In this guide
Every couple of months, the Reserve Bank of India's Monetary Policy Committee announces a decision that is reported on every front page: the repo rate is raised, cut or held. For UPSC, you need to know what that rate is, how the RBI's other tools work alongside it, who decides, and why rate changes take time to affect the economy.
What monetary policy is for
Monetary policy is the use of interest rates and the money supply to influence demand, inflation and growth. In India, its primary objective — set by law since 2016 — is price stability while keeping in mind the objective of growth, with a target of 4 per cent CPI inflation (tolerance band 2–6 per cent).
The Monetary Policy Committee
- Created by the 2016 amendment to the RBI Act, 1934.
- Six members: three from the RBI (the Governor, who chairs it, a Deputy Governor and one other RBI officer) and three external members appointed by the central government for four years.
- Decisions are by majority vote; the Governor has a casting vote in case of a tie.
- It must meet at least four times a year; in practice it meets about six times.
- Minutes are published, and each member's vote is recorded — a significant move towards transparency.
The policy rates and the corridor
The RBI manages short-term interest rates through the Liquidity Adjustment Facility (LAF), which works as a corridor.
| Rate | What it is | Role |
|---|---|---|
| Repo rate | The rate at which the RBI lends to banks against government securities | The policy rate — the signal of the monetary stance |
| Standing Deposit Facility (SDF) | The rate at which banks can park surplus funds with the RBI without collateral | The floor of the corridor (introduced in 2022) |
| Marginal Standing Facility (MSF) | Emergency overnight borrowing by banks, including against part of their SLR holdings | The ceiling of the corridor |
| Bank rate | The rate for longer-term lending to banks | Aligned with the MSF rate |
The SDF replaced the fixed-rate reverse repo as the floor; the reverse repo still exists but has become less important. The aim is to keep the overnight money market rate — the weighted average call rate — close to the repo rate.
Reserve requirements
| Tool | What it requires | Effect of an increase |
|---|---|---|
| Cash Reserve Ratio (CRR) | Banks keep a share of their deposits as cash with the RBI, earning no interest | Less money for lending; liquidity tightens |
| Statutory Liquidity Ratio (SLR) | Banks hold a share of deposits in liquid assets — mainly government securities | Less money for lending; supports demand for government bonds |
Changes in CRR are a powerful but blunt tool; they are used less frequently than rate changes.
Liquidity tools
- Open Market Operations (OMOs) — buying government securities injects money into the system; selling them absorbs it.
- Variable rate repo and reverse repo auctions — fine-tune liquidity for various durations.
- Foreign exchange operations — when the RBI buys dollars, it releases rupees; when it sells dollars to support the rupee, it absorbs rupee liquidity.
How a rate change reaches the economy
This is monetary transmission, and it works through several channels:
- Interest rate channel — banks change their lending and deposit rates; borrowing becomes cheaper or dearer; investment and consumption respond.
- Credit channel — banks change how much they are willing to lend.
- Exchange rate channel — higher rates can attract foreign capital and strengthen the rupee, making imports cheaper.
- Asset price channel — rate changes affect bond, equity and property prices, and so wealth.
- Expectations channel — a credible central bank shapes what people expect inflation to be.
Why transmission has been slow — and what changed
For years, banks' lending rates responded slowly to repo rate changes. Their benchmarks (such as the base rate and later the MCLR) were linked to their own cost of funds, which changes slowly because deposit rates are sticky.
From October 2019, the RBI required banks to link new floating-rate loans to certain categories of borrowers — retail loans and loans to micro and small enterprises — to an external benchmark, most commonly the repo rate (the external benchmark lending rate, or EBLR). This has made transmission for these loans much faster.
The stance
Alongside the rate decision, the MPC states its stance — for example, "withdrawal of accommodation", "neutral" or "accommodative". The stance signals the likely direction of future policy and helps shape market expectations.
Limits of monetary policy
- It works with long and variable lags — often several quarters.
- It is weak against supply-side inflation (food, fuel).
- Its effect depends on the health of the banking system.
- A large informal sector reduces its reach.
- It must be coordinated with fiscal policy; a large fiscal deficit can offset tight monetary policy.
Practice questions
- Prelims-type: What is the floor of the LAF corridor today? How many members of the MPC are appointed by the central government?
- Mains-type (150 words): Explain the channels through which a change in the repo rate affects inflation and growth.
- Mains-type (250 words): Why has monetary policy transmission been weak in India, and what steps have been taken to improve it?
A note on dates and numbers. Exam patterns, vacancies and schedules change from year to year. Always confirm the current details in the latest notification on the Union Public Service Commission website .
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