What Is Monetary Policy – Tools Used By Central Banks

Summary Points:

1. Monetary policy is the RBI’s main tool to control money in the country. Changing interest rates and bank rules help keep prices steady, create jobs, and support smooth growth in the economy.
    
2. The government controls borrowing, spending, and prices using tools like bonds, interest rates, and bank money rules.
    
3. India faces problems like banks not fully passing the RBI’s rate cuts, food prices changing often, and people not trusting inflation to stay stable. Because of this, the effects of monetary policy become slower and tougher to manage.

Monetary policy controls the money supply and the ways through which new money enters. It is shaped by GDP, inflation, and growth statistics across different industries and sectors.

Let’s understand it with the help of an example:

Imagine you take a home loan of ₹20,00,000 for twenty years. At 9% interest, your EMI comes to about eighteen thousand rupees a month. If the RBI reduces the rate to 8%, your EMI drops to nearly sixteen thousand seven hundred rupees. 

That is a saving of around one thousand three hundred rupees every month, or more than fifteen thousand rupees in a year. Isn’t it interesting how such a small rate change can make such a big difference? 

Now imagine the same happening for millions of families. They save money on loans, spend more on cars, education, and shopping, which creates jobs and boosts business. That is exactly how the RBI uses monetary policy to keep our economy moving.

This blog explains how monetary policy works, the tools the RBI uses to control money flow, and how it impacts your daily life, from loan EMIs to job creation and overall economic growth.

What is Monetary Policy?

Monetary policy is a powerful tool used by the Reserve Bank of India (RBI) to control the money supply, manage interest rates, and keep the Indian economy stable and growing. It helps regulate inflation, encourages investments, and ensures that borrowing is neither too cheap nor too expensive.

Let’s Understand It Like a Car Ride

Think of the Indian economy as a car and the RBI as the driver.

• When growth is too slow, the RBI presses the accelerator by lowering interest rates, making borrowing cheaper.
   
• When inflation rises too fast, the RBI presses the brake by increasing interest rates, making loans more expensive to control spending.

Let’s understand the home loan impact with the help of an example:

Let’s say you want to buy a house worth ₹50,00,000.
 

• At 10%, fewer people take loans due to higher EMIs, and the economy slows down.
   
• At 5%, EMIs are lighter, encouraging more home purchases and business investments, boosting the economy.

As of August 2025, the repo rate is 6.50%, and the average home loan interest rate in India ranges from 8.50% to 9.50%, depending on your credit score and bank.

Inflation Control: Why Prices Matter

Let’s say onion prices shoot up to ₹120/kg from ₹40/kg in just one month. That’s a 200% increase, a clear sign of rising inflation.

• The RBI responds by raising the repo rate.
   
• Costlier loans reduce borrowing and spending.
   
• Lower demand helps bring down prices.

In June 2024, India’s retail inflation (CPI) hit 4.81%, up from 4.31% in May, mainly driven by food prices.

The RBI aims to keep inflation between 2% and 6%. This means prices should not rise too fast or too slowly.

Why It Matters to You?

• Lower interest rates = cheaper loans, more jobs, and economic growth.
   
• Higher rates = controlled prices, better savings interest, but slower business activity.

Why is Monetary Policy Important?

Monetary policy is important because it helps balance growth, employment, and stable prices in the economy. It controls inflation and boosts investments by managing interest rates and money supply effectively nationwide.

Let’s understand it with the help of an example:

Think of monetary policy as the remote control of the economy, held by the RBI. With this remote, the RBI can make money cheaper or costlier, depending on what the country needs.

Suppose India is facing a slowdown. Businesses are not investing, people are saving too much, and jobs are limited. To fix this, the RBI reduces the interest rate.

Now imagine this:

You plan to buy a car worth ₹10,00,000.

• At 12% interest, your yearly EMI might be close to ₹1,20,000. That feels heavy, so you postpone the purchase.
   
• But if the RBI cuts the interest rate to 8%, your EMI reduces to about ₹80,000 a year. That’s much lighter. Suddenly, buying the car feels possible.
   

Multiply this by millions of people and thousands of businesses. Cheaper loans mean more cars, houses, shops, and factories being built. This creates new jobs, increases consumer spending, and gives the economy a strong push forward.

On the flip side, if prices rise too fast (say, vegetables shoot up from ₹50/kg to ₹120/kg), the RBI raises interest rates. Expensive loans reduce borrowing and spending, slowing demand and cooling inflation.

So, the importance of monetary policy is simple: it is the RBI’s tool to keep the economy healthy, speeding it up when it’s weak, and slowing it down when it overheats.

Challenges of Monetary Policy:

Monetary policy in India faces weaker transmission, unstable prices, and high dependence on volatile food costs. Inflation expectations drift easily, making it difficult for RBI decisions to show quick, effective results.

Let’s understand it with the help of an example:

Unlike advanced economies, India’s monetary policy faces unique hurdles. Let’s break them down:

1. Weak Transmission of Policy
Even when the RBI cuts interest rates, banks often don’t pass on the benefit quickly.

For example, if the RBI reduces the repo rate from 6% to 5.5%, ideally, home loan interest should drop from 9% to 8.5%.
But in reality, banks may only reduce it to 8.9%, which barely changes your EMI. So the impact on spending and investment is slower.

2. Food Prices Affect Inflation Strongly
In India, food makes up a big part of household expenses. If onion prices jump from ₹40/kg to ₹120/kg, families immediately feel the pinch. This pushes inflation higher, even though the RBI’s interest rate moves can’t make onions grow faster!

3. Unstable Prices & Expectations
India has a history of fluctuating inflation. When people expect prices to rise (say milk prices from ₹50/litre to ₹70/litre), they start buying more in advance. This creates more demand, pushes prices up further, and makes the RBI’s job harder.

Monetary policy in India is tricky because cheaper loans don’t always reach people fast, food price shocks quickly raise inflation, and people’s expectations of rising prices often turn into reality.

What Are The Tools of Monetary Policy?

The RBI controls money supply using tools like CRR, SLR, repo rate, and open market operations for economic stability. It also uses qualitative tools like credit rationing, margin requirements, and moral suasion to influence banks’ lending behaviour.

1. Open Market Operations (OMO)

This means the central bank (RBI in India, Fed in the U.S.) buys or sells government bonds in the market.

• If RBI BUYS bonds -> It gives money to banks/investors, therefore more money flows into the economy.
   
• If RBI SELLS bonds-> It takes money from banks/investors, therefore less money remains in the economy.
   

Example:

Suppose RBI buys bonds worth ₹1,000 crore from banks. Banks now have more cash instead of bonds. With this extra money, banks can lend more. This reduces loan interest rates, encouraging people to take loans for homes, cars, or business.

On the other hand, if the RBI sells bonds worth ₹500 crore, banks give money to the RBI to buy them. This reduces money available in the system, loans become costly, and inflation cools down.

2. Interest Rates (Repo Rate / Discount Rate)

This is the rate at which the central bank lends money to commercial banks.

• When the rate is lower, banks borrow cheaply. This allows banks to provide cheaper loans. People then spend more, which leads to economic growth.
   
• When the rate is higher, banks borrow expensively. This makes loans costlier. As a result, people spend less, which helps inflation fall.

Example:

If the repo rate is 6%, a bank borrowing ₹100 crore from the RBI pays ₹6 crore interest.
 

If RBI cuts the repo to 5%, the bank pays only ₹5 crore interest.
 

This saving allows the bank to reduce home loan interest from, say, 9% to 8%, lowering EMI.

For a ₹20,00,000 home loan for 20 years:

• At 9% interest, the EMI is around eighteen thousand rupees per month.
   
• At 8% interest, the EMI drops to about sixteen thousand seven hundred rupees per month.

That’s ₹1,300 saved every month, which encourages more people to borrow and spend.

3. Reserve Requirements (CRR/SLR)

Banks must keep a certain percentage of deposits with the RBI (called Cash Reserve Ratio – CRR) or in safe assets (Statutory Liquidity Ratio – SLR).

• When the reserve requirement is lower, banks keep less money with the RBI. This leaves more money available for lending.
   
• When the reserve requirement is higher, banks keep more money with the RBI. This leaves less money available for lending.

Example:

Suppose a bank has deposits worth ₹1,000 crore.

• If CRR is 5%, the bank must keep ₹50 crore with RBI and can lend ₹950 crore.
   
• If RBI reduces CRR to 4%, the bank keeps ₹40 crore and can lend ₹960 crore.

That extra ₹10 crore of lending, multiplied across thousands of banks, can inject huge liquidity into the economy, encouraging growth.

Conclusion:

Monetary policy is how the RBI controls money flow to keep prices steady and the economy strong. It does this by changing interest rates, buying or selling bonds, and setting rules for banks. Lower rates help people borrow more and boost jobs, while higher rates control rising prices. Though helpful, it faces challenges in India like food price shocks and slow impact. Still, it plays a big role in everyday life.

FAQs:

Q1: Who sets monetary policy?

The Monetary Policy is framed by the Reserve Bank of India through the Monetary Policy Committee (MPC), with inflation targets set by the Government every five years.

Q2: What is a monetary authority?

A monetary authority is an organisation, like a central bank, that controls a country’s money supply and interest rates.

Q3: Which Act governs monetary policy in India?

Monetary policy in India is governed by the RBI Act, 1934, amended in 2016 to establish the Monetary Policy Committee (MPC).

Q4: How long does it take for the monetary policy to work?

Monetary policy usually takes one to two years to show full impact, though timing can vary with economic conditions.
 

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