Monetary Policy in India Since 1991: RBI, Inflation Targeting and Tools for RBI Grade B ESI
Last updated: 2026-11-11 · MockMentor
"Monetary and Fiscal Policy since economic reforms of 1991" is one of the most important topics in the Indian Economy unit of the RBI Grade B Phase 2 Economic and Social Issues (ESI) syllabus. For an exam conducted by the central bank, monetary policy is home ground: questions range from the definition of the repo rate to the merits of inflation targeting and the challenge of transmission. This chapter covers the goals and tools of monetary policy, how it works, how it has changed since 1991, and the current framework.
In one line: RBI uses interest rates and liquidity to keep inflation close to 4% while supporting growth, through a six-member Monetary Policy Committee set up under the inflation targeting framework of 2016.
Basic concepts
- Monetary policy: the actions of the central bank to manage the supply of money, the cost of credit (interest rates) and liquidity in the economy, to achieve price stability and support growth.
- Repo rate: the rate at which RBI lends money to banks for short periods against government securities. It is the policy rate that signals RBI's stance.
- Liquidity: the amount of money available in the banking system for lending. Surplus liquidity pushes short-term interest rates down; a deficit pushes them up.
- Inflation targeting: a framework in which the central bank is given a numerical inflation target and is accountable for meeting it.
- Transmission: how a change in the policy rate passes through to the interest rates that banks charge borrowers and pay depositors, and then to spending and inflation.
- Stance: a signal of the likely direction of future policy: accommodative (ready to cut), neutral, or tight (ready to raise rates).
- Basis point (bps): one-hundredth of a percentage point. A 25 bps hike raises a rate from 5.25% to 5.50%.
Why in News?
- On 7 October 2026, the Monetary Policy Committee (MPC) raised the repo rate by 25 bps to 5.50%, its first hike since February 2023, and changed its stance to "calibrated tightening". The Standing Deposit Facility (SDF) rate rose to 5.25%, and the Marginal Standing Facility (MSF) rate and Bank Rate to 5.75%.
- RBI projected CPI inflation at 5.2% for 2026-27 and real GDP growth at 7.1%.
- CPI inflation rose to 5.54% in September 2026, a 23-month high, with food inflation at 7.74%. The CPI is now measured on a new series with base year 2024.
- The next MPC meeting is scheduled for 2 to 4 December 2026.
Meaning and goals of monetary policy
Monetary policy works on the demand side of the economy. By making credit cheaper or costlier, and money more or less plentiful, the central bank influences how much households spend, how much firms invest, and through these, output, employment and prices.
| Goal | Why it matters |
|---|---|
| Price stability | High and unstable inflation hurts the poor most, erodes savings, distorts investment decisions and weakens the currency. Low, stable inflation is the base for sustained growth. |
| Growth | By keeping credit available at a reasonable cost, monetary policy supports investment and consumption, especially when the economy is slowing. |
| Financial stability | Avoiding asset bubbles, excessive credit growth and stress in banks. |
| Exchange rate stability | Preventing sharp, disorderly movements in the rupee, without targeting a fixed level. |
| Employment | A stable, growing economy creates jobs, though monetary policy does not target employment directly in India. |
Since 2016, the primary objective is written into law: the RBI Act, as amended, states that the objective of monetary policy is "to maintain price stability while keeping in mind the objective of growth".
How monetary policy works: transmission
When RBI raises the repo rate:
- Banks pay more to borrow from RBI and from each other, so short-term money market rates (such as the overnight call rate and Treasury bill yields) rise.
- Banks raise the rates on loans linked to external benchmarks, such as the repo rate, almost at once, and over time raise the Marginal Cost of Funds based Lending Rate (MCLR) and deposit rates.
- Costlier loans reduce borrowing for homes, cars and business investment. Higher deposit rates encourage saving.
- Higher interest rates make rupee assets more attractive to foreign investors, which supports the rupee and lowers the cost of imports.
- With lower demand and a stronger currency, inflation eases over the next few quarters.
A rate cut works the other way. These channels are called the interest rate channel, the credit channel, the exchange rate channel, the asset price channel and the expectations channel. Monetary policy acts with a lag of about two to four quarters, which is why RBI sets policy by looking at projected inflation over the next year or so.
Why transmission in India is often slow
- A large share of bank funds comes from fixed-rate term deposits, so banks' cost of funds changes slowly.
- Small savings schemes offered by the government compete with bank deposits, and their rates are not always revised in step with policy.
- Banks with high bad loans may keep lending rates high to protect margins.
- Large parts of the economy depend on informal credit that policy rates barely reach.
To speed up transmission, RBI required banks from October 2019 to link new floating-rate loans to retail and small businesses to an external benchmark, usually the repo rate.
The Reserve Bank of India
RBI was set up on 1 April 1935 under the Reserve Bank of India Act, 1934, on the recommendation of the Hilton Young Commission. It was privately owned at first and was nationalised on 1 January 1949. Its central office moved from Calcutta to Mumbai in 1937.
Its main functions are:
- Monetary authority: framing and implementing monetary policy.
- Issuer of currency: the sole authority to issue banknotes, except one-rupee notes and coins, which the Government of India issues.
- Banker to the government: managing the accounts and public debt of the Centre and states.
- Banker's bank and lender of last resort: holding banks' reserves and lending to them in emergencies.
- Regulator and supervisor of banks, non-bank financial companies and other financial institutions.
- Manager of foreign exchange under the Foreign Exchange Management Act (FEMA), 1999, and custodian of foreign exchange reserves.
- Regulator of payment and settlement systems.
- Developmental role: financial inclusion, priority sector credit and financial literacy.
Monetary policy since 1991
Before the reforms
Before 1991, monetary policy was dominated by the needs of the government. RBI automatically financed the Centre's deficit by issuing "ad hoc" Treasury bills, which created money and fed inflation. To fund the government and priority sectors, banks had to keep up to 38.5% of deposits in government securities (Statutory Liquidity Ratio) and 15% as cash with RBI (Cash Reserve Ratio). Interest rates were set by RBI for both deposits and loans. The system was called "financial repression".
Phase 1 (1991 to 1998): freeing the system
The Narasimham Committee (1991) and the Chakravarty Committee (1985) shaped this phase. SLR and CRR were cut steadily, interest rates on most deposits and loans were deregulated, and an agreement between the government and RBI in 1994 phased out ad hoc Treasury bills by April 1997. RBI gained real control over money creation for the first time.
Phase 2 (1998 to 2014): the multiple indicator approach
From 1998-99, RBI moved from targeting money supply growth (followed since 1985 on the advice of the Chakravarty Committee) to a "multiple indicator approach", looking at interest rates, credit, inflation, output, the exchange rate and capital flows. The Liquidity Adjustment Facility (LAF), introduced in 2000, made the repo rate the main tool for managing short-term rates. In 2011, the repo rate became the single policy rate, and the Marginal Standing Facility was added. Critics argued that with so many indicators, the policy lacked a clear anchor, and inflation remained high from 2008 to 2013.
Phase 3 (2016 onwards): flexible inflation targeting
The Urjit Patel Committee (2014) recommended inflation targeting based on the Consumer Price Index (CPI). RBI and the government signed a Monetary Policy Framework Agreement in February 2015, and the RBI Act was amended in 2016 to make it law.
The inflation targeting framework
The target
The Government of India, in consultation with RBI, sets the inflation target every five years. The target is CPI (Combined) inflation of 4%, with a tolerance band of 2% to 6%. It was first set for 2016 to 2021 and has since been renewed.
RBI is deemed to have failed if average inflation stays above 6% or below 2% for three consecutive quarters. It must then send a report to the government explaining the reasons, the steps it will take and the time needed to bring inflation back. This happened for the first time in November 2022, after inflation stayed above 6% for most of the year.
The Monetary Policy Committee
| Feature | Detail |
|---|---|
| Legal basis | Section 45ZB of the RBI Act, 1934 (inserted in 2016) |
| Members | Six: the RBI Governor (chairperson), a Deputy Governor in charge of monetary policy, one RBI officer nominated by the Central Board, and three external members appointed by the Central Government |
| External members | Appointed for four years, not eligible for reappointment; chosen by a search committee headed by the Cabinet Secretary |
| Meetings | At least four a year; in practice, six |
| Quorum | Four members, including the Governor (or the Deputy Governor in his absence) |
| Decisions | By majority vote; the Governor has a casting vote in a tie |
| Transparency | Each member's vote and statement are published in the minutes, released on the fourteenth day after the meeting |
The MPC decides the policy repo rate. RBI then sets the operating framework and manages liquidity to keep the weighted average call rate, the operating target, close to the repo rate.
Assessment
The framework is credited with bringing average inflation down from about 9% to 10% in 2009 to 2013 to around 5% since 2016, anchoring inflation expectations, and making policy more transparent and predictable. Its critics argue that food and fuel price shocks, which make up a large part of CPI, are beyond the reach of interest rates; that a strict focus on inflation can neglect growth and jobs; and that the government's fiscal policy and supply-side measures matter as much as monetary policy for inflation.
Instruments of monetary policy
Quantitative tools
These affect the overall volume and cost of credit in the economy.
| Tool | What it is | Current level |
|---|---|---|
| Cash Reserve Ratio (CRR) | The share of a bank's net demand and time liabilities (deposits) that it must keep as cash balance with RBI. It earns no interest. | 3% (cut from 4% in four stages from September to November 2025) |
| Statutory Liquidity Ratio (SLR) | The share of deposits that banks must keep in liquid assets: cash, gold or approved government securities. Set under Section 24 of the Banking Regulation Act. | 18% |
| Repo rate | The rate at which RBI lends to banks overnight or for short terms, against government securities, under the LAF | 5.50% |
| Standing Deposit Facility (SDF) | A facility for banks to park surplus funds with RBI without RBI having to give securities in return. Introduced in April 2022, it replaced the fixed rate reverse repo as the floor of the policy corridor. | 5.25% |
| Marginal Standing Facility (MSF) | Banks can borrow overnight from RBI at a penal rate, even by dipping into their SLR holdings up to a limit. It is the ceiling of the corridor. | 5.75% |
| Bank Rate | The rate at which RBI rediscounts bills or lends without collateral; now aligned with the MSF rate and used to set penalties | 5.75% |
| Reverse repo rate | The rate at which RBI absorbs liquidity from banks against government securities. Now kept for occasional use; the SDF serves as the floor. | 3.35% |
| Open Market Operations (OMOs) | Purchase or sale of government securities by RBI. Buying injects money (durable liquidity); selling absorbs it. | Used as needed |
| Market Stabilisation Scheme (MSS) | Special government securities issued to absorb surplus liquidity arising from large capital inflows. The money raised is kept in a separate account and not spent by the government. | Introduced in 2004 |
The policy corridor
RBI keeps short-term rates within a corridor. The repo rate sits in the middle, the SDF rate is the floor (25 bps below) and the MSF rate is the ceiling (25 bps above). If banks have surplus funds, they park them at the SDF; if short of funds, they borrow at the MSF. So the overnight call rate stays within this band, close to the repo rate.
Liquidity Adjustment Facility (LAF)
The LAF lets RBI inject or absorb liquidity every day. It includes fixed rate repos, variable rate repo (VRR) and variable rate reverse repo (VRRR) auctions of different maturities, the SDF and the MSF. The main tool since 2020 has been variable rate auctions, which allow RBI to fine-tune liquidity. RBI also uses long-term repo operations and foreign exchange swaps (buying dollars from banks now and selling them back later) to inject durable liquidity.
Effects of each tool
| Tool | To fight inflation (tighten) | To support growth (ease) |
|---|---|---|
| Repo, SDF and MSF rates | Raise | Cut |
| CRR | Raise | Cut |
| SLR | Raise | Cut |
| OMOs | Sell securities | Buy securities |
| Variable rate auctions | Absorb through VRRR | Inject through VRR |
Qualitative (selective) tools
These direct credit towards or away from particular uses, rather than changing its overall volume.
- Margin requirements and loan-to-value ratios: the share of an asset's value that a bank can lend against it. A lower loan-to-value ratio for gold loans or housing loans reduces speculative borrowing.
- Credit rationing: limits on the total credit to certain sectors or borrowers.
- Risk weights: higher capital requirements for loans to sectors seen as risky (such as unsecured consumer loans, raised in November 2023), which make such loans costlier for banks.
- Moral suasion: persuading banks through meetings, letters and speeches to follow a desired policy.
- Direct action: penalties and restrictions on banks that do not follow RBI's directions.
- Priority sector lending (PSL): a requirement that banks lend a set share of their credit to sectors such as agriculture, micro and small enterprises, education, housing, renewable energy and weaker sections.
Priority sector lending
| Category | Target for domestic scheduled commercial banks |
|---|---|
| Total priority sector | 40% of Adjusted Net Bank Credit (ANBC) or credit equivalent of off-balance sheet exposure, whichever is higher |
| Agriculture | 18%, of which 10% to small and marginal farmers |
| Micro enterprises | 7.5% |
| Weaker sections | 12% |
Regional rural banks have a target of 75%, and small finance banks and urban cooperative banks 60%. Banks that fall short must deposit the shortfall in funds such as the Rural Infrastructure Development Fund (RIDF) with the National Bank for Agriculture and Rural Development (NABARD). Banks can also buy and sell Priority Sector Lending Certificates (PSLCs): a bank that has lent more than its target to a priority sector can sell the excess to a bank that has lent less, without transferring the loans themselves.
Types of monetary policy
| Expansionary (accommodative) | Contractionary (tight) |
|---|---|
| Used in a slowdown or when inflation is low | Used when inflation is high or the economy is overheating |
| Cuts in repo rate, CRR and SLR; purchase of securities | Hikes in repo rate, CRR and SLR; sale of securities |
| Cheaper and more plentiful credit | Costlier and scarcer credit |
| Example: 2020, when RBI cut the repo rate to 4% during the pandemic | Example: May 2022 to February 2023, when the repo rate rose from 4% to 6.5% |
Between February 2025 and the start of 2026, with inflation well below target, RBI cut the repo rate in steps from 6.5% to 5.25% and lowered the CRR to 3%. In October 2026, with inflation rising on account of food prices, costlier oil and a weaker rupee, it reversed course with a 25 bps hike.
Limitations of monetary policy in India
- Food and fuel make up a large share of the CPI, and their prices depend on weather, global markets and supply, which interest rates cannot change.
- Fiscal dominance: large government borrowing can push up interest rates and limit RBI's room.
- Weak transmission to lending and deposit rates.
- A large informal sector and cash use, which reduce the reach of policy.
- Global spillovers: interest rate moves by the US Federal Reserve and capital flows can force RBI's hand.
- Conflicts between goals: supporting growth and the rupee at the same time as fighting inflation.
Way forward
- Strengthen transmission through more external benchmark-linked loans and deposits, and by aligning small savings rates with market rates.
- Coordinate with fiscal policy and supply-side measures, especially on food: better storage, trade policy and supply chains.
- Deepen the government securities and corporate bond markets to improve the working of OMOs and the transmission of rates.
- Keep the inflation target and the MPC framework credible, while explaining clearly how growth risks are being weighed.
- Watch financial stability risks such as rapid growth in unsecured loans and asset prices.
Possible exam and interview questions
- Explain the evolution of monetary policy in India since 1991, with reference to the move from multiple indicators to flexible inflation targeting. (420 words)
- Critically evaluate the flexible inflation targeting framework in India. Should RBI also target growth or employment? (620 words)
- What is monetary policy transmission? Why is it weak in India, and what has RBI done to improve it?
- Distinguish between quantitative and qualitative instruments of monetary policy, with examples.
- Interview: Why did RBI raise rates in October 2026 even though growth was strong?
Related reading: fiscal policy since 1991, economic reforms since 1991, and our RBI Grade B Phase 2 Finance guide.
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