Monetary policy and methods of credit control: quantitative and qualitative

1. Monetary policy: meaning and objectives

Monetary policy is the policy of the central bank on the supply, cost and availability of money and credit to achieve the economic objectives of the government. In India its objectives have been:

• price stability, now the primary statutory objective (4 per cent CPI inflation, band 2–6 per cent);
• economic growth through adequate credit to productive sectors;
• exchange-rate stability;
• financial stability of banks and markets; and
• social justice: credit to agriculture, small industry and weaker sections.

Policy is tight (dear money) when inflation is high and easy (cheap money) when growth is slow.

2. Quantitative (general) methods

These affect the total volume and cost of credit in the economy, without regard to its use.

(1) Bank rate. The standard rate at which the RBI buys or rediscounts bills of exchange or lends to banks (section 49, RBI Act). Raising it makes borrowing from the RBI dearer; banks raise their own lending rates, credit contracts and demand falls. Lowering it has the opposite effect. Since 2012 the bank rate is aligned to the MSF rate and is used mainly as the rate for penal interest; the active signalling rate is the repo rate.

(2) Repo rate and the Liquidity Adjustment Facility (LAF). Introduced in 2000, the LAF lets banks borrow overnight from the RBI by selling government securities with an agreement to repurchase them (repo). The policy repo rate, set by the Monetary Policy Committee, is the main signal of monetary policy. The corridor around it has an upper bound, the Marginal Standing Facility (MSF, 2011), at which banks can borrow in emergency by dipping into their SLR securities, and a lower bound, the Standing Deposit Facility (SDF, 2022), at which banks park surplus funds with the RBI without collateral. The reverse repo rate, which earlier formed the floor, now has a lesser role.

(3) Open market operations (OMO). Purchase and sale of government securities by the RBI in the open market. To curb inflation the RBI sells securities; buyers pay from bank deposits, bank reserves fall and credit contracts. To ease credit it buys securities, injecting liquidity. Variable rate repo auctions and foreign-exchange swaps serve similar liquidity purposes.

(4) Cash Reserve Ratio (CRR). The percentage of a scheduled bank’s net demand and time liabilities (NDTL) that it must keep as cash balance with the RBI (section 42, RBI Act). The bank earns no interest on it. A higher CRR reduces the funds banks can lend and the credit multiplier. The 2006 amendment removed the earlier floor and ceiling, so the RBI may fix any rate.

(5) Statutory Liquidity Ratio (SLR). The percentage of NDTL a bank must keep in liquid assets: cash, gold and unencumbered approved (government) securities (section 24, Banking Regulation Act, 1949). It ensures bank liquidity and creates a captive market for government debt. The ceiling is 40 per cent; the old floor was removed in 2007. Raising SLR reduces loanable funds.

3. Worked example: CRR and the credit multiplier

A bank system receives fresh deposits of Rs. 1,000 crore. If the CRR is 5 per cent and banks lend the rest, what is the maximum total deposit created? What happens if CRR rises to 10 per cent?

Credit multiplier = 1 ÷ reserve ratio. At 5 per cent, 1 ÷ 0.05 = 20, so maximum deposits = 1,000 × 20 = Rs. 20,000 crore. At 10 per cent, 1 ÷ 0.10 = 10, so maximum deposits = Rs. 10,000 crore. Doubling CRR halves the potential expansion. (In practice SLR, cash held by the public and excess reserves make the actual multiplier smaller.)

4. Qualitative (selective) methods

These control the direction and use of credit, discouraging it for speculative or non-essential purposes while protecting priority sectors. Power comes from sections 21 and 35A of the Banking Regulation Act.

1. Margin requirements. The margin is the part of the value of a security that the borrower must provide himself. Raising margins on loans against, say, food grains or shares reduces credit for hoarding and speculation.
2. Credit ceilings (rationing). Fixing the maximum amount of credit for a particular sector or bank; also fixing minimum shares for priority sectors.
3. Regulation of consumer credit: down-payment and maximum period of instalment loans for durables.
4. Differential interest rates: lower rates for priority sectors (the Differential Rate of Interest scheme, 1972), higher for others.
5. Moral suasion: persuasion through letters, meetings and speeches asking banks to follow policy.
6. Direct action: penalties, refusal of refinance, or other action against banks that disregard directions.
7. Publicity: publishing reports and data to influence bank and public behaviour.
8. Selective credit controls on advances against sensitive commodities, widely used in India from 1956 to the 1990s and largely withdrawn after liberalisation.

5. Limitations of credit control in India

• A large unorganised money market (moneylenders, indigenous bankers) outside RBI control;
• fiscal dominance: high government borrowing limits the RBI’s freedom (the subject of the Chakravarty Committee);
• weak and slow transmission of policy rates to bank lending rates, which the RBI addressed by moving to the MCLR (2016) and external-benchmark lending (2019);
• supply-side inflation (food, fuel) that monetary policy cannot cure directly;
• large foreign capital flows that affect liquidity.

How this is examined

June/July 2025 (80 marks): “Explain qualitative and quantitative methods of credit control policy of RBI” (10) and “Write a short note on CRR and SLR” (6). January/February 2025: “Bank rate and CRR” and “Qualitative credit control measures” (6 each). For the 10-mark answer give each instrument a heading, its mechanism and its effect in inflation; the multiplier example adds a mark-earning illustration.