RBI Monetary Policy — Fundamentals

What is Monetary Policy?

Monetary policy is the process by which the central bank (RBI in India) controls money supply and interest rates to achieve macroeconomic objectives: price stability, growth, and employment.

RBI's Mandate (since 2016 FIT framework):

•Primary: Maintain CPI inflation at 4% (band: 2%–6%)

•Secondary: Support growth while keeping inflation in check

Instruments of Monetary Policy

Quantitative Instruments (affect money supply volume)

Repo Rate

•Short form: Repurchase Agreement Rate

•Definition: Rate at which RBI lends overnight to commercial banks against G-Secs

•Impact of Repo Rate increase: Banks borrow at higher cost → raise lending rates → credit becomes expensive → consumers/businesses borrow less → demand falls → inflation moderates

•Impact of Repo Rate decrease: Reverse — stimulates credit and growth

CRR (Cash Reserve Ratio)

•Definition: % of a bank's NDTL (Net Demand and Time Liabilities) to be maintained as cash with RBI

•RBI pays NO interest on CRR balances

•Increase in CRR: Banks have less money to lend → credit contraction → controls inflation

•Current CRR: ~4% (verify before exam)

SLR (Statutory Liquidity Ratio)

•Definition: % of NDTL banks must hold in liquid assets (cash, gold, G-Secs)

•Banks earn interest on G-Secs (unlike CRR cash)

•Current SLR: ~18% (verify before exam)

•Higher SLR: More money parked safely → less available for lending to private sector

Open Market Operations (OMOs)

•RBI buys/sells G-Secs in open market

•OMO Purchase (by RBI): Injects liquidity (banks get cash, RBI gets G-Secs)

•OMO Sale (by RBI): Absorbs liquidity (banks give cash, RBI gives G-Secs)

MSF (Marginal Standing Facility)

•Emergency overnight window at 25 bps above Repo Rate

•Banks can borrow even against securities below SLR requirement

•Sets the upper bound of the Liquidity Adjustment Facility (LAF) corridor

SDF (Standing Deposit Facility)

•Replaced Reverse Repo in April 2022

•Banks park excess cash with RBI at SDF rate (25 bps below Repo)

•No collateral required (unlike Repo) — purely cash

•Sets the lower bound of the LAF corridor

Qualitative Instruments (affect direction/purpose of credit)

•Credit rationing for specific sectors

•Margin requirements (LTV ratios for home loans, gold loans)

•Moral suasion: RBI guidance to banks without formal rule

•Direct action: Penalties for non-compliance

The LAF Corridor

MSF Rate (Repo + 25 bps) ← upper bound
    |
Repo Rate (benchmark)
    |
SDF Rate (Repo - 25 bps) ← lower bound

The Weighted Average Call Rate (WACR) — overnight interbank rate — should stay within this corridor.

MPC — Monetary Policy Committee

Established under RBI Act 1934 (amended 2016):

Member	Appointed By

|--------|-------------|

RBI Governor (Chair)	Government
Deputy Governor (monetary policy)	Ex-officio
Executive Director	Ex-officio
External Member 1	Government (4-year term)
External Member 2	Government (4-year term)
External Member 3	Government (4-year term)

Decision: Simple majority. Governor has casting vote in tie.

Meetings: 6 per year (bi-monthly). Minutes released after 14 days.

Resolution: If inflation breaches 6% for 3 consecutive quarters — MPC must report to Government explaining why and remedial steps.

Transmission Problem in India

Monetary policy transmission is weak in India because:

1.Base Rate/MCLR lag: Banks slow to pass on rate cuts to borrowers

2.PSB dominance: Public sector banks (65%+ market) slower to respond vs private banks

3.Inflation expectations: Entrenched food inflation affects expectations regardless of repo rate

4.Savings culture: Households prefer fixed deposits → deposit rates influence lending rates more than repo

5.Structural bottlenecks: Supply-side inflation (onion, tomato, fuel) not responsive to monetary tools

Solution attempts: External Benchmark Lending Rate (EBLR) mandated for retail/MSME loans from Oct 2019 — directly linked to repo rate, revises monthly. Faster transmission than MCLR.

Inflation Measurement in India

Index	Base Year	Measures	Released By

|-------|-----------|---------|------------|

CPI (Consumer Price Index)	2012	Retail prices at consumer level — RBI target	MOSPI (monthly)
CPI Rural, Urban, Combined	2012	Separate for rural/urban	MOSPI
WPI (Wholesale Price Index)	2011-12	Wholesale prices at producer level — not RBI target	DPIIT (monthly)
PPI (Producer Price Index)	Planned	Replace WPI eventually	—

CPI basket weights:

•Food & Beverages: 45.86% (highest — why food inflation affects CPI so much)

•Housing: 10.07%

•Fuel & Light: 6.84%

•Miscellaneous (health, education, etc.): 28.32%

Core inflation = CPI minus food and fuel — less volatile, shows underlying demand pressure. RBI watches core closely for monetary policy decisions.

RBI & Monetary Policy — Fundamentals