Economy Handout: 02

Mr. Shyam Sunder

Lecture 06

Role of RBI and Monetary Policy Instruments

History of RBI

The formation of a Central Bank in India was first recommended by the Royal Commission on India
Currency and Finance, popularly known as the Hilton-Young Commission in 1926. The main purposes
for such recommendation were to separate the control of currency and credit from the government
(then Government of India under the British Rule) and to facilitate the spread of the banking sector
in India. The Reserve Bank of India (RBI) Act, 1934 established RBI as the Central Bank of India and
its operations started from 1935.

Roles of the RBI in the Indian Economy

RBI’s roles in the economy have changed over time as India witnessed various political and economic
changes. In 1949, RBI was nationalized i.e., brought under the control of the Government of
Independent India. After 1950, the role of RBI was crucial in ensuring planned economic development
of India. After 1969, with the nationalization of the commercial banks, the RBI guided the commercial
banks to provide banking services to the less-privileged sectors and population. The role of RBI was
instrumental in implementing the reforms related to the financial sector and foreign sector, initially
during the 1980s and more comprehensively after 1991. Since 1991, RBI has following important roles
to play:

1. Regulator of the Monetary Policy

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Monetary Policy

This policy is related to the regulation of the availability, cost, and use of money and credit in the
economy. The main objectives of the monetary policy are:

1. Macroeconomic Stability: It aims to achieve the twin goals of price stability and supporting
economic growth through adequate flow of credit to the firms, government, and the households.

2. Financial Stability: It aims to ensure that the financial system (mainly the banking system)
remains stable even under a crisis originating either in the domestic or international economy.

Monetary Policy Framework since 2016

The above objectives were to be achieved by RBI under the provisions of the RBI Act, 1934. However,
there were certain amendments made in the Act in May, 2016 introduced through the Finance
Act, 2016. These amendments were made mainly in the background of the Urjit Patel Committee
constituted under the RBI in September 2013 for revising the monetary policy framework. The
committee submitted its report in January, 2014.
Before these amendments, RBI was the solely responsible for regulating monetary policy in India
and fulfil the above objectives. Since May 2016, the regulation of the monetary policy has shifted to
the Monetary Policy Committee (MPC) constituted by the Central Government. MPC has 6 members
including (a) the Governor of the RBI, (b) Deputy Governor of the RBI in charge of the Monetary
Policy, (c) one officer of the RBI nominated by the Central Board, and (d) 3 persons appointed by
the Central Government. Thus, three members of the MPC are from RBI. The remaining 3 external
members are appointed by the Central Government for 4 years.
The MPC is required to meet at least 4 times in a year to announce continuation or change in
the nature of the monetary policy. Each MPC member has one vote during any decision related to
the monetary policy instruments. The Governor of RBI, who is also the Chairperson of the MPC also
has a vote. But in case of a tie or equality of votes the RBI Governor has a casting or second vote.
This feature gives RBI an edge in the MPC meetings and thus, RBI still has significant role in the
regulation of the monetary policy. But, it is clear that the Central Government can also communicate
its standpoint on the policy through 3 external members. It was claimed that MPC will ensure better
synchronization in the working of the fiscal and monetary policy. However, critiques of the MPC argue
that it has reduced autonomy of RBI in the regulation of the monetary policy. Till now, most of the
RBI and non-RBI members of the MPC tend to agree on the monetary policy decisions.
Another shift in the monetary policy since 2016 is that its objective of macroeconomic stability is
restricted, primarily to price stability. Inflation Targeting is the formal objective of monetary policy.
The Central Government, in consultation with the RBI shall determine the inflation target in terms of
the consumer price index (CPI) once in every 5 years. Before 2016, there was a Multiple Indicator

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Approach adopted by RBI since 1998. It means that RBI targeted both quantity and rate variables to
be determined through the monetary policy. Quantity variables included variables like money supply,
credit, output, trade, capital flows and fiscal position. Rate variables included variables like inflation
rate, interest rate, and exchange rate. For a decade, such approach worked well as India achieved both
higher GDP growth (more than 7% per annum) and controlled inflation (about 5.5% both in terms of
WPI and CPI) from 1998-99 to 2008-09. But, the Global Financial Crisis of 2008-09 led to economic
slowdown in India as well. Simultaneous increase in crude oil prices, led to higher inflation as well,
resulting in stagflation.
In this background, RBI constituted and expert committee in 2013 under the chairmanship of Dr.
Urjit Patel. In its report submitted in 2014, a flexible inflation targeting approach was recommended.
Under this, the inflation target will be set by the Government of India in consultation with the RBI
in terms of the all India CPI once in every 5 years. In August, 2016, the inflation target was decided
to be 4% with the upper tolerance limit of 6% and lower tolerance limit of 2%. Flexible inflation
targeting means that CPI inflation can be between 2% to 6%. Inflation targeting fails if (a) average
inflation is above the upper tolerance level for any 3 consecutive quarters or (b) average inflation is
below the lower tolerance level for any 3 consecutive quarters. In case of such failure, RBI is expected
to provide to the Central Government the reasons for the failure, remedial measures taken by it to
meet the failure, and an estimate of the time-period to achieve such target.
In order to keep inflation in this range, the MPC is expected to set the Repo Rate on the basis of
existing and expected situations in the macro economy. Thus, Repo Rate is used by MPC as the main
monetary policy instrument and is also known as the Policy Rate. However, there are other policy
instruments that are also available with the MPC that is discussed in another section.
The main operating target of the monetary policy, through changes in Repo Rate, is the weighted
average call money rate (WACR). Call money rate refers to the interest rate at which banks take
short-term loans from each other in the call money market. The rate is market determined and can
fluctuate with change in demand and supply of the funds even within a day. WACR refers to the
average call money rate weighted by the volumes of the loans taken at different call money rates
during any particular day.

Types of the Monetary Policy

Monetary policy can be divided into two main types:

1. Expansionary Monetary Policy (Easy or Cheap Money Policy): Under such a policy RBI (and
more formally MPC since 2016) tries to make credit cheaper (or lower lending rates) for the
public. This can result in higher demand for loans taken by the firms, and households that helps
in increasing investment and consumption expenditures in the economy. It finally leads to an
increase in money supply that tends to increase economic growth. However, it also increases

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 inflation due to increase in demand for goods and services as in short-term the increase in money
supply takes place at a faster pace than real production of goods and services.

2. Contractionary Monetary Policy (Tight or Dear Money Policy): It is opposite of the expansionary
monetary policy. It tends to make credit costlier (or higher lending rates) for the public leading to
fall in demand for the loans. Money supply also falls that tends to decrease inflationary pressures
in the economy. But, it also lowers the pace of economic growth.

Therefore, in either type of monetary policy, RBI faces a dilemma whether to focus on economic
growth or to control inflation. Such conflict is called Inflation-Growth Conflict. With inflation
targeting framework, the primary role of RBI has shifted to inflation control. But, in times of severe
economic slowdown like faced by India since 2019, RBI tends to use its policy to revive economic
growth as well.

Instruments of the Monetary Policy

RBI can use a number of instruments to impact the level of money supply in the economy. These
instruments can be classified in different ways. In a classification, these instruments can be quantitative
or qualitative in nature. Quantitative instruments have similar impacts on all types of borrowers,
without any differentiation among the borrowers. Most common instruments used by RBI are quantitative.
Qualitative instruments can be used by RBI to differentiate among the borrowers, mainly with a
purpose to support certain categories of less-privileged borrowers.
On the basis of impact on the liquidity situation of the banks, monetary policy instruments can
be direct or indirect. Direct instruments have a direct impact on the liquidity, mainly through the
reserves requirements of the banks as determined by RBI. Indirect instruments often operate in a
more market-determined manner where the banks have more freedom to adjust their liquidity situation.

Quantitative Monetary Policy Instruments (Discussed in detail along with their working
in the class)

1. Cash Reserve Ratio (CRR): It refers to the minimum proportion of the net demand and time
liabilities (NDTL) that the commercial banks need to maintain statutorily as cash balance with
the RBI. It has often remained in the range of 4-5% of NDTL in the last few decades. Currently
(April 2023), it is 4.5% of NDTL.

2. Statutory Liquidity Ratio (SLR): It is the minimum proportion of NDTL that banks are
statutorily required maintain in some safe and liquid assets like government securities, cash
(excess reserves), gold, and current account balances with the other banks.

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Both CRR and SLR are also Direct Monetary Policy instruments. For example, CRR has been
increased by RBI during the last year (2022-23). This immediately led to the compulsion on the banks
to keep more reserves with the RBI, thereby reducing liquidity with the banks. It was done to make
the credit costlier so that inflation can be kept under control.

Indirect Quantitative Instruments of Monetary Policy

1. Repo Rate and Reverse Repo Rate: Repo rate refers to the interest rate at which the banks
can borrow short-term funds from the RBI using government securities. Reverse repo rate is the
interest rate earned by the banks when they keep their surplus funds in the form of government
securities with the RBI.

2. Liquidity Adjustment Facility (LAF): By changing repo and reverse repo rates, RBI provides
facility to the bank to manage their short-term liquidity mismatch. This facility is called Liquidity
Adjustment Facility (LAF).

Repo and reverse repo rates are often changed simultaneously. However, the absolute change
in interest rates may vary. For example, with higher repo and reverse repo rates, the banks that
expect need for short-term loans in near future tend to keep higher excess reserves so that it
can avoid costlier loans from RBI in future. This reduces the funds available with the banks to
give loans to public and increases interest rates on loans, finally reducing money supply. The
banks with sufficient liquidity may park more funds with RBI under the Reverse Repo market and
buy government securities. These government securities are helpful as collateral if it needs loans
from RBI later.

Thus, the interlinkage between repo and reverse repo markets makes LAF the preferred way of
taking short-term loans by the banks. The LAF corridor or the difference between repo and
reverse repo rates has crucial impact on corridor of the short-term money market interest rates
as well as other lending rates in the economy.

3. Marginal Standing Facility (MSF): Under Marginal Standing Facility (MSF), the scheduled
commercial banks can take overnight loans from RBI up to 1% of their NDTL at an interest rate
higher than Repo Rate. These loans are taken to handle unanticipated liquidity crisis faced by
the banks. The banks are allowed to use their SLR government securities to take these overnight
loans. Policy Corridor refers to the difference between MSF rate as the highest interest rate
and reverse repo rate as the lowest interest rate.

4. Bank Rate: It is also an interest rate at which the banks can borrow form RBI (like repo rate),
but these loans are given through rediscounting of the commercial bills or other commercial
papers with the banks. It working as a monetary policy instrument is also similar to that of repo

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 rate. For example, an increase in bank rate can also encourages banks to keep more excess
reserves to avoid costlier loans from RBI. This reduced funds available for giving loans by the
banks and increases interest rates on loans.

But the popularity of repo and reverse repo market has resulted in minimal usage of bank rate by
the banks to borrow from RBI. Hence, RBI (and MPC) also discusses repo rate more during
their policy discussions, making Repo Rate the Policy Rate.

Bank rate has been aligned to the MSF rate and thus it changes automatically with change in
MSF rate. Bank rate can still be used by RBI to signal the mediumterm stance of monetary
policy over a period of a few months.

5. Open Market Operations (OMOs): It refers to sale or purchase of the government securities
between RBI and the commercial banks. OMOs can be of two types. In one type, RBI buys
the G. Secs from the banks while in the other it sells G. Secs to the banks. In the first OMO,
RBI provides more liquidity to the banks by paying for the G. Secs bought. This leads to more
funds available with the banks for giving loans, thereby decreasing the interest rates. The second
OMO results in an increase in interest rates. OMOs are often used by RBI when LAF is not
enough to allow the banks to manage liquidity mismatch.

6. Market Stabilization Scheme (MSS): It is similar to the second type of OMO in concept (i.e.,
sale of G. Secs by RBI to the banks), but here liquidity that is to be absorbed is more enduring
in nature. It means that regular OMOs are not enough to absorb liquidity. OMOs for absorbing
liquidity need the availability of G. Secs with the RBI, but government can not issue G. Secs in
any amount. Such issuance should be in link with the fiscal deficit of the government.

To handle such problem, MSS was introduced by RBI in 2004 when there was sudden rise in
liquidity with the banks due to large foreign capital inflows. To absorb such liquidity, RBI sold
treasury bills and short-dated G. Secs to the banks. But these G. Secs were different from ordinary
G. Secs The cash mobilized through G. Secs in MSS is kept in a separate government account
called MSS account held with RBI. This amount cannot be used by the government for regular
expenditures so that the liquidity does not return back in the economy through government
expenditure. The amount can only be used to redeem or buyback the G. Secs issued under the
MSS. The amount of money to be absorbed under MSS is mutually decided by the government
in consultation with the RBI.

Some Unconventional Quantitative Instruments used by RBI since December 2019

Indian economy has been facing economic slowdown since 2017 and the situation deteriorated over
the next two years. By 2019, most of the conventional instruments of RBI as discussed above were
not highly functional. Therefore, RBI tried to bring some unconventional instruments to handle the

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economic slowdown persisting in India. More of such instruments were introduced in 2020 with the
Covid pandemic and the resulting lockdown worsening the slowdown.

1. Operation Twist: RBI implemented this policy from December 2019 and it was adopted from
U.S Federal Reserve policy. The main goal of this policy was to lower the yield on long-term G.
Secs issued by the Government of India. The background of this policy can be traced from the
policy of lower interest rate (expansionary monetary policy) followed by RBI during most of 2018
and 2019. It had decreased demand for bonds in general, and G. Secs in particular. The resulting
fall in bond price had increased the yield on the G. Secs issued earlier. Bond yield is directly
related to the expected interest rate on the bonds to be issued in future as the future investors
would also expect to earn more like the past investors. For this, they will buy bonds only if it
promises higher interest rates.In the context of the G. Secs, this means that the government will
have to pay a higher interest rate on their future borrowings. This can worsen the fiscal deficit
in future.

So, RBI implemented Operation Twist. Under this, RBI bought the long-term G. Secs from the
banks and sold these banks equivalent amount of the short-term G. Secs. It was like an open
market operation but different from ordinary as the purchase and sale of two types of securities
happen simultaneously. The purchase of long-term securities reduces it supply in the market
and leads to higher prices. Higher G. Secs prices reduces the yield on long-term G. Secs. A
simultaneous sale of the short-term G. Secs is done so that the extra liquidity with the banks
can be absorbed due to long-term G. Secs bought from them. If this is not done, it can increase
money supply in the economy leading to inflation.

2. Long-Term Repo Operation (LTRO): Under this operation introduced in February, 2020, the
RBI allowed the commercial banks to take long-term loans from RBI at repo rate. It is similar to
the repo operation discussed earlier, except that the banks received loans for a longer time-period
from 1 year to 3 years.

3. Government Securities Acquisition Programme (GSAP): It was an unconventional type of

GSAP was different from ordinary OMOs as RBI had made purchase of G. Secs in higher amount
as compared to earlier purchases over two quarters. Thus, GSAP was taken up at a larger scale
than other OMOs and was also more predictable due to RBI announcing the amount of purchase
before the actual purchase. Such a policy was taken mainly to keep interest rates on G. Secs
lower so that the government can borrow at lower interest rates to follow their policies during
the pandemic in a better manner.

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 Although RBI succeeded in achieving lower interest rates, it also put inflationary pressures on
the economy due to excessive liquidity with the banks in short period. Thus, after GSAP in two
quarters starting from June to August (GSAP 1.0) and from September to November (GSAP
2.0), RBI decided to stop GSAP.

Qualitative Instruments of Monetary Policy

Most of the monetary policy instruments used to regulate money supply are quantitative. But, RBI
can use a few qualitative instruments as well to differentiate among the different types of borrowers to
achieve certain objectives like benefitting the less-privileged sectors. In other words, through qualitative
instruments, RBI can ensure better financial inclusion in the Indian Economy. Some examples of these
instruments are as follows:

1. Selective Credit Controls (SCC): It ensures more equitable distribution of credit by the commercial
banks as instructed by RBI. For example, under the Priority Sector Lending (PSL), RBI makes it
mandatory for the banks to distribute some minimum proportion of credit to the less privileged
sectors like Agriculture and MSMEs. RBI can also restrict the flow of credit to certain sectors
under SCC. This process is called Credit Rationing.

2. Differential Rates of Interest (DRI): Apart from regulating sector-wise flow of volume of
credit, RBI also directs banks to provide credit to certain less-privileged population/sectors at
lower interest rates. For instance, under PSL, RBI can instruct banks to give cheaper credit
to the priority sectors. The borrowers belonging to Scheduled Castes and Scheduled Tribes or
differently abled categories can also benefit from DRI. At least 1% of total credit must be given
by the banks to these sectors at 4% per annum interest rate and the maximum credit amount
is Rs. 15, 000 per borrower.

3. Margin Requirements on Secured Loans: In case of a loan taken on the basis of some security,
margin is defined as the difference between the loan amount being demanded and the security
value in the market. Let margin requirement on a loan is 30%, then bank can give only 70% of
the security value as a loan to the borrower. For example, if a borrower has a property worth
Rs 1 Crore to offer as collateral, the bank can give a maximum loan of Rs. 70 Lakhs to the
borrower.

RBI can change the margin requirements to direct credit flow to desirable sectors. For example,
if RBI suspects that loans are being taken by certain borrowers only for speculative purposes (say
to invest in currency market that can lead to rupee depreciation), then RBI can increase margin
requirement on such loans. Similarly, RBI can decrease margin requirements for the loans going
to the productive sectors.

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 Loan to Value (LTV) Ratio is inverse of the percentage margin. LTV can be defined as the
amount of loan that a borrower can get as a percentage of the security asset value provided by
the borrower. Lower LTV ensures less risk for the lender but the borrower gets lesser amount of
loan. Generally, LTV is ideally kept at 80% or below to ensure that loan does not become too
risky.

RBI can give guidelines on LTV depending upon the type of loan being considered. For example,
on home loans, RBI advices up to 90% LTV if loan amount is Rs. 30 lakhs or below, 80% LTV
for loan amounts between Rs. 30 lakhs to Rs. 75 lakhs, and up to 75% LTV for loan amounts
higher than Rs. 75 lakhs. However, RBI can only set a maximum LTV to be followed by the
banks. Banks can impose LTV that is lower than that prescribed by RBI depending upon the
risk-appraisal system followed by the bank. A bank that wants to take less risk while giving loans
can impose lower LTV than prescribed by RBI.

During the Covid pandemic period, RBI increased the maximum permissible LTV on gold loans
given by the banks from 75% to 90% of the value of the gold ornaments given as security for
these loans given up to 31st March 2021. After that it has been restored to 75%.

4. Moral Suasion: Under this RBI can put pressure on banks informally to follow certain type of
monetary policy. Such pressure can be provided through letters, discussions etc. Mostly it is
provided informally by making some speeches from a public forum. For instance, RBI Governor
can persuade banks to give cheaper credit to certain sector (say for home loans) through some
speech given (say at a builders’ meeting). This tool is mostly qualitative as it is used to benefit
a sector but can be quantitative as well if RBI wants to benefit all types of borrowers.