Monetary Policy Framework in India- Explained in Laymen Language


Monetary as the term indicates is the “money supply”. Therefore monetary policy is the policy of the central bank that deals with the inflow and outflow of money in the market of any economy. Generally central bank deals with monetary policy decisions because of the fact that money minting and interest rate changes comes under Central Banks. In India, the policy is dealt by Reserve Bank of India.

However, the definition of monetary policy can be different though the meaning will be same. For example,

“Monetary Policy is the policy of the central bank that deals with the changes in the interest rate structure of the economy”


“Monetary Policy is the framework that deals with money supply, creating employment and controlling inflation in an economy”

The essence of monetary policy lies in the fact that all the economic terms mentioned in the definitions have interlink with monetary policy as well as with each other. It is like an ecosystem which has various components that are inter linked with each other and outer environment as well.

Before going into the details of all these things, it is necessary to know the major components of monetary policy available with the RBI. These are broadly classified into

  1. Quantitative Measure
  2. Qualitative Measures

At the very beginning, it must be kept in mind that Quantitative measures, as the name suggests, deals with the quantity of money that is there in the market. Therefore measures that increase or decrease the amount of money supply itself in the market for borrowing and lending are quantitative measures. On the other hand, Qualitative measures do not decrease or increase the money supply in the market as a whole but on RBI suggestions, the banks change the way they lend to their customers that may be the differential loan interest to specific sectors, groups which will be discussed later in this article.

  1. Quantitative Measures

As already discussed, these measures decrease the overall quantity of fund available in the market. RBI has various tools under this section which are:

  1. a) CRR (Cash Reserve Ratio):

It is the reserved cash which cannot be used by banks. It is a ratio (means percentage) of NDTL (Net Demand and Time Liabilities) that the bank has to keep with RBI. This means that it is a kind of security kept with the RBI which cannot be used by the banks. When this ratio is increased, the banks will have to keep more funds with RBI and thus have less to offer to the public and corporates leading to a dearer monetary policy. Similarly, vice-versa when this ratio is decreased, more funds are available with the banks and thus known as cheap monetary policy

For example, a bank has Rs 100 as NDTL. If CRR is 4%, the bank has only Rs 96 with itself for lending to customers (called as retail investors) and corporates as loan/investing, as the rest Rs 4 has been kept with RBI as a security.

  1. b) SLR (Statutory Liquidity Ratio)

It is defined as the ratio of NDTL that a bank has to invest in certain securities, gold etc. It is also like CRR but the difference lies in the fact that the amount is not kept with RBI but is invested in government securities, gold etc. Thus the banks do get return on this investment. The increase and decrease in the percentage of SLR is similar impact like that of CRR.

Now continuing with same example, if SLR is 23%, the bank has to invest at least Rs 23 in certain government securities, gold etc. That means that now the bank has (100-04-23) Rs 73 to lend to borrowers.

There is a take here, SLR is the minimum ratio. It a bank wants, it can invest as mch as possible in SLR but the fact is, the retail and corporates are given loan at higher interest rates like 12-14% while government securities return is at most 9%. So it is prudent for banks to invest in lending activities and not in SLR.

  1. c) Repo and Reverse Repo Rate

Repo (repurchase rate) is the rate (read: interest rate) at which RBI lends to bank for short-term against securities (like government securities, T-Bills). Reverse Repo is rate at which the banks park their excess cash with the RBI.

These are the Liquidity Adjustment Facility (LAF) measures which are taken by RBI in order to control the inflation. A repo rate short for repurchase agreement in which commercial banks borrow from the RBI in return of the collateral for the short term government securities. So if there is a high inflation in the economy in that case RBI would increase the repo rate so that the commercial banks would have less money for giving out loans. Lesser the loans mean less money in the hands of the people which would in turn reduce the spending of the people, and if the whole economy is spending less than obviously there would be an ease of inflation. This is vice versa for reverse repo rate.

  1. d) Marginal Standing Facility(MSF)

It refers to the penal rate at which banks can borrow money from the RBI over and above what is available to them through the LAF window. That means that if banks cannot borrow on repor rate, they can get money from RBI at a higher rate of 1% point.

  1. e) Base Rate

It is the minimum rate at which a bank can charge to its customer based on operational and administrative cost; market risk etc. The base rate replaced Prime lending Rate (PLR) in 2010 in lieu of its ineffectiveness in promoting loan facilities to retail investors due to cross subsidization by banks.

Now the banks cannot charge to corporates below this interest rate. Every bank has to declare base rate at initial stage to RBI so as to make the process transparent.

  1. Quanlitative measures

These measures does not take into consideration the decrease or increase in percentage of funds for lending rather focus on persuading banks on its decisions. The measures include margin requirement, credit rationing, regulation of consumer credit, moral suasion, guidelines etc. The two most important of these are:

2. a) Credit Rationing

It deals with rationalisation of credit/money. The banks generally have the tendency to give loans to corporates or people offering good collateral as they have more possibility to repay the interest and principle. This leads to sub-ordination of certain class of borrowers like farmers, students, women groups etc. Therefore the RBI decides that certain minimum percentage of funds shall be routed to these social groups so that they are not overlooked in the process of credit. This has taken a new turn, known as priority sector lending and generally the interest rates are lower than normal

2. b) Moral Suasion:

It is a psychological methodology adopted by RBI. Many times the RBI may increase the interest rates like repo and reverse repo for banks. However, it persuades are banks not to increase the interest rates for the retail investors so that the growth trajectory is maintained and employment is generated

At these aforesaid measures have been used and reused by RBI in order to infuse money in the market, at right time, for right sectors ensuring growth and development. The main stand of RBI’s monetary policy as of now is accommodative inflation and growth which are antithetical at times leading to many issues with regard to investment and saving. The Monetary policy is an important tool for a country’s growth and must be in tandem with the overall fiscal policy goals.


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