Monetary Policy Instruments and Monetary Policy Committee (MPC) of RBI

Monetary Policy Committee (MPC) was constituted by ammending the Reserve Bank of India Act, 1934 through Finance Act, 2016 - to bring more transparency and accountability in fixing Monetary Policy.

The amended RBI Act, 1934 also provides for the inflation target (4% +-2%) to be set by the Government of India (GoI), in consultation with the Reserve Bank, once in every five years.

The Monetary Policy Committee is responsible for fixing the benchmark interest rate in India.

The benchmark interest rate or the base or reference rate is used to set other interest rates in India.

The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.

The committee comprises six members - three officials of the Reserve Bank of India (RBI) and three external members nominated by the Government of India (GoI).

They need to observe a "silent period" seven days before and after the rate decision for "utmost confidentiality".

The Governor of RBI is the chairperson ex officio of the committee, decisions are taken by majority with the Governor having the casting vote in case of a tie.

Monetary Policy Instruments

Quantitative instruments includes - Open Market Operations, Bank Rate, Repo Rate, Reverse Repo Rate, Cash Reserve Ratio, Statutory Liquidity Ratio, Marginal standing facility and Liquidity Adjustment Facility (LAF).

Qualitative Instruments includes - Direct action, change in the margin money and moral suasion.

Open Market Operations

Open Market Operations (OMOs) are market operations conducted by RBI by way of sale/purchase of government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market.

If there is excess liquidity, RBI resorts to sale of securities to sucks out the rupee liquidity.

Similarly, when the liquidity conditions are tight, RBI buys securities from the market to release liquidity into the market.

Repo rate

Repo rate is the rate at which the central bank of a country (RBI) lends money to commercial banks in the event of any shortfall of funds.

It is also used by monetary authorities (RBI) to control inflation.

In the event of inflation, RBI increase repo rate as this acts as a disincentive for banks to borrow from the central bank.

This ultimately reduces the money supply in the economy and thus helps in arresting inflation.

The central bank takes the contrary position by decreasing repo rate in the event of a fall in economic activities or recession.

The decrease in repo rates is to aim at bringing in growth and improving economic development in the country.

Reverse repo rate

Reverse repo rate is the rate at which the central bank of a country (RBI in case of India) borrows money from commercial banks within the country.

It is a monetary policy instrument which can be used to control the money supply in the country.

An increase in the reverse repo rate will decrease the money supply and vice-versa.

An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.

Bank Rate

Repo rate is the rate at which the RBI lends to commercial banks by purchasing securities while bank rate is the lending rate at which commercial banks can borrow from the RBI without "providing any security".

There is no agreement on repurchase that will be drawn up or agreed upon with no collateral as well.

It is usually higher than a Repo Rate on account of its ability to regulate liquidity.

So now if the RBI were to increase the bank rate, the commercial banks would also have to increase their lending rates. And this will help control the supply of money in the market.

And the reverse will obviously increase the supply of money in the market.

Liquidity adjustment facility (LAF)

Liquidity adjustment facility (LAF) is used to aid banks in adjusting the day to day mismatches in liquidity.

Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements.

Liquidity adjustment facility (LAF) helps banks to quickly borrow money in case of any emergency or for adjusting in their Statutory Liquidity Ratio (SLR)/Cash Reserve Ratio (CRR) requirements.

The RBI introduced the LAF as a result of the Narasimham Committee on Banking Sector Reforms (1998).

Marginal standing facility (MSF)

Marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency when inter-bank liquidity dries up completely.

The Marginal Standing facility allows banks to borrow money with an interest rate above the repo rate and can be termed as the Marginal standing facility rate.

Under MSF, banks can borrow funds overnight up to 1% (100 basis points) of their net demand and time liabilities (NDTL) i.e. 1% of the aggregate deposits and other liabilities of the banks.

This provides a safety valve against unanticipated liquidity shocks to the banking system.


Cash Reserve Ratio (CRR) is the portion of deposits with the commercial banks that it has to deposit to the RBI.

The RBI will adjust the said percentage to control the supply of money available with the bank.

And accordingly, the loans given by the bank will either become cheaper or more expensive.

The Statutory Liquidity Ratio (SLR) is the percent of total deposits that the commercial banks have to keep with themselves in form of cash reserves or gold.

So increasing the SLR will mean the banks have fewer funds to give as loans thus controlling the supply of money in the economy. And the opposite is true as well.

What is inflation targeting

Inflation targeting is a policy followed by the central regulator in the monetary policy and is adjusted to achieve a specified annual rate of inflation.

The strategy is based on the belief that long-term economic growth is best achieved by maintaining price stability that can be achieved by controlling inflation.

The central bank employs all tools that are available to it for this purpose ranging from open market operations to increasing and decreasing interest rates.

The central bank raises interest rates to slow inflation in order to slow the economic growth whereas the interest rates are decreased to boost inflation and economic growth.

The Flexible Inflation Target (FIT) was adopted in 2016. This has put India on par with other nations in terms of flexible inflation targeting.

The Reserve Bank of India Act, 1934 was amended to provide a statutory basis for a Flexible Inflation Target (FIT) framework.

The amended Act provides for the inflation target to be set by the Government, in consultation with the RBI, once every five years.

India adopted a flexible inflation targeting mandate of 4 (+/-2) percent and headline consumer price inflation was chosen as a key indicator.