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Monetary Policy Tool

Definition

Objective

Mechanism/Usage

Impact on the Economy

Repo Rate

The rate at which the RBI lends money to commercial banks

Stimulate borrowing and control liquidity

Banks borrow funds from RBI against government securities. Lowering the repo rate reduces banks’ cost of funds, encouraging them to lend more.

Lower loan interest rates, boosting spending and investment.

Reverse Repo Rate

The rate at which banks deposit surplus funds with the RBI

Absorb excess liquidity in the banking system

Banks park their excess funds with RBI. A higher reverse repo rate encourages banks to deposit money rather than lend it, thereby reducing liquidity.

Helps control money supply and inflation by sucking up extra liquidity from the system.

Cash Reserve Ratio (CRR)

The percentage of deposits banks must hold with the RBI as reserves

Ensure banks have a safety cushion and maintain liquidity

Banks are required to keep a fixed percentage of their deposits in cash with the RBI, which is not available for lending.

Limits the amount of money available for loans, thus managing credit growth and liquidity in the market.

Statutory Liquidity Ratio (SLR)

The percentage of deposits banks must invest in liquid assets (e.g., government securities, cash, gold)

Ensure bank solvency and readiness to meet liabilities

Banks must invest a specified percentage of their deposits in approved liquid assets, as mandated by the RBI.

Controls the funds available for lending, thereby affecting credit creation and liquidity.

Open Market Operations (OMO)

The buying and selling of government securities by the RBI

Manage short-term liquidity in the financial system

The RBI buys securities to inject liquidity into the system or sells them to withdraw excess funds, thereby stabilizing market interest rates.

Helps regulate money supply and stabilize short-term interest rates by managing liquidity in the market.

Marginal Standing Facility (MSF)

An emergency lending facility that allows banks to borrow funds overnight from the RBI against approved securities

Provide banks with a safety valve for short-term liquidity needs

Banks can borrow funds at the MSF rate during liquidity shortages, serving as a last-resort option when other sources are not available.

Acts as a backup liquidity source, preventing market disruptions during periods of short-term cash shortages.

PRACTICE QUESTION

Q.Consider the following statements about the RBI’s monetary policy stance?

1. The RBI’s neutral stance means it can adjust rates based on economic conditions.
2. A lower repo rate always leads to higher inflation.
3. A rise in call money market participation can improve liquidity.
4. The RBI directly controls the exchange rate of the rupee.

How many of the above statements are correct?

A) Only one

B) Only two

C) Only three 

D) All four

Answer: B

Explanation:

Statement 1 is correct: The RBI’s neutral stance allows flexibility to adjust interest rates based on evolving economic conditions.

Statement 2 is incorrect: A lower repo rate can stimulate demand and inflation, but it does not always lead to higher inflation (e.g., in recessions or supply-driven inflation scenarios).

Statement 3 is correct: Increased participation in the call money market (short-term interbank lending) enhances liquidity by facilitating smoother fund transfers between banks.

Statement 4 is incorrect: The RBI influences the rupee’s exchange rate via forex interventions and policies but does not directly control it (India follows a managed float regime).