Monetary Policy - Tools and Transmission for UPSC

Objectives of Monetary Policy

The RBI’s monetary policy has evolved over time from a focus on development and credit allocation to maintaining macroeconomic stability under the flexible inflation targeting framework. The primary goals are price stability, growth and financial stability. Specifically, the objectives include:

• Price stability: Keeping inflation within the 4% ±2% target band to ensure households’ purchasing power is not eroded.
• Growth promotion: Providing adequate liquidity at reasonable rates to support investment, consumption and job creation.
• Financial stability: Ensuring orderly functioning of money markets, managing capital flows and preventing asset bubbles.
• Exchange rate management: Avoiding excessive volatility in the rupee while allowing market‑determined movements.
• Credit allocation: Encouraging lending to priority sectors such as agriculture, MSMEs and housing without compromising systemic risk.

To achieve these aims, the Monetary Policy Committee (MPC) meets at least six times a year and sets the policy repo rate. It uses a framework of tools discussed below to steer liquidity and interest rates.

Instruments of Monetary Policy

The RBI uses several qualitative and quantitative tools to influence the banking system. Each instrument serves a specific purpose and has a measurable impact on liquidity and borrowing costs. The table below summarises key instruments and their prevailing rates as of October 2025.

Repo Rate

The repo rate is the rate at which the RBI lends short‑term funds to commercial banks against government securities. It is the anchor for all other short‑term interest rates in the economy. By increasing or reducing the repo rate, the central bank signals its policy stance. When the repo rate goes up, borrowing becomes costlier, discouraging credit and slowing inflation. When it goes down, banks can borrow cheaply and pass the benefit to borrowers.

In June 2025, the MPC cut the repo rate by 50 basis points to 5.50%, citing soft inflation and the need to support growth. It has since kept the rate unchanged through the October 2025 policy, maintaining a neutral stance. Real GDP growth is forecast at around 6.8% for 2025–26, while consumer inflation has declined to around 2.6%. Stable rates allow the transmission of past cuts to play out.

Reverse Repo Rate & SDF

The reverse repo rate was long the floor of the interest rate corridor. It is the rate at which banks place surplus funds with RBI in exchange for securities. However, in April 2022 the RBI introduced the Standing Deposit Facility (SDF) as a collateral‑free instrument to absorb excess liquidity. Banks can now deposit excess reserves without providing securities, and the SDF rate (5.25% at present) is set 25 basis points below the policy repo rate, forming the effective floor of the corridor.

With abundant liquidity after the pandemic and record government cash balances, the SDF has emerged as a key tool. By adjusting the SDF rate and using variable rate reverse repo auctions, the RBI guides the weighted average call money rate (WACR) toward the policy target.

Marginal Standing Facility (MSF)

The MSF allows banks facing short‑term liquidity shortages to borrow overnight funds from the RBI by pledging government securities above the statutory requirement. The MSF rate acts as the ceiling of the corridor and is typically 25 basis points above the repo rate; it is currently 5.75%. Because borrowing at MSF is more expensive, banks use it only when interbank or repo markets are strained. The facility helps cap overnight rates and prevents spikes in the call money market.

Cash Reserve Ratio (CRR)

The CRR is a statutory ratio requiring banks to maintain a portion of their Net Demand and Time Liabilities (NDTL) as cash with the RBI. Since banks cannot lend this portion, a higher CRR reduces funds available for lending, tightening liquidity. In June 2025, the RBI reduced the CRR by 100 basis points over four tranches, bringing it down from 4.00% to 3.00% to stimulate credit growth. This move freed up resources for banks without changing the policy rate.

While CRR adjustments have a lasting impact on liquidity, they are used sparingly because they affect banks’ income (no interest is paid on CRR balances). For exam purposes, remember that CRR influences the money multiplier and controls inflation by altering the reserve base.

Statutory Liquidity Ratio (SLR)

The SLR mandates banks to invest a specified share of their deposits in liquid assets—primarily cash, gold or approved government securities. As of July 2025, the SLR stands at 18%. Raising the SLR tightens liquidity by locking more funds in safe assets, while lowering it frees up resources. Unlike CRR, banks earn interest on the securities held under SLR. The SLR also helps the government borrow at lower cost, as banks become captive buyers of government bonds.

Open Market Operations (OMOs)

OMOs involve outright sale or purchase of government securities by the RBI to influence durable liquidity. When liquidity is abundant, the central bank sells securities to absorb cash; when it is tight, it buys securities to inject money. Unlike repo operations, OMOs change the stock of base money permanently. In 2025 the RBI conducted several rounds of OMO purchases and foreign exchange swaps to inject liquidity when large government tax payments caused temporary shortages. It also undertook variable rate reverse repo auctions to mop up excess cash during festival seasons.

Aspirants should note the distinction between OMOs and repo operations: OMOs are outright and have a long‑term effect on liquidity, while repo operations are reversible and operate within the LAF corridor.

Monetary Policy Transmission Channels

Monetary policy decisions affect the wider economy through various channels. Understanding these pathways helps explain why changes in the repo rate or liquidity conditions take time to influence growth and inflation. The main channels are:

• Interest rate channel: Changes in the policy rate alter bank lending and deposit rates. Lower rates encourage borrowing for housing, vehicles and investment, boosting aggregate demand. Higher rates have the opposite effect.
• Credit channel: Monetary policy influences the quantity of credit supplied. A higher CRR or tighter liquidity reduces banks’ ability to lend, while expansionary policy increases credit availability. Borrower balance sheets also matter: higher rates raise debt servicing costs, discouraging new loans.
• Expectation channel: Forward guidance and policy credibility shape households’ and firms’ inflation expectations. If the RBI is seen as committed to the inflation target, wages and price contracts adjust accordingly, making policy more effective.
• Exchange rate channel: Interest rate differentials influence capital flows and the rupee’s exchange rate. A lower repo rate may depreciate the rupee, making exports more competitive and increasing imported inflation. A higher rate can attract foreign capital and strengthen the currency.
• Asset price channel: Monetary policy affects stock and real estate prices. Lower interest rates raise asset values, increasing wealth and consumption (the “wealth effect”). Conversely, tight policy can deflate asset bubbles.

In India, the transmission of policy rate changes to bank lending rates has improved over recent years due to the introduction of the Marginal Cost of Funds based Lending Rate (MCLR) and the external benchmark system. Still, transmission is sometimes delayed by rigid deposit rates, small savings schemes and structural bottlenecks.

The RBI monitors indicators such as the weighted average lending rate (WALR), corporate bond yields, and credit growth to assess transmission. It uses additional tools like targeted long‑term repo operations (TLTROs) and regulatory adjustments to strengthen specific channels.

LAF & Interest Rate Corridor

The Liquidity Adjustment Facility (LAF) is the operational framework through which the RBI manages day‑to‑day liquidity. Under the LAF, the central bank conducts repo and reverse repo auctions—both fixed rate and variable rate—to align the weighted average call money rate with the policy repo rate. The introduction of the SDF in 2022 refined the corridor. Key features include:

• The corridor width is 50 basis points, with the MSF rate at 25 bps above and the SDF rate at 25 bps below the repo rate.
• The weighted average call money rate (WACR) is the operating target. Through fine‑tuning operations like 1‑day/7‑day variable rate repos and reverse repos, the RBI keeps WACR near the repo rate.
• In addition to overnight operations, the RBI conducts 14‑day variable rate repo auctions to inject liquidity on a rolling basis. It has announced a roadmap to gradually phase out 14‑day variable rate reverse repo auctions as liquidity normalises.
• The corridor ensures predictability in money markets. When liquidity is abundant, overnight rates move toward the SDF rate as banks park funds with the RBI. When liquidity is tight, rates approach the MSF rate as banks borrow at a penalty rate. The RBI intervenes to keep rates within the band.

A clear understanding of the corridor helps aspirants grasp why the repo rate change alone may not immediately influence market rates. Liquidity conditions and the corridor’s boundaries guide the actual rates faced by banks.

Liquidity Conditions

Liquidity in the banking system reflects the balance between the demand for funds and the supply of reserves. It is influenced by various factors such as government cash balances, currency in circulation, capital flows, seasonal demand (like festivals and harvests) and FX market interventions. The RBI closely monitors liquidity conditions and uses the following instruments to manage them:

• Variable rate repos and reverse repos: Auctions of varying tenors (1‑day, 7‑day, 14‑day) to fine‑tune liquidity depending on short‑term mismatches. When liquidity is tight, repos inject funds; when there is a surplus, reverse repos absorb funds.
• Term lending facilities: Long‑term repo operations (LTROs) and targeted LTROs provide durable liquidity to specific sectors, ensuring credit flows during stress periods.
• Forex swaps: The RBI buys or sells foreign exchange in the spot market while simultaneously entering into offsetting forward contracts, thereby injecting or absorbing rupee liquidity without affecting its foreign exchange reserves permanently.
• Government cash management: Coordination with the Centre and states on timing of tax collections, GST settlements, and treasury bill issuances helps smooth liquidity. Large tax outflows can drain liquidity, requiring the RBI to conduct OMOs or repos.
• Macro‑prudential measures: Adjustments to risk weights, capital buffers and sectoral exposure norms can modulate credit growth and indirectly influence liquidity.

In recent months, liquidity has generally been in surplus due to government cash balances and weak credit demand. The RBI has used the SDF and variable rate reverse repos to absorb this excess and prevent the overnight call rate from falling below the floor. Conversely, during festival seasons or tax payment dates, the RBI injects liquidity through repos and OMOs to prevent spikes. This active liquidity management keeps monetary transmission smooth.

For UPSC Prelims vs. UPSC Mains

Prelims Pointers

• Know the current rates of repo, SDF, MSF, reverse repo, CRR and SLR.
• Understand which instrument is collateral‑free (SDF) and which requires government securities.
• Identify the components of the interest rate corridor and its width.
• Recall the objectives of monetary policy: price stability, growth and financial stability.
• Differentiate between CRR and SLR and between repo, reverse repo and OMOs.
• Be aware of the year of introduction of SDF (2022) and when MPC started meeting (2016 under the new framework).

Mains Perspective

• Analyse how monetary policy transmission in India is improving and what structural factors still hinder it.
• Discuss the trade‑offs faced by the RBI when balancing growth and inflation—why a neutral stance was maintained in 2025 despite low inflation.
• Evaluate the effectiveness of non‑traditional tools like TLTROs, variable rate auctions and macro‑prudential measures.
• Examine the role of expectations and communication (forward guidance) under the inflation‑targeting regime.
• Comment on the interplay between monetary policy and fiscal operations (government borrowing, GST flows) in determining liquidity.

Quick Facts

• The Monetary Policy Committee has six members; three are from the RBI and three are external experts appointed by the government.
• Since 2016, the policy goal is to maintain consumer inflation at 4% with a tolerance band of ±2%.
• As of October 2025, the repo rate is 5.50%, SDF 5.25%, MSF 5.75%, CRR 3.00% and SLR 18%.
• The Standing Deposit Facility was introduced on 8 April 2022 and replaced the reverse repo as the primary floor of the corridor.
• The interest rate corridor is 50 basis points wide, ensuring the WACR remains close to the repo rate.
• Open market operations have a permanent effect on base money, while repo operations are temporary.
• Liquidity management tools include variable rate repo/reverse repo auctions, forex swaps, term facilities and coordination with government cash flows.
• Transmission channels include interest rate, credit, expectation, exchange rate and asset price channels.

UPSC Previous Year Questions (Selected)

1. Question (Prelims 2023): Which of the following statements best describes the standing deposit facility (SDF)?

   Answer: It is a collateral‑free instrument introduced by the RBI in 2022 that allows banks to park surplus funds with the central bank. The SDF rate forms the lower bound of the monetary policy corridor.

2. Question (Mains 2022): Discuss the challenges in the transmission of monetary policy in India and suggest measures to improve the effectiveness of the repo rate as a signalling device.

   Answer: Students should highlight factors like rigid deposit rates, small savings schemes, high non‑performing assets, and uneven credit demand. Measures include strengthening competition in the banking sector, moving to external benchmarks, enhancing financial literacy, and using targeted lending schemes.

3. Question (Prelims 2017): Consider the following statements:

   1. Open market operations change the permanent supply of money.
   2. Repo operations under the LAF are reversible and temporary.
   3. Cash Reserve Ratio balances earn interest from the RBI.
   Which of the above are correct?

   Answer: Only statements (a) and (b) are correct. CRR balances do not earn interest.

Practice MCQs

1. Which of the following instruments is collateral‑free and forms the floor of the policy corridor?
   • Reverse repo rate
   • Standing Deposit Facility (SDF)
   • Marginal Standing Facility (MSF)
   • Cash Reserve Ratio (CRR)
2. An increase in the Cash Reserve Ratio leads to which of the following?
   • Increase in money multiplier
   • Decrease in banks’ lending capacity
   • Decrease in repo rate
   • Rise in SLR
3. The interest rate corridor maintained by the RBI is currently how wide?
   • 25 basis points
   • 50 basis points
   • 75 basis points
   • 100 basis points
4. Which of the following best explains the asset price channel of monetary policy transmission?
   • Changes in policy rates alter stock and property prices, affecting household wealth and spending.
   • Policy rate changes influence the exchange rate, making exports competitive.
   • Policy rate changes alter banks’ balance sheets.
   • None of the above.
5. Open market operations differ from repo operations in that:
   • OMOs are permanent and repos are temporary.
   • Repos change the CRR while OMOs do not.
   • OMOs require collateral, repos do not.
   • Repos affect exchange rates directly.

Answer Key: 1.B, 2.B, 3.B, 4.A, 5.A

Frequently Asked Questions

Explore related articles to broaden your understanding: GDP Growth Rate, Inflation Measurement, Fiscal Policy, RBI Functions, Balance of Payments, Money Supply, Public Debt Management, Financial Markets.