Economy Simplified: Instruments of Monetary Policy 

There are several direct and indirect instruments that are used for implementing monetary policy.

Liquidity Adjustment Facility (LAF)

1. Liquidity Adjustment Facility (LAF): The LAF refers to the Reserve Bank’s operations through which it injects/absorbs liquidity into/from the banking system. It consists of overnight as well as term repo/reverse repos (fixed as well as variable rates), SDF (Standing Deposit Facility) and MSF(Marginal Standing Facility)
2. LAF’s can manage inflation in the economy by increasing and reducing the money supply via tools such as CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio).
3. LAF’s help the RBI manage liquidity and provide economic stability by offering banks the opportunity to borrow money through repurchase agreements or repos or to make loans to the RBI via reverse repo agreements.
4. Apart from LAF, instruments of liquidity management include outright open market operations (OMOs), forex swaps and market stabilisation scheme (MSS).
Instruments available ṭo RBI: (Quantitative Instruments)Repo and Reverse Repo
Marginal Standing Facility
Standing Deposit Facility
Bank Rate 
Open Market Operations 
LTRO (Long term Repo Operations)Market Stabilisation Scheme
Qualitative InstrumentsCredit Rationing 
Moral Suasion 
Prompt Corrective Action

Bank Rate

1. Rate at which RBI provides long-term borrowings to its clients. Its clients include GoI, state governments, banks, financial institutions, cooperative banks etc.
2. Increase in the bank rate symbolizes tightening of RBI monetary policy. 
3. An increase in bank rate will make borrowing from RBI expensive. Hence  discourages banks to borrow from RBI. This results in decreasing the money supply in the economy.

Repo and Reverse Repo Rate

Repo rate is the rate at which the central bank gives loans to commercial banks against government securities.
1. So, if the repo rate increases, it means banks are getting funds from RBI at a higher cost. This, in turn, will mean that banks will also lend to others at a higher cost. So, if you take a loan from a bank when the repo rate is high, you will have to pay a higher interest rate.
2. ‘Repo’ stands for ‘Repurchasing Option’. It is an agreement between the banks and the central bank. Banks take overnight loans from the RBI and provide securities such as treasury bills. There is also an agreement to repurchase these securities at a predetermined price.
3. In this way, banks get the cash they need for different operations and the central bank gets the security.
Reverse repo rate is the interest that RBI pays to banks for the funds that the banks deposit with it.
1. Sometimes, there is excess liquidity in the market. To absorb this excess liquidity, the central bank takes out money from the overall system by borrowing the money from banks. 
2. The banks benefit from this as they earn interest for their holdings with the central bank. 
3. Reverse repo rate is often used in times of high levels of inflation in the economy. When such conditions prevail, the central bank increases the reverse repo rate.
4. This prompts banks to park more funds with RBI to earn higher returns on their excess funds. As a result, banks have lesser funds to extend as loans and borrowings to consumers, and the liquidity in the system reduces.


1. CRR stands for Cash Reserve Ratio. Every commercial bank is obligated to maintain CRR, which is a specified percentage of their net demand and time liabilities.
2. Commercial banks must maintain the CRR in the form of cash balances with the RBI. These banks are not allowed to use the money for economic or commercial purposes.
3. The RBI uses CRR to maintain liquidity and cash flow in the economy.
1. SLR stands for Statutory Liquidity Ratio.
2. It is an obligatory reserve that commercial banks must maintain.
3. Commercial banks may maintain this reserve requirement in the form of approved securities per a specific percentage of the net demand and time liabilities.
4. SLR can also be defined as a tool used to maintain the stability of the banks by restricting the credit facility they offer to their customers. 
5. Banks usually hold more than the required SLR, per RBI norms stating that they must maintain a certain amount of money as liquid assets. This helps banks fulfill their depositors’ demands as and when they arise.

What is the difference between CRR and SLR?

MeaningIt is a percentage of money that a bank has to keep with the RBI.It is a proportion of liquid assets per a percentage of time and demand liabilities.
FormMaintained in the form of cash.Maintained in the form of cash, gold and government-approved securities.
UsesRegulates the flow of money in the economy.Ensures the solvency of banks.
Reserved WithReserved with the RBI.Reserved with commercial banks.
National ImpactRegulates the liquidity of cash in the country.Maintains the credit growth of the country.

What is MSF ‘Marginal Standing Facility’?

1. Marginal standing facility (MSF) is a window for banks to borrow from the Reserve Bank of India in an emergency situation when interbank liquidity dries up completely.
2. Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short.
3. The MSF rate is pegged 100 basis points or a percentage point above the repo rate. Under MSF, banks can borrow funds up to one percent of their net demand and time liabilities (NDTL).

What is (SDF) Standing Deposit Facility?

1. The RBI’s new tool to absorb excess liquidity to control inflation.
2. In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the SDF – an additional tool for absorbing liquidity without any collateral.
3. In other words, the SDF will help the central bank in absorbing liquidity (deposits) from commercial banks without giving government securities in return to the banks.
4. By removing the binding collateral constraint on the RBI, the SDF strengthens the operating framework of monetary policy.
5. The SDF is also a financial stability tool in addition to its role in liquidity management.
6. The SDF will replace the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor.
7. Both the standing facilities — the MSF (marginal standing facility) and the SDF will be available on all days of the week, throughout the year.
8. The SDF rate will be 25 bps below the policy rate (Repo rate).

What is the LAF corridor?

The LAF corridor has the marginal standing facility (MSF) rate as its upper bound (ceiling) and the standing deposit facility (SDF) rate as the lower bound (floor), with the policy repo rate in the middle of the corridor.

Open Market Operations (OMO)

OMO refers to sale and purchase of government securities by RBI in the open market with the aim of influencing liquidity in the economy in the medium term.
If RBI sells government securities, Banks and the public will buy these securities and pay money to the RBI. Hence the RBI successfully absorbs excess liquidity. During inflation the RBI  sells government securities and as a result money supply in the economy falls, thereby reducing inflationary price rise.
If the RBI buys government securities, If the RBI buys these instruments from instrument holders, it will pay money to the latter. Hence infuses liquidity to the economy. During deflation, the RBI  will buy back the securities thus increasing money supply and thereby triggering demand for goods and services. 

Market Stabilisation Scheme

1. Under the Market Stabilization Scheme or MSS, if there is an excess money supply in the economy, RBI intervenes by selling Government securities (like Treasury Bills, Cash Management Bills & Dated securities.). 
2.This helps to withdraw the excess liquidity from the system.
3. The money raised through the selling of securities is kept in a separate account known as MSS account.
4. The amount kept in the MSS account is only used for the redemption (repayment) of securities issued under the MSS. 
5. This money is not used by the Government to meet its expenditure requirement. It is not a part of Government borrowing.
6. However, interest is paid on the securities issued under MSS. Hence, there is a marginal impact on the fiscal deficit due to interest payments. 
7. But, there is no impact on fiscal deficit due to borrowings under MSS as it is not used to meet expenditure requirements.

How is Market Stabilization Scheme different from Open Market Operations?

Open Market Operations (OMO)Market Stabilization Scheme
OMO is buying and selling Government securities to manage money supply in the economy. Thus, it is used to both inject and withdraw liquidity. Moreover, these securities are a part of Government borrowing.MSS is only selling Government securities to withdraw excess liquidity. The money raised through the selling of securities is kept in a separate account known as MSS account. The amount kept in the MSS account is only used for the redemption (repayment) of securities issued under the MSS. This money is not used by the Government to meet its expenditure requirement. It is not a part of Government borrowing.

LTRO (Long term Repo Operations)

1. New policy tool used by the RBI to inject more liquidity into the Economy.
2. Similar to the term repos, but with a longer maturity period of 1 year and 3 years.
3. Through the LTRO, the RBI seeks to inject long term liquidity into the economy at a lower interest rate.
4. The LTROs would be carried out through e-Kuber.
(e-Kuber is the Core Banking Solution (CBS) of the RBI which enables each bank to connect their single current account across the country.).

Credit Rationing 

Rationing of credit is a method by which the RBI seeks to limit the maximum amount of loans and advances and, also in certain cases, fix ceilings for specific categories of loans and advances.

Moral Suasion

To persuade or convince the commercial banks to advance credit in the economic interest of the country. “Persuasion” without applying punitive measures.

Prompt Corrective Action

1. The PCA is triggered when banks breach certain regulatory requirements like minimum capital, and quantum of non-performing assets.
2. To ensure that banks don’t go bust, RBI has put in place some trigger points to assess, monitor, control and take corrective actions on banks which are weak and troubled.

Legal Framework (Acts administered by Reserve Bank of India)

  • Reserve Bank of India Act, 1934
  • Public Debt Act, 1944/Government Securities Act, 2006
  • Government Securities Regulations, 2007
  • Banking Regulation Act, 1949
  • Foreign Exchange Management Act, 1999
  • Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
  • Credit Information Companies(Regulation) Act, 2005
  • Payment and Settlement Systems Act, 2007
  • Factoring Regulation Act, 2011

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