Monetary Policy Explained: MPC, Repo Rate, SDF, MSF and Inflation
Monetary policy is one of the most important topics in banking and competitive examinations. Repo rate, Monetary Policy Committee, inflation targeting, liquidity and policy transmission are all parts of the same framework.
Monetary Policy → RBI and monetary conditions
Fiscal Policy → Government taxation, spending and borrowing
What Is Monetary Policy?
Monetary policy refers broadly to the actions and framework through which the central bank influences monetary and financial conditions in pursuit of its statutory objectives.
In India, the Reserve Bank of India operates monetary policy within the framework established by law.
Monetary Policy → RBI
What Is the Main Objective?
The Reserve Bank of India Act provides that the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth.
Price stability + Keep growth in mind
What Is the Monetary Policy Committee?
The Monetary Policy Committee, commonly called the MPC, determines the policy rate required to achieve the inflation target under India’s monetary-policy framework.
How Many Members Are in the MPC?
The MPC has six members.
Three RBI Members
Three members are from the Reserve Bank of India, including the RBI Governor.
Three External Members
Three members are appointed by the Central Government under the statutory framework.
MPC = 6 members = 3 RBI + 3 Central Government appointees
Who Chairs the MPC?
The Governor of the Reserve Bank of India is the ex-officio Chairperson of the Monetary Policy Committee.
How Does MPC Voting Work?
Each member has one vote.
Decisions are made according to the statutory voting framework. In the event of an equality of votes, the RBI Governor has a second or casting vote.
Governor → Chairperson + Casting vote in case of a tie
What Is Inflation Targeting?
India follows a flexible inflation-targeting framework.
The inflation target is specified by the Central Government in consultation with RBI for the period prescribed under the RBI Act.
The relevant measure is the Consumer Price Index.
Inflation target → CPI, not WPI
What Is the Repo Rate?
The repo rate is the policy rate at which RBI provides liquidity against eligible collateral under the applicable liquidity framework.
It serves as the central policy-rate signal in India’s monetary-policy framework.
Repo → RBI provides funds/liquidity to banks against eligible collateral
What Happens When Repo Rate Rises?
A higher policy rate tends to tighten financial conditions, although the extent and timing of transmission can vary.
Simplified Repo Increase Chain
This is a simplified transmission chain. A repo-rate change does not guarantee that every loan rate changes immediately or by exactly the same amount.
What Happens When Repo Rate Falls?
A reduction in the policy rate can contribute to easier financial conditions and lower borrowing costs if the change is transmitted through the financial system.
This may support credit demand, consumption and investment, depending on broader economic conditions.
Repo ↑ → Tighter monetary conditions
Repo ↓ → Easier monetary conditions
What Is Monetary Policy Transmission?
Monetary policy transmission describes the process through which a change in the policy rate or liquidity conditions affects financial markets, bank deposit and lending rates, credit, demand, output and eventually inflation.
Transmission Map
Why Can Transmission Take Time?
Existing loans may be linked to different benchmarks or reset dates. Banks also consider funding costs, deposit rates, credit risk, competition and liquidity.
Therefore, monetary policy normally works with time lags.
What Is SDF?
SDF stands for Standing Deposit Facility.
It provides RBI with a mechanism to absorb liquidity from eligible entities without providing collateral in return.
SDF → RBI absorbs liquidity
What Is MSF?
MSF stands for Marginal Standing Facility.
It provides eligible banks with an overnight borrowing facility from RBI against eligible securities under the applicable framework.
MSF → Banks can obtain overnight funds from RBI under the facility
The Policy Corridor
The monetary-policy operating framework uses standing facilities around the policy repo rate to help form an interest-rate corridor.
Simple Corridor Memory
Upper side
Centre / policy signal
Lower side
MSF → Above repo
Repo → Policy rate
SDF → Below repo
What Happened to Reverse Repo?
The fixed reverse repo rate was historically prominent as the lower side of the liquidity adjustment corridor.
With the introduction of the Standing Deposit Facility in 2022, SDF became the standing absorption facility at the lower end of the current policy corridor.
Older books may still show reverse repo as the normal lower bound of the policy corridor. Check the current RBI framework.
What Is CRR?
CRR stands for Cash Reserve Ratio.
It is the prescribed proportion of a bank’s relevant net demand and time liabilities that must be maintained as cash balance with RBI, subject to the applicable statutory framework.
CRR → Cash with RBI
What Is SLR?
SLR stands for Statutory Liquidity Ratio.
Banks are required to maintain the prescribed proportion of their relevant liabilities in specified liquid assets in accordance with the statutory framework.
CRR → Cash balance with RBI
SLR → Specified liquid assets maintained by banks
Repo vs CRR
Repo Rate
A policy interest rate influencing the price of short-term liquidity and broader financial conditions.
CRR
A reserve requirement affecting the amount of cash banks maintain with RBI.
Repo is a rate on a liquidity facility.
CRR is a reserve ratio.
What Is Liquidity?
In the banking system, liquidity broadly refers to the availability of funds that allow institutions to meet payment and funding requirements.
RBI manages system liquidity through various instruments within its operating framework.
What Is LAF?
LAF stands for Liquidity Adjustment Facility.
It forms part of RBI’s framework for managing short-term liquidity and aligning money-market conditions with the monetary-policy stance.
What Is an Accommodative Policy?
An accommodative monetary-policy approach generally seeks to support economic activity through relatively easier monetary and financial conditions, while remaining consistent with the monetary-policy framework.
What Is Monetary Tightening?
Monetary tightening refers broadly to making monetary conditions less accommodative or more restrictive.
This can involve increases in policy rates or other actions that tighten financial and liquidity conditions.
Easing
Monetary conditions become relatively easier.
Tightening
Monetary conditions become relatively tighter.
Monetary Policy and Inflation
Interest-rate policy primarily influences inflation through demand, financial conditions, expectations and monetary transmission.
However, not every source of inflation can be directly controlled by interest rates.
A repo-rate increase cannot directly produce more vegetables after a crop failure. Monetary policy can influence broader demand and expectations, but supply-side problems may require other responses.
Monetary Policy and Growth
Higher interest rates can moderate demand and borrowing, while lower rates can support spending and investment.
The challenge for monetary policy is that inflation and growth conditions can sometimes point in different directions.
Monetary Policy vs Fiscal Policy
Monetary Policy
Institution: RBI framework
Key areas: Policy rate, liquidity, monetary conditions
Primary objective: Price stability while keeping growth in mind
Fiscal Policy
Institution: Government
Key areas: Taxes, expenditure and borrowing
Expression: Budget and fiscal decisions
Monetary → Money and rates
Fiscal → Government budget
Does RBI Directly Set Your Home Loan Rate?
Not generally.
RBI sets the monetary-policy framework and regulates applicable benchmarking requirements, while individual banks determine lending rates according to the applicable regulatory framework, benchmark, funding costs, credit risk and other factors.
Repo rate and your loan rate are related through transmission, but they are not necessarily identical.
What Is an External Benchmark?
For specified categories of floating-rate loans, RBI requires banks to link lending rates to eligible external benchmarks under the applicable framework.
The policy repo rate is one benchmark that can be used where permitted.
What Is EBLR?
EBLR commonly refers to an External Benchmark Linked Lending Rate.
When the external benchmark changes, the loan rate may reset according to the terms of the loan and applicable regulatory requirements.
What Is MCLR?
MCLR stands for Marginal Cost of Funds Based Lending Rate.
It is an internal benchmark framework introduced for bank lending rates before external benchmarking became mandatory for specified categories of new floating-rate loans.
MCLR → Internal bank benchmark framework
External benchmark → Linked to an eligible external reference
Why Do Bond Prices React to Interest Rates?
Interest-rate expectations affect the attractiveness and valuation of existing fixed-income securities.
In general, for a conventional fixed-rate bond, market yields and bond prices move in opposite directions, other things being equal.
Yield ↑ → Existing bond price ↓
Yield ↓ → Existing bond price ↑
Common Exam Traps
Incorrect. India’s monetary policy operates through the RBI/MPC framework.
Incorrect. It has six members.
Incorrect. It is based on CPI.
Incorrect.
Incorrect. SDF is a liquidity-absorption facility.
Incorrect. MSF forms the upper side of the corridor.
Incorrect.
Test Yourself
1. What does MPC stand for?
2. How many members are there in the MPC?
3. Who chairs the MPC?
4. Which inflation measure is used for India’s inflation target?
5. What does SDF stand for?
6. Does SDF inject or absorb liquidity?
7. What does MSF stand for?
8. Which normally forms the upper side of the policy corridor?
9. What does CRR stand for?
10. What does LAF stand for?
60-Second Revision
MPC → Monetary Policy Committee
MPC Members → 6
Composition → 3 RBI + 3 Government appointees
MPC Chairperson → RBI Governor
Inflation measure → CPI
Repo → Main policy rate
SDF → Absorbs liquidity
MSF → Overnight borrowing facility for eligible banks
Corridor → SDF → Repo → MSF
CRR → Cash Reserve Ratio
SLR → Statutory Liquidity Ratio
LAF → Liquidity Adjustment Facility
Fiscal policy → Government budget
Monetary policy → Money, rates and liquidity