).
RBI Sells G-Secs → Takes money from banks/investors → Reduces liquidity → Controls inflation (done during high inflation).
Importance:
Helps RBI manage inflation, money supply, and interest rates.
Used flexibly depending on economic conditions.
Example:
2020 COVID slowdown → RBI bought G-Secs to inject liquidity.
2022 high inflation → RBI sold G-Secs to absorb excess liquidity.
MSF vs OMO
| Feature | MSF | OMO |
|---|---|---|
| Introduction | 2011 | Long-standing RBI tool |
| Purpose | Emergency borrowing for banks | Liquidity management in economy |
| Rate | 25 bps above Repo (penal) | Market-driven (depends on buy/sell G-Secs) |
| Collateral | Banks pledge G-Secs (up to 2% of SLR) | RBI directly buys/sells G-Secs |
| Usage | Last resort in crisis | Regularly used depending on inflation/growth needs |
Mains Key Points
MSF strengthens financial stability by acting as emergency cushion.
OMO is flexible and widely used to balance inflation and growth.
Together, MSF (emergency) + OMO (regular tool) provide RBI with control over liquidity shocks and long-term policy goals.
MSF penal rate discourages over-reliance, while OMO ensures market stability.
Prelims Strategy Tips
MSF introduced in 2011; last resort borrowing option for banks.
MSF = Repo + 25 bps.
OMO = RBI buying/selling G-Secs to manage liquidity.
OMO injects liquidity in slowdown (buy) and absorbs liquidity in inflation (sell).
Qualitative Tools of Monetary Policy
Key Point
Unlike quantitative tools (CRR, SLR, Repo, OMO), which change the overall money supply in the economy, qualitative tools are selective. They guide or control the flow of credit towards or away from certain sectors or activities. These are also called Direct or Selective Instruments of RBI’s monetary policy.
Unlike quantitative tools (CRR, SLR, Repo, OMO), which change the overall money supply in the economy, qualitative tools are selective. They guide or control the flow of credit towards or away from certain sectors or activities. These are also called Direct or Selective Instruments of RBI’s monetary policy.
Detailed Notes (34 points)
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1. Margin Requirements / Loan-to-Value (LTV)
'Margin' = part of collateral not financed by the bank.
If margin requirement is high → loan amount is lower → discourages borrowing.
If margin requirement is low → loan amount is higher → encourages borrowing.
Example: Auto Loan
Margin requirement 20% → For ₹10 lakh collateral, loan = ₹8 lakh.
Margin requirement reduced to 10% → Loan = ₹9 lakh.
Used to encourage/discourage loans in housing, auto, business sectors.
2. Regulation of Consumer Credit
RBI can set loan terms like minimum down payment, EMI size, or maximum loan tenure.
During inflation → RBI increases down payment or EMI → reduces borrowing and consumption.
Example: Home Loan
RBI sets minimum down payment at 15%.
For ₹1 crore house → Borrower must pay ₹15 lakh upfront, loan = ₹85 lakh.
Affects credit flow in automobiles, real estate, consumer durables (TVs, fridges, etc.).
3. Credit Rationing
RBI directly limits loan amount for certain sectors regardless of eligibility.
Aim: Prevent speculative hoarding or misuse of credit.
Example: RBI may instruct banks not to lend beyond a set amount to onion/potato traders (to prevent hoarding of essentials).
4. Moral Suasion
'Persuasion without strict legal action'.
RBI uses meetings, circulars, statements, or Governor’s appeals to influence banks’ behavior.
Example:
Asking banks to pass repo rate cuts to customers.
Encouraging banks to open rural branches or lend more to farmers.
Advising financial literacy campaigns.
Works on cooperation and trust rather than compulsion.
5. Direct Action
RBI can punish or take strict action if banks/NBFCs violate rules or instructions.
Actions may be:
Monetary penalty (fines).
Non-monetary: restrictions, cancellation of license, changes in management, etc.
Example:
In 2019, RBI ordered 'Clawback Clause' in CEOs’ salaries: If a top executive was later found guilty of fraud/scam, earlier bonuses/salaries could be taken back, even if he had left the job.
Quantitative vs Qualitative Tools
| Aspect | Quantitative Tools | Qualitative Tools |
|---|---|---|
| Definition | Control overall money supply | Control direction of credit |
| Examples | CRR, SLR, Repo, OMO | Margin Requirements, Moral Suasion |
| Focus | Entire economy | Specific sectors/activities |
| Nature | Indirect, volume-based | Direct, selective |
| Impact | Affects inflation, growth | Affects allocation of credit |
Mains Key Points
Qualitative tools ensure credit reaches priority sectors while preventing misuse in speculative activities.
They complement quantitative tools for balanced monetary policy.
Help RBI align banking sector lending with developmental priorities (like agriculture, rural credit).
Limitations: Less effective in modern digital/market-driven economy where credit can move globally.
Still important for targeted interventions in inflation-sensitive commodities or vulnerable sectors.
Prelims Strategy Tips
Qualitative tools = Selective credit control measures.
Margin requirement (Loan-to-Value ratio) is a key tool.
Credit rationing limits lending to specific sectors.
Moral suasion is persuasion, not compulsion.
Direct Action involves penalties/sanctions on banks & NBFCs.
Priority Sector Lending (PSL)
Key Point
Priority Sector Lending (PSL) is a policy of the Reserve Bank of India (RBI) under which banks are mandated to provide a certain portion of their loans to specific sectors of the economy that are considered essential for the country’s growth, welfare, and inclusive development. These sectors include agriculture, micro-enterprises, weaker sections, housing, education, and renewable energy.
Priority Sector Lending (PSL) is a policy of the Reserve Bank of India (RBI) under which banks are mandated to provide a certain portion of their loans to specific sectors of the economy that are considered essential for the country’s growth, welfare, and inclusive development. These sectors include agriculture, micro-enterprises, weaker sections, housing, education, and renewable energy.
Detailed Notes (22 points)
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Overview
The term 'Priority Sector' was first used by RBI in 1968.
By 1985, banks were mandated to give 40% of their total loans to agriculture, small industries, and exporters.
Over time, more categories have been added like housing, education, renewable energy, and weaker sections.
PSL ensures that credit reaches those parts of society and economy which may otherwise be neglected by profit-driven lending.
Who is Covered under PSL?
Domestic Commercial Banks – Must give at least 40% of Adjusted Net Bank Credit (ANBC) as PSL.
Foreign Banks (≥20 branches) – 40% of ANBC.
Foreign Banks (<20 branches) – 40% of ANBC.
Regional Rural Banks (RRBs) – 75% of ANBC.
Small Finance Banks – 75% of ANBC.
Urban Cooperative Banks – 75% of ANBC (to be achieved by March 31, 2024).
Targets for Commercial Banks
Agriculture – 18% of ANBC (out of which 10% must go to small and marginal farmers).
Micro Enterprises – 7.5%.
Weaker Sections (SC, ST, Women, Physically Handicapped, Manual Scavengers, Artisans, NRLM/ NULM beneficiaries) – 12%.
Other Sectors (Education, Housing, Social Infrastructure, Export Credit, Renewable Energy) – 2.5%.
Overall PSL requirement – Minimum 40% of ANBC.
Important Notes
These are minimum targets – banks can lend more if they wish.
Loans given by banks to NBFCs that further lend to PSL categories are also counted towards PSL quota.
PSL rules are binding only on banks, not on NBFCs.
PSL Targets for Banks
| Bank Type | Target |
|---|---|
| Domestic Commercial Banks | 40% of ANBC |
| Foreign Banks (≥20 branches) | 40% of ANBC |
| Foreign Banks (<20 branches) | 40% of ANBC |
| Regional Rural Banks (RRBs) | 75% of ANBC |
| Small Finance Banks | 75% of ANBC |
| Urban Cooperative Banks | 75% of ANBC (by March 31, 2024) |
PSL Sectoral Targets for Commercial Banks
| Sector | Target |
|---|---|
| Agriculture | 18% (10% for small & marginal farmers) |
| Micro Enterprises | 7.5% |
| Weaker Sections | 12% |
| Other Sectors (Education, Housing, Social Infra, Export Credit, Renewable Energy) | 2.5% |
| Total | 40% of ANBC |
Mains Key Points
PSL ensures inclusive growth by channeling credit to agriculture, MSMEs, weaker sections, and social sectors.
Helps balance profit motive of banks with developmental goals of the government.
Important tool for financial inclusion and rural credit delivery.
Criticism: Banks sometimes treat PSL as compulsion and may prefer indirect lending through NBFCs.
PSL has been key in supporting small farmers, artisans, and vulnerable groups.
Prelims Strategy Tips
PSL term first used in 1968 by RBI.
By 1985, PSL target was fixed at 40%.
Agriculture PSL = 18% (10% small & marginal farmers).
RRBs, SFBs, and UCBs have 75% PSL target.
PSL rules apply only to banks, not NBFCs.
PSL Certificates and Assessment of RBI’s Monetary Policy
Key Point
PSL Certificates were introduced in 2016 to allow banks that exceed their Priority Sector Lending (PSL) targets to sell surplus lending as 'certificates' to banks that fall short. RBI’s monetary policy framework has achieved progress in growth support, inflation targeting, and transmission reforms, but faces challenges in effective implementation due to structural and external constraints.
PSL Certificates were introduced in 2016 to allow banks that exceed their Priority Sector Lending (PSL) targets to sell surplus lending as 'certificates' to banks that fall short. RBI’s monetary policy framework has achieved progress in growth support, inflation targeting, and transmission reforms, but faces challenges in effective implementation due to structural and external constraints.
Detailed Notes (27 points)
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PSL Certificates
Introduced in 2016 as a market-based mechanism.
If a bank lends more to PSL sectors than its target, it can sell the excess as PSL Certificates.
Banks that are short of their PSL target can buy these certificates to meet compliance.
Important: Only the certificate is transferred, not the loan itself or its risk.
Example: If Bank A’s PSL target is 40% but it achieves 45%, it can sell 5% worth of PSL Certificates to Bank B that achieved only 35%.
Assessment of RBI’s Monetary Policy
Economic Growth: RBI supported growth by keeping an accommodative stance, especially during COVID-19 when it reduced repo rate and infused liquidity.
Inflation Control: With the inflation-targeting framework (2016), RBI has kept CPI inflation within 2–6% band most of the time, ensuring price stability.
Transmission Mechanism: RBI introduced Marginal Cost of Funds based Lending Rate (MCLR) and later External Benchmark Lending Rate (EBLR) to improve rate transmission from repo to lending rates.
Challenges in Transmission of Monetary Policy
# 1. CPI vs WPI Debate
CPI (Consumer Price Index) is RBI’s official target, but WPI (Wholesale Price Index) is broader and available earlier.
WPI covers more commodities, tradeable items, and is pan-India, whereas CPIs are city/region-based.
# 2. Low Utility of Repo Rate
Indian banks rely more on deposits (people’s savings) rather than RBI borrowing, making repo rate changes less impactful.
# 3. Dependency on Uncontrollable Events
Agriculture heavily depends on monsoon → poor rains = food inflation.
Global crude oil dependence (80% imported) makes inflation sensitive to geopolitical events (Ukraine-Russia war, Gulf crisis, etc.).
# 4. Structural Issues
Weak infrastructure, high logistics costs, and poor ease of doing business raise domestic production costs compared to imports.
# 5. Challenges Faced by Banks
High NPAs, scams, and inefficiency in PSBs affect monetary policy transmission.
Rural areas: low financial literacy and weak banking habits reduce reach of RBI policy.
Small savings schemes like PPF and NSC compete with bank deposits, reducing banks’ control over savings.
# 6. Informal Credit in Rural India
Many farmers still rely on local moneylenders outside RBI’s regulation, weakening policy effectiveness.
CPI vs WPI as Inflation Indicators
| Aspect | CPI | WPI |
|---|---|---|
| Coverage | Household consumption basket | Wider coverage, incl. tradeables |
| Timeliness | Available with longer lag | Available faster |
| Geography | Constructed for centres/regions | Pan-India |
| Focus | Retail prices (consumers) | Wholesale prices (traders, producers) |
Mains Key Points
PSL Certificates make PSL compliance flexible and market-driven.
RBI’s monetary policy has improved credibility after inflation targeting (2016).
Transmission challenges highlight structural weaknesses in India’s economy and banking sector.
Dependence on monsoon and oil imports weakens RBI’s control over inflation.
Strengthening rural banking penetration and reducing NPAs are key to improving monetary policy effectiveness.
Prelims Strategy Tips
PSL Certificates introduced in 2016.
Certificates transfer compliance, not loans or risks.
RBI adopted Flexible Inflation Targeting in 2016: 4% CPI ± 2%.
MCLR (2016) and EBLR (2019) improved transmission of repo rate.
WPI is broader, CPI is official target for RBI.
How RBI Influences Bank’s Interest Rates
Key Point
RBI influences lending rates of banks through different regulatory frameworks. Over time, India has moved from the Base Rate (2010) → MCLR (2016) → External Benchmark Linked Lending Rate (2019). This ensures better and faster transmission of RBI’s policy rate changes (like repo rate) to the borrowers.
RBI influences lending rates of banks through different regulatory frameworks. Over time, India has moved from the Base Rate (2010) → MCLR (2016) → External Benchmark Linked Lending Rate (2019). This ensures better and faster transmission of RBI’s policy rate changes (like repo rate) to the borrowers.
Detailed Notes (30 points)
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1. Base Rate / Benchmark Prime Lending Rate (BPLR) – 2010
Introduced by RBI in July 2010.
Minimum interest rate set by RBI below which no bank (public or private) could lend.
Purpose: To bring transparency and stop banks from arbitrarily giving loans at very low rates to select customers.
Limitation: Transmission of repo rate changes was still slow and incomplete.
2. Marginal Cost of Funds based Lending Rate (MCLR) – 2016
Introduced in April 2016, replacing Base Rate.
Aim: To improve transmission of monetary policy rates to borrowers.
Components of MCLR:
Repo rate (base policy rate by RBI).
Operating costs of banks.
Cost of maintaining CRR (Cash Reserve Ratio).
Loan Tenor Premium (extra charge for long-term loans).
Limitation: Even with MCLR, banks did not always pass repo rate cuts immediately to borrowers. Delays reduced its effectiveness.
3. External Benchmark Linked Lending Rate (EBLR) – 2019
Implemented from October 1, 2019 by RBI.
Banks now must link lending rates to any external benchmark:
Repo rate.
Yield of 91-day Treasury Bill.
Yield of 182-day Treasury Bill.
Any benchmark market interest rate set by Financial Benchmark India Pvt Ltd (FBIL).
Features:
Lending rates automatically adjust with changes in external benchmark.
Interest rates must be reviewed at least every 3 months.
Ensures faster and transparent transmission of RBI’s policy rate cuts or hikes.
Eligible Borrowers under EBLR:
Retail Loans (Home, Vehicle, Consumer loans).
Personal Loans (emergency expenditures).
Loans to Micro & Small Enterprises.
Loans to Medium Enterprises.
Evolution of Lending Rate Framework
| System | Year Introduced | Features | Limitations |
|---|---|---|---|
| Base Rate / BPLR | 2010 | Minimum rate below which no loan can be given | Slow transmission, not transparent enough |
| MCLR | 2016 | Based on repo rate, costs, CRR, tenor premium | Delay in passing repo changes to customers |
| External Benchmark Rate | 2019 | Linked to repo, T-bills or FBIL benchmark; review every 3 months | More transparent and faster, but banks can add spread |
Mains Key Points
Base Rate, MCLR, and EBLR show RBI’s progressive steps to improve monetary policy transmission.
EBLR ensures quick alignment of bank lending rates with RBI policy rates.
Helps borrowers (retail, MSME) to benefit directly from repo rate cuts.
Still, banks maintain some flexibility by adding 'spread' above benchmark.
Overall, shift to external benchmarks improves transparency and accountability.
Prelims Strategy Tips
Base Rate introduced in 2010, replaced by MCLR in 2016.
MCLR = repo rate + CRR cost + operating cost + tenor premium.
External Benchmark Rate started Oct 1, 2019.
External benchmarks include Repo, 91-day/182-day T-bill yield, FBIL benchmark.
Interest rates must be reset every 3 months under EBLR.
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