Credit Control — Instruments of Monetary Policy
Class 12 Macro Economics — Quantitative and Qualitative Tools Used by RBI
Monetary Policy — An Overview
Two Categories of Instruments
RBI controls credit using:
- Quantitative methods (traditional): Repo rate, bank rate, reverse repo rate, open market operations, varying reserve requirements (CRR, SLR). These affect ALL sectors using bank credit and regulate the total volume of credit.
- Qualitative methods (selective): Margin requirements, moral suasion, selective credit controls. These affect the direction or specific use of credit.
Liquidity Funnel — Quantitative Instruments at a Glance
Each quantitative instrument acts as a valve controlling the flow of money from RBI to the economy. Click any valve to see how it works.
Click a valve above to see how it controls money flow
Repo Rate, Bank Rate and Reverse Repo Rate
Always Remember: Repo Rate and Reverse Repo Rate work oppositely in terms of direction of funds (RBI lending vs. RBI borrowing/accepting deposits) but are used together to manage the lending capacity of commercial banks.
| Aspect | Bank Rate | Repo Rate |
|---|---|---|
| Loan Charge On | Charged by RBI for lending loans to banks | Charged on repurchase of securities sold by banks to RBI |
| Collateral | No collateral or security required | Approved securities required as collateral |
| Tenure | Long-term financial requirements | Short-term financial needs |
| Rate Level | Generally higher than Repo Rate | Always lower than Bank Rate |
| Repurchase Agreement | No repurchase agreement | Involves repurchase agreement |
Open Market Operations (OMO)
Tightens Money Supply
Conditions Necessary for Success of OMO
- A well-developed and organized security market must exist
- The sale/purchase of securities must effectively impact commercial banks' reserves
- The central bank must hold sufficient securities to influence money supply
- The value of government securities should be relatively stable
Legal Reserve Requirements (CRR and SLR)
Cash Reserve Ratio (CRR)
Minimum percentage of net demand and time liabilities (deposits) that banks must keep WITH THE CENTRAL BANK.
↑ CRR Increased
Reduces excess reserves of commercial banks → Limits their credit creating power → ↓ Money supply
Statutory Liquidity Ratio (SLR)
Minimum percentage of net demand and time liabilities that banks must maintain WITH THEMSELVES in the form of designated liquid assets.
↑ SLR Increased
Reduces funds available for lending and limits banks' ability to sell securities → ↓ Credit creation
Definitions
- Unencumbered securities: Those not used as security for loans from the Central Bank
- Approved securities: Those whose repayment is guaranteed by the government
Qualitative Instruments
Quantitative vs Qualitative Methods
- Quantitative: Repo rate, bank rate, reverse repo rate, OMO, CRR, SLR. Affect total volume of credit. Also called traditional methods.
- Qualitative: Margin requirements, moral suasion, selective credit controls. Affect direction/use of credit. Also called selective methods.
Summary — All Instruments at a Glance
| Instrument | Type | Mechanism | ↑ Effect (Tightening) | ↓ Effect (Loosening) |
|---|---|---|---|---|
| Repo Rate | Quantitative | Short-term lending rate to banks | ↓ Money supply | ↑ Money supply |
| Bank Rate | Quantitative | Long-term lending rate to banks | ↓ Money supply | ↑ Money supply |
| Reverse Repo Rate | Quantitative | Rate paid to banks for parking funds | ↓ Money supply | ↑ Money supply |
| Open Market Operations | Quantitative | Buying/selling govt securities | Sale: ↓ Money supply | Purchase: ↑ Money supply |
| CRR | Quantitative | Reserves kept with RBI | ↓ Money supply | ↑ Money supply |
| SLR | Quantitative | Liquid assets kept with bank | ↓ Money supply | ↑ Money supply |
| Margin Requirements | Qualitative | Loan % of security value | ↓ Money supply | ↑ Money supply |
| Moral Suasion | Qualitative | Persuasion & pressure by RBI | ↓/↑ (advisory) | ↓/↑ (advisory) |
| Selective Credit Controls | Qualitative | Directions to priority sectors | Reduces specific credit | Increases specific credit |
Key Takeaways
- Quantitative instruments control the total volume of credit in the economy
- Qualitative instruments control the direction/specific use of credit
- Repo Rate and Reverse Repo Rate move together — both raised to tighten, both lowered to loosen
- CRR and SLR are direct, powerful tools — changes here have strong immediate effects
- Moral Suasion is persuasive (not punitive) but effective due to RBI's authority as lender of last resort