Knowledge Nugget : RBI's Monetary policy instruments—From Repo Rate to CRR, UPSC must-know

Indian Express

9 hours ago

Take a look at the essential concepts, terms, quotes, or phenomena every day and brush up your knowledge. Here's your knowledge nugget for today.
(Relevance: This is an important topic for both Prelims and Mains. In 2024, GS III, a question was asked to comment on the effectiveness of the monetary policy of the RBI to control inflation. Prelims questions have been asked on the impact of increasing or decreasing the repo rate. In this regard, understanding the RBI's monetary policy instruments becomes important for your exam.)
The Reserve Bank of India's six-member Monetary Policy Committee (MPC) has slashed the repo rate by a bigger-than-expected 50 basis points to 5.50 per cent, marking the third consecutive reduction since February 2025. The central bank also cut the cash reserve ratio of banks by 100 basis points to 3 per cent, releasing Rs 2.5 lakh crore of lendable resources to the banking system.
1. The interest rate that the RBI charges when commercial banks borrow money from it is called the repo rate. The interest rate the central bank pays commercial banks when they park their excess cash is called the reverse repo rate.
2. Impact of reducing repo rate: When the RBI wants to encourage economic activity in the economy, it reduces the repo rate. Doing this enables commercial banks to bring down the interest rates they charge (on their loans) as well as the interest rate they pay on deposits. This, in turn, incentivises people to spend money, because keeping their savings in the bank now pays back a little less, and businesses are incentivised to take new loans for new investments because new loans now cost a little less as well.
3. Impact of increasing repo rate: When the RBI wants to control inflation, it increases the repo rate. Banks thus have to pay more interest to borrow from the RBI, which means they will charge more interest to their borrowers. At a macro level, this inhibits people from borrowing money as well as from spending, which in turn reduces the amount of money in the market, and thus negates inflation.
Apart from Repo rate and reverse repo rate, the RBI uses several other direct and indirect instruments to maintain price stability while keeping the objective of growth.
(i) Standing Deposit Facility (SDF) Rate: It is the rate at which the RBI, on an overnight basis, accepts uncollateralised deposits from all liquidity adjustment facility (LAF) participants. The SDF is also a financial stability tool in addition to its role in liquidity management. It was introduced in 2022 to replace the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor.
(ii) Marginal Standing Facility (MSF) Rate: It is the rate at which a bank can borrow, on an overnight basis, from the RBI in an emergency situation when inter-bank liquidity dries up completely. It is typically placed at 25 basis points above the policy repo rate.
(iii) Liquidity Adjustment Facility (LAF): LAF is a facility extended by RBI to the scheduled commercial banks (excluding Regional Rural Banks) and Primary Dealers to avail of liquidity in case of requirement or park excess funds with RBI in case of excess liquidity on an overnight basis against the collateral of G-Secs including State Development Loans (SDLs).
(iv) Main Liquidity Management Tool: To manage the frictional liquidity requirements, a 14-day term repo/reverse repo auction operation at a variable rate is conducted to coincide with the cash reserve ratio (CRR) maintenance cycle.
(v) Bank Rate: In case of shortfalls in meeting the reserve requirements (cash reserve ratio and statutory liquidity ratio) by the banks, the Reserve Bank provides to buy or rediscount bills of exchange or other commercial papers at a rate which is called Bank rate.
(vi) Cash Reserve Ratio (CRR): It is the percentage of a bank's net demand and time liabilities (NDTL) that is required to be maintained in liquid cash with the RBI as a reserve. The CRR percentage is determined by the RBI from time to time.
(vii) Statutory Liquidity Ratio (SLR): Every bank is required to maintain in Indian assets, the value of which shall not be less than such percentage of the total of its demand and time liabilities in India as on the last Friday of the second preceding fortnight, in the form of liquid cash, gold, government and state government securities.
(vii) Open Market Operations (OMOs): These include outright purchase or sale of government securities by the Reserve Bank for injection or absorption of durable liquidity in the banking system.
1. In May 2016, the RBI Act was amended to provide a legislative mandate to the central bank to operate the country's monetary policy framework.
2. The RBI formed an 'Expert Committee to Revise and Strengthen the Monetary Policy Framework' under the chairmanship of Urjit Patel in 2013 recommended a flexible inflation target (FIT) for the RBI. In May 2016, the RBI Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
3. Under Section 45ZA, the Central Government, in consultation with the RBI, determines the inflation target in terms of the Consumer Price Index (CPI), once in five years and notifies it in the Official Gazette. On August 5, 2016, the Central government notified the Consumer Price Index (CPI) at 4 per cent with a band of +/-2 per cent. On March 31, 2021, the Central Government retained the inflation target and the tolerance band for the next 5-year period – April 1, 2021 to March 31, 2026.
FYI: Inflation refers to the rate at which the general price level for goods and services increases over a period of time, causing a decrease in purchasing power of money or real income. In other words, as inflation rises, each unit of currency can buy fewer goods and services than before.
If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? (UPSC CSE 2020)
1. Cut and optimize the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate
Select the correct answer using the code given below:
(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3
(Source: Repo Rate, RBI cuts rates again by 50 bps: Borrowers to benefit, savers and depositors to feel the pinch, What is SDF, the RBI's new tool to absorb excess liquidity to control inflation?, How inflation affects cost of living)
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Khushboo Kumari is a Deputy Copy Editor with The Indian Express. She has done her graduation and post-graduation in History from the University of Delhi. At The Indian Express, she writes for the UPSC section. She holds experience in UPSC-related content development. You can contact her via email: [e-mail] ... Read More