4. Monetary Policy and Banking

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4. Monetary Policy and Banking

4.1 Money and Money Supply

Money is anything generally accepted in payment. It works as a medium of exchange, a unit of account, a store of value and a standard of deferred payment.

Measures of money supply

Measure	What it includes
M0 (Reserve money)	Currency in circulation + Bankers' deposits with the RBI + Other deposits with the RBI. Also called high-powered money
M1 (Narrow money)	Currency with the public + Demand deposits with banks + Other deposits with the RBI
M2	M1 + Savings deposits with Post Office Savings Banks
M3 (Broad money)	M1 + Time deposits with banks. This is the most commonly used measure
M4	M3 + All deposits with Post Office Savings Banks (excluding National Savings Certificates)

Remember

M1 is the most liquid; M4 is the least liquid.
Money multiplier = M3 ÷ M0. A bank deposit can be lent out again and again, so total money created is a multiple of reserve money.
The Reserve Bank of India is the sole authority for managing money supply.

4.2 Reserve Bank of India

Set up on 1 April 1935 under the RBI Act, 1934, on the recommendation of the Hilton Young Commission; headquartered in Mumbai.
Nationalised on 1 January 1949.
First Governor: Sir Osborne Smith; first Indian Governor: C. D. Deshmukh.
Governor and Deputy Governors are appointed by the Central Government.

Functions of the RBI

Function	Detail
Issuer of currency	Issues all notes except the one-rupee note and coins, which are issued by the Government of India (Finance Ministry)
Banker to the Government	Keeps government accounts, manages public debt and acts as its agent
Banker's bank	Holds banks' reserves, lends to them and clears settlements
Controller of credit	Regulates the supply and cost of credit through monetary policy
Custodian of foreign exchange	Manages foreign exchange reserves and administers FEMA, 1999
Regulator of payment systems	Under the Payment and Settlement Systems Act, 2007
Lender of last resort	Gives emergency funds to banks facing a liquidity crisis

Notes are issued under the Minimum Reserve System (since 1957), under which the RBI must hold at least Rs 200 crore of assets as backing, of which Rs 115 crore is gold and Rs 85 crore foreign securities.

4.3 What is Monetary Policy?

Monetary policy is the RBI's management of the money supply and interest rates to achieve price stability and support growth. It works through liquidity (the amount of money in the system) and the cost of credit.

Stance	Effect
Expansionary (easy / accommodative)	Cuts rates and releases liquidity to raise demand; used in a slowdown
Contractionary (tight / hawkish)	Raises rates and reduces liquidity to control inflation

4.4 Instruments of Monetary Policy

Quantitative (general) instruments

Instrument	Meaning
Repo rate	Rate at which the RBI lends short-term funds to banks against government securities. It is the main policy rate
Reverse repo rate	Rate at which the RBI borrows from banks. It is lower than the repo rate
Standing Deposit Facility (SDF)	Introduced in 2022; lets banks park surplus funds with the RBI without collateral. It sets the lower end of the rate corridor
Marginal Standing Facility (MSF)	Banks borrow overnight from the RBI against their SLR holdings in an emergency. Its rate is above the repo rate and sets the upper end of the corridor
Bank rate	Rate for long-term lending to banks without collateral; aligned with the MSF rate and used as a penal rate
Cash Reserve Ratio (CRR)	Share of a bank's deposits (Net Demand and Time Liabilities) that must be kept as cash with the RBI. No interest is paid on it
Statutory Liquidity Ratio (SLR)	Share of Net Demand and Time Liabilities that banks must keep with themselves in cash, gold or government securities. Under the Banking Regulation Act it cannot exceed 40%
Open Market Operations (OMO)	RBI buying or selling government securities. Buying adds liquidity; selling removes it
Market Stabilisation Scheme (MSS)	Started in 2004; the RBI sells special government bonds to absorb excess liquidity

Remember

Liquidity Adjustment Facility (LAF) was introduced in 2000 and works through repo and reverse repo; it manages day-to-day liquidity.
Rate corridor: SDF < Repo < MSF.
CRR is kept with the RBI and SLR with the banks themselves.
To fight inflation, the RBI raises the repo rate and CRR, and sells securities.

Qualitative (selective) instruments

Margin requirement: the difference between the value of a loan's security and the loan amount.
Moral suasion: persuasion, advice and informal requests to banks.
Selective credit control: limits on credit for specific sectors or commodities.
Credit rationing: caps on the credit given by banks to certain borrowers.

4.5 Monetary Policy Committee and Inflation Targeting

India adopted flexible inflation targeting in 2016, based on the recommendation of the Urjit Patel Committee (2014).
The target is 4% CPI inflation with a tolerance band of ±2%, set by the Government in consultation with the RBI and reviewed every five years.
The Monetary Policy Committee (MPC) was made statutory by the Finance Act, 2016, which amended the RBI Act, 1934 (Section 45ZB).

Feature	Detail
Members	Six: the Governor (Chairperson), the Deputy Governor in charge of monetary policy, one more RBI officer, and three external members appointed by the Central Government for four years
Meetings	At least four times a year
Decisions	By majority vote; the Governor has a casting vote in case of a tie
Failure to meet the target	If inflation stays outside the band for three straight quarters, the RBI must report to the Government with reasons and remedial steps

4.6 Lending Rate Benchmarks

The repo rate affects borrowers only when banks pass the change into their lending rates. The benchmark system has changed several times to make this transmission faster.

System	Introduced	Key Point
BPLR	Earlier	Benchmark Prime Lending Rate; banks lent below it, so it was not transparent
Base Rate	2010	Minimum lending rate; no loan could be given below it
MCLR	April 2016	Marginal Cost of Funds based Lending Rate, linked to banks' own cost of funds
EBLR	October 2019	External benchmark such as the repo rate; mandatory for floating-rate retail and MSME loans, so policy changes pass through quickly

4.7 Monetary Policy versus Fiscal Policy

Feature	Monetary Policy	Fiscal Policy
Authority	Reserve Bank of India	Government (Finance Ministry)
Tools	Repo, CRR, SLR, OMO	Taxes, spending, borrowing
Aim	Price stability and liquidity	Growth, equity and public services
Speed	Quicker to change	Slower; needs Parliament

Quick Recall

RBI: founded 1 April 1935; nationalised 1 January 1949.
M3 = broad money; M0 = reserve money (high-powered money).
Repo rate = RBI lends to banks; reverse repo = RBI borrows from banks.
CRR is cash with the RBI; SLR is held with banks themselves.
Rate corridor: SDF < Repo < MSF.
MPC: six members, Governor holds the casting vote; inflation target 4% ± 2%.
EBLR (Oct 2019) links retail loans to an external benchmark such as the repo rate.

4. Monetary Policy and Banking