What Are Monetary Policy Instruments?

Monetary Policy is a General Awareness topic that is one of the most asked topics in the banking exams. Monetary Policy Instruments are tools that the Reserve Bank of India (RBI) uses to control the money supply in the economy of our country. Monetary Policy instruments are of two types: Quantitative and Qualitative. The Quantitative tools include Bank Rate, CRR, SLR, Marginal Standing Facility, Liquidity Adjustment Facility, and Open Market Operations. Whereas, the Qualitative tools include Marginal Requirements, Selective Credit Controls, Moral Suasion, Rationing of Credit, and Direct Action. Continue to read below and know the details about both types of Monetary Policy Instruments.

What is Monetary Policy in India? – Overview

Monetary Policy is a macroeconomic tool used by the RBI to influence the money supply in an economy and achieve the macroeconomic goals. It involves the use of certain monetary policy instruments and regulates the availability of credit in the market. It aims to maintain the financial stability in the market and manage inflation.

Objectives of Monetary Policy:

• To accelerate the growth of the economy.
• To maintain price stability.
• To generate employment.
• To stabilize the exchange rate.

There are two types of monetary policy in India: Expansionary Policy and Contractionary Policy.

Expansionary Monetary Policy is used to increase the money supply in the economy. It is done by decreasing the interest rates, lowering reserve requirements for banks, and purchasing government securities by the Central Bank.

Contractionary Monetary Policy is used to decrease the amount of money supply in the economy. This is done by increasing interest rates, raising reserve requirements for banks, and selling government bonds.

Monetary Policy instruments in India

The Central Bank, which is Reserve Bank of India (RBI), possesses a wide range of tools to be used as Monetary Policy Instruments. These instruments are used to regulate the money supply in the economy.

The higher the money supply, the higher the inflation (the price of common goods increases). And, the lower the money supply, the lower the inflation (the price of common goods decreases).

Monetary policy instruments are classified into two types: Quantitative Instruments and Qualitative Instruments. Let’s discuss these tools individually and see how they bring change to the economy.

Quantitative Tools of Monetary Policy

Quantitative Monetary Policy Tools are the measures used by the RBI to influence the overall money supply and credit conditions in the economy. These types of monetary policy instruments directly influence the amount of money supply in the economy. These are further classified into three types: Open Market Operations, Reserve Requirements, and Policy Interest Rates.

Open Market Operations

This involves the central bank buying or selling government securities in the open market. 

Buying securities injects money into the economy, which increases the money supply.

While selling securities leads to a withdrawal of money from the market, it decreases the money supply. 

Reserve Requirements

These are the minimum percentage of deposits that commercial banks must hold as reserves, either as cash within their bank or as deposits with the central bank. Changes to reserve requirements (like the Cash Reserve Ratio – CRR and Statutory Liquidity Ratio – SLR) affect the amount of money banks can lend out. 

CRR

The CRR is a Cash Reserve Ratio, which is defined as the percentage of deposited money (NDTL – Net Demand and Time Liabilities) that commercial banks are required to keep with the RBI in the form of cash only. The banks do not get interest on this money. Currently, the CRR rate is 3% set by the RBI.

SLR

The SLR is the Statutory Liquidity Ratio, which is a percentage of deposited money (NDTL – Net Demand and Time Liabilities) that the Commercial Banks are required to keep with themselves as a security. It can be kept in the form of liquid assets like cash, gold, and government securities. The SLR rate is currently 18% set by the RBI.

What is NDTL?

NDTL is the Net Demand and Time Liabilities. It refers to the total deposits a bank owes to its customers, including both demand deposits (like savings and current accounts) and time deposits (like fixed deposits).

Policy Interest Rates

These are the rates at which the central bank lends money to commercial banks. Changes to these rates (like the repo rate, bank rate, and Marginal Standing Facility – MSF) influence borrowing costs for banks and, consequently, the interest rates they charge their customers, affecting overall borrowing and lending activity. 

Repo Rate

Repo Rate full form is Repurchase Agreement. Banks take loans from the Reserve Bank of India (RBI) by selling securities. The current Repo rate in India is 5.50%, as announced by RBI’s Governor Sanjay Malhotra on 6 June 2025 in the RBI MPC Meeting.

Bank Rate

Bank rate is the interest rate at which the Reserve Bank of India (RBI) provides loans to commercial banks without keeping any security. These are short-term loans. A bank rate is also known as the discount rate. Banks request loans from the central bank to maintain liquidity and meet reserve requirements. 

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. 

Qualitative Tools of Monetary Policy

The Qualitative Tools of Monetary Policy are the selective measures that influence the direction and allocation of credit in the economy. These tools do not directly control the amount of money supply in the economy. These tools are used to increase or decrease lending to specific sectors based on the central bank’s priorities for economic development and stability. 

Examples of Qualitative Monetary Policy Tools:

The examples of Qualitative Monetary Policy tools include Moral Suasion, Credit Rationing, Margin Requirement, Direct Action, and Selective Credit Control. Let’s discuss these tools in detail.

Moral Suasion

Moral suasion is used by the RBI to persuade commercial banks to act under the RBI’s directives. The RBI might request banks to reduce lending to speculative sectors or restrict financing for certain types of projects. During periods of rupee depreciation, the RBI might ask banks to refrain from aggressively betting against the currency. These suggestions are not legally binding to the banks.

Credit Rationing

Credit rationing is a qualitative monetary policy tool used by the Reserve Bank of India (RBI) to control the flow of credit in the economy. It involves setting a maximum limit on the amount of loans and advances that commercial banks can provide, especially to specific sectors or for certain types of activities. 

Margin Requirement

RBI uses margin requirements as a selective credit control tool to influence the money supply and credit availability in specific sectors of the economy, especially during inflationary or deflationary periods. The margin requirement is the difference between the market value of the collateral and the loan amount provided by a bank. By adjusting margin requirements, the RBI can influence borrowing and lending activity. 

Direct Action

Direct action by the Reserve Bank of India (RBI) refers to the specific measures taken by the central bank to enforce its monetary policy and regulatory directives on commercial banks. This action is usually taken when banks fail to comply with the RBI’s instructions or when there are persistent supervisory concerns. 

Selective Credit Control

Selective Credit Control (SCC) is a qualitative monetary policy tool used by the Reserve Bank of India (RBI) to influence the flow of credit to specific sectors of the economy. It aims to manage the availability and cost of credit for particular industries or activities, often to curb excessive speculation, inflation, or over-expansion in certain areas. 

Significance of Monetary Policy

Monetary Policy is significant for a stable and growing economy. It aims to control inflation, promote employment, and encourage sustainable economic growth by managing the money supply.

Controlling Inflation

• Monetary policy helps maintain price stability by managing the money supply.
• Excessive money supply can lead to inflation, while insufficient supply can cause deflation.
• Central banks use tools like interest rate adjustments and reserve requirements to keep inflation within a desired target range.

Promoting Economic Growth

• Monetary policy can stimulate economic growth by lowering interest rates, making borrowing cheaper for businesses and consumers.
• This encourages investment, spending, and job creation, leading to increased economic activity.
• Conversely, contractionary monetary policy (raising interest rates) can slow down an overheated economy.

Maintaining Financial Stability

• Monetary policy plays a role in ensuring the stability of the financial system.
• By managing liquidity and interest rates, central banks can prevent financial crises and promote confidence in the financial markets.
• This stability is crucial for sustainable economic growth and development.

Influencing Exchange Rates

• Monetary policy can affect exchange rates between currencies.
• For example, increasing the money supply can make a country’s currency less attractive and cheaper relative to other currencies.
• This can impact international trade and investment.

Impacting Employment

• Monetary policy can influence employment levels by affecting economic growth and business investment.
• Lower interest rates and increased money supply can stimulate job creation, while higher interest rates can lead to job losses.

Limitations of Monetary Policy in India

Monetary policy in India is an important tool for managing inflation and economic growth, faces several limitations. These include the prevalence of cash-based transactions, an underdeveloped money market, the existence of black money, conflicting policy objectives, and the limitations of specific monetary policy instruments. 

Unfavourable Banking Habits

• A large portion of transactions in India still occur in cash. It affects the credit creation process of banks.
• This reliance on cash reduces the effectiveness of monetary policy tools that rely on bank lending and credit availability.

Underdeveloped Money Market

• A weak money market limits the ability of the Reserve Bank of India (RBI) to effectively implement and monitor its policy decisions.
• The limited development of the money market hinders the transmission of monetary policy signals to the broader economy.

Existence of Black Money

• Black money transactions are not recorded. It makes it difficult to accurately assess the supply and demand for money in the economy.
• This creates a gap between the intended effects of monetary policy and the actual impact on the economy, as black money transactions are not subject to policy controls.

Limitations of Monetary Policy Tools

• The availability and effectiveness of specific monetary policy instruments, such as interest rates, can be limited by various factors.
• The complexity of the Indian financial system and the existence of multiple interest rates can make it difficult to control the overall monetary conditions.
• Frequent changes in interest rates can create uncertainty for investment.

Weak Policy Transmission Mechanism

• The impact of monetary policy decisions on the broader economy can be weaker than in more developed economies.
• This can be due to factors such as the informal sector, the reliance on cash transactions, and the prevalence of non-bank financing.

Food Price Dynamics

• Food prices in India have a significant impact on inflation, and monetary policy may be less effective in controlling inflation if food prices are driven by supply-side shocks rather than monetary factors.
• The influence of global food prices and domestic supply chain issues on inflation can limit the ability of monetary policy to control overall inflation.

Summary

The Monetary Policy Instruments are divided into two types: Quantitative and Qualitative. These tools are used by the central bank to regulate the money supply in the economy of a country. The Quantitative instruments of Monetary Policy include open market operations, reserve requirements, and Policy Interest Rates. The examples of Qualitative Monetary Policy Instruments are moral suasion, credit rationing, margin requirement, direct action, and selective credit control. The Monetary Policy is significant for controlling inflation, promoting economic growth, maintaining financial stability, influencing exchange rates, and impacting employment. The limitations of Monetary Policy in India include unfavourable banking habits, an underdeveloped money market, the existence of black money, conflicting objectives, a weak policy transmission mechanism, etc. Thus, monetary policy instruments play a major role in shaping the economy of a country.

Note: The rates of the monetary policy tools mentioned here are as per the data available on the date of publishing of this blog( as of June 2025). Please check the revised rates at the time of your exam.

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