Practice Questions on Monetary Policy for UPSC, APPSC and other state PSC exams

• Total Members: 6 (Six).

• RBI Members (3): Governor (Chairperson) + Deputy Governor (Monetary Policy) + One RBI Officer.

• External Members (3): Nominated by Central Government.

• External members criteria: Persons of ability and integrity with knowledge in economics/banking/finance.

• Tenure of external members: 4 years, not eligible for reappointment.

• EBLR Introduction: October 2019.

• Applicable to: Retail and MSME loans by banks.

• External benchmarks: Repo Rate, 3-month/6-month T-Bill yield, any other benchmark by FBIL.

• Purpose: Faster transmission of policy rate changes to lending rates.

• Banks must reset: At least once every 3 months.

• OMO Purpose: Regulate liquidity on a durable basis.

• OMO Purchase: RBI buys G-Secs → Injects liquidity → Expansionary.

• OMO Sale: RBI sells G-Secs → Absorbs liquidity → Contractionary.

• Legal basis: Section 17(8) of RBI Act 1934.

• Different from LAF: LAF is for short-term; OMO is for durable liquidity.

• Forex Reserves (Feb 2026): Approximately USD 723-724 billion.

• Components: Foreign Currency Assets + Gold + SDRs + Reserve Position in IMF.

• FCA: Largest component (~90% of total reserves).

• Import cover: About 10-11 months of imports.

• India ranks: 4th globally in forex reserves (after China, Japan, Switzerland).

• Recommended target: 4% CPI inflation.

• Tolerance band: ± 2% (i.e., 2% to 6%).

• Timeline proposed: Achieve 4% by 2016-17.

• Anchor: CPI (Combined) as nominal anchor.

• Accountability: Report to Parliament if target missed for 3 consecutive quarters.

• M3 (Broad Money): M1 + Time deposits with banks.

• Most commonly used: Measure of money supply in India.

• Components: Currency + Demand deposits + Time deposits.

• Growth target: RBI monitors M3 growth (indicative, not strict target).

• Also called: Aggregate monetary resources.

• SLR maintained in: Cash + Gold + Unencumbered Government Securities.

• Maintained where: With the bank itself (not with RBI).

• Legal basis: Section 24 of Banking Regulation Act 1949.

• Current SLR: 18% of NDTL.

• RBI can prescribe: SLR up to 40% of NDTL (no minimum specified).

• Qualitative/Selective tools: Affect specific sectors, not overall credit.

• Examples: Margin requirements, credit rationing, moral suasion, direct action.

• Moral Suasion: RBI persuades banks through advice, appeals, warnings.

• Quantitative tools: CRR, SLR, Repo, Bank Rate, OMO (affect overall credit).

• Qualitative tools: Used for targeted credit control.

• GDP Projection FY26: 7.4% (revised up from 7.3%).

• Q1 FY27 projection: 6.9%.

• Q2 FY27 projection: 7.0%.

• Growth drivers: Private consumption, fixed investment, services sector.

• Positive factors: India-US trade deal, India-EU FTA, robust domestic demand.

• MSS Introduction: April 2004.

• Purpose: Absorb excess liquidity from large capital inflows.

• Instrument: Government issues securities; proceeds kept in separate account with RBI.

• Difference from OMO: MSS has ceiling; funds not used by government.

• Interest cost: Borne by Government of India, not RBI.

• Liquidity Trap: Interest rates so low that monetary policy becomes ineffective.

• People prefer: Holding cash over bonds (expect rates to rise, bond prices to fall).

• Central bank: Cannot stimulate economy by cutting rates further.

• Concept by: John Maynard Keynes.

• Solution: Fiscal policy becomes more important; unconventional monetary policy.

• Primary Objective: Maintain price stability while keeping in mind the objective of growth.

• Inflation Target: 4% CPI inflation with tolerance band of ±2% (i.e., 2% to 6%).

• Legal Basis: Section 45ZA of RBI Act 1934 (amended in 2016).

• Target set by: Central Government in consultation with RBI, reviewed every 5 years.

• Current target period: April 2021 to March 2026.

• Liquidity Injection Tools: Repo, OMO Purchase, Forex Buy, CRR cut, MSF.

• Repo: RBI lends to banks against G-Secs (overnight/term).

• OMO Purchase: RBI buys G-Secs from market.

• CRR cut: Releases locked funds with RBI.

• Forex Swap (Buy-Sell): RBI buys USD, injects rupees.

• Neutral Stance: RBI not committed to either rate hike or cut.

• Flexibility: Policy direction depends on incoming data.

• Other stances: Accommodative (bias towards cuts), Hawkish/Tightening (bias towards hikes).

• Current RBI stance: Neutral (as of Feb 2026).

• Stance indicates: Forward guidance to markets about likely policy direction.

• Hawkish: Focus on controlling inflation, even at cost of growth.

• Implies: Higher interest rates, tighter liquidity.

• Opposite: Dovish (focus on growth, tolerant of inflation).

• Named after: Hawks (aggressive) vs Doves (peaceful) analogy.

• Hawkish MPC: Likely to raise rates or maintain tight stance.

• Inverted Yield Curve: Short-term yields exceed long-term yields.

• Signal: Potential economic recession ahead.

• Reason: Markets expect future rate cuts due to slowdown.

• Historical accuracy: Has preceded many recessions in US.

• RBI watches: Yield curve shape for economic outlook assessment.

• Liquidity Absorption Tools: Reverse Repo/SDF, OMO Sale, Forex Sell, CRR hike.

• SDF: Banks park excess funds with RBI (no collateral).

• OMO Sale: RBI sells G-Secs, absorbs rupees.

• CRR hike: Locks more funds with RBI.

• Forex Swap (Sell-Buy): RBI sells USD, absorbs rupees.

• WACR: Weighted average interest rate in overnight inter-bank market.

• Published by: RBI (daily).

• Significance: Operating target for monetary policy implementation.

• Ideally: Should be close to Repo Rate.

• Indicates: Short-term liquidity conditions in banking system.

• Credit Multiplier: Reciprocal of reserve requirement (1/r).

• Higher CRR: Lower multiplier, less credit creation.

• Lower CRR: Higher multiplier, more credit creation.

• Formula: ΔM = ΔR × (1/r), where r is reserve ratio.

• Example: If CRR = 4%, multiplier = 1/0.04 = 25.

• Committee: Urjit Patel Committee (2014).

• Report: Report on Revision of Monetary Policy Framework.

• Key recommendation: CPI inflation targeting with 4% ± 2% band.

• Other recommendations: MPC constitution, accountability framework.

• Implementation: Through RBI Act amendment in 2016.

• Quantitative Easing: Central bank purchases large quantities of financial assets.

• Assets purchased: Government bonds, mortgage-backed securities, corporate bonds.

• Purpose: Inject liquidity when interest rates near zero (conventional tools exhausted).

• Used by: US Fed, ECB, Bank of Japan during financial crises.

• India: Has not formally adopted QE, but OMOs serve similar purpose.

• CPI Inflation Projection FY26: 2.1% (marginally raised from 2.0%).

• Q4 FY26 projection: 3.2%.

• Q1 FY27 projection: 4.0%.

• Q2 FY27 projection: 4.2%.

• Key factors: Rising gold/silver prices impacting core inflation; food deflation moderating.

• Credit Rationing: Placing ceiling on loans to certain sectors.

• Qualitative tool: Affects credit allocation, not total credit.

• Purpose: Divert credit from speculative to productive sectors.

• Example: Caps on loans for real estate, commodities.

• Also called: Selective credit control.

• Current CRR: 3.00% of NDTL.

• Reduced in June 2025: From 4% to 3% (100 bps cut in staggered manner).

• Liquidity released: Approximately ₹2.5 lakh crore.

• RBI can prescribe: CRR between 3% and 15% of NDTL.

• No interest paid: On CRR balances held with RBI.

• Transmission: Process by which policy rate changes affect real economy.

• Channels: Interest rate channel, credit channel, asset price channel, exchange rate channel.

• WALR: Weighted Average Lending Rate – key measure of transmission.

• After 125 bps repo cut in 2025: WALR declined by 105 bps (fresh loans).

• Transmission takes time: Usually 2-4 quarters for full effect.

• Current Repo Rate: 5.25% (unchanged in Feb 2026).

• Previous cut: December 2025 (25 bps cut from 5.50% to 5.25%).

• Total cuts in 2025: 125 basis points (from 6.50% to 5.25%).

• Policy stance: Neutral.

• GDP projection FY26: 7.4%; CPI inflation projection: 2.1%.

• Moral Suasion: RBI persuades banks through advice, appeal, and suggestion.

• Not legally binding: Banks voluntarily comply.

• Methods: Meetings, circulars, public statements, press conferences.

• Example: RBI advising banks to pass on rate cuts to customers.

• Qualitative tool: Does not directly change any rates or ratios.

• CRR maintained with: Reserve Bank of India.

• Form: Cash balance (not securities or gold).

• Calculated on: Net Demand and Time Liabilities (NDTL).

• Interest on CRR: Banks earn NO interest on CRR balances.

• Legal basis: Section 42 of RBI Act 1934.

• LAF Introduction: June 2000.

• Recommended by: Narasimham Committee on Banking Sector Reforms (1998).

• Components: Repo (injection) and Reverse Repo (absorption).

• Purpose: Manage day-to-day liquidity mismatches in banking system.

• Now: SDF has replaced fixed Reverse Repo as floor.

• Inflation Measure: Consumer Price Index (CPI) – Combined.

• Earlier: Wholesale Price Index (WPI) was primary focus.

• CPI chosen because: Better reflects cost of living for common people.

• Published by: National Statistical Office (NSO), MoSPI.

• Base Year (current): 2012 (new 2024 base being introduced).

• Accommodative Stance: Bias towards maintaining or cutting rates.

• Signal: RBI unlikely to raise rates in near term.

• Used when: Growth needs support, inflation is under control.

• Opposite: Hawkish/Tightening stance (bias towards rate hikes).

• One MPC member (Prof. Ram Singh) voted for accommodative stance in Feb 2026.

• MPC Constitution: Section 45ZB of RBI Act 1934.

• Amendment: RBI Act amended in 2016 to introduce MPC.

• First MPC meeting: October 2016.

• Earlier: RBI Governor had sole authority to decide policy rates.

• MPC brings: Collective decision-making and transparency to monetary policy.

• Failure clause: If inflation > 6% or < 2% for 3 consecutive quarters.

• RBI must submit: Written report to Central Government explaining reasons.

• Report must include: Remedial actions proposed and estimated time to return to target.

• This is: Accountability mechanism for MPC.

• Legal basis: Section 45ZN of RBI Act 1934.

• WALR: Measures average interest rate on bank loans.

• Published by: RBI (monthly).

• Two types: WALR on fresh loans and WALR on outstanding loans.

• Use: Assesses effectiveness of monetary policy transmission.

• Better transmission: Lower difference between Repo cut and WALR decline.

• MCLR Introduction: April 2016.

• Replaced: Base Rate system (introduced July 2010).

• Components: Marginal cost of funds + Operating costs + Tenor premium + CRR cost.

• Reset period: Monthly by banks.

• Now being replaced by: External Benchmark Lending Rate (EBLR) for many loan categories.

• Real Interest Rate: Nominal Interest Rate – Inflation Rate.

• Fisher Equation: (1+i) = (1+r)(1+π), approximately i = r + π.

• Significance: Measures true cost of borrowing adjusted for inflation.

• Negative real rate: When inflation exceeds nominal rate (erosion of savings).

• RBI considers: Real rate while setting policy (currently positive at ~3%).

• Quorum: 4 members must be present.

• Decision: By majority vote of members present and voting.

• Tie situation: RBI Governor has a second or casting vote.

• Meeting frequency: At least 4 times a year (bi-monthly in practice = 6 times).

• Each member has one vote; no weighted voting.

• M1 (Narrow Money): Currency with public + Demand deposits with banks.

• Currency with public: Notes + Coins in circulation (excluding bank holdings).

• Demand deposits: Current accounts + Savings accounts (demand portion).

• M1 is: Most liquid form of money supply.

• Also called: Transaction money (used for daily transactions).

• CRR: Maintained as cash with RBI; No interest earned.

• SLR: Maintained as liquid assets with the bank itself; Earns interest on G-Secs.

• CRR purpose: Direct liquidity control by RBI.

• SLR purpose: Ensures bank solvency and creates demand for G-Secs.

• Both calculated on: NDTL as on last Friday of second preceding fortnight.

• Sterilization: Offsetting impact of forex intervention on domestic liquidity.

• Example: RBI buys USD → Rupee liquidity increases → RBI sells G-Secs to absorb excess rupees.

• Purpose: Maintain domestic monetary conditions despite forex operations.

• Tools used: OMO, MSS (Market Stabilization Scheme).

• Prevents: Imported inflation due to excess liquidity from capital inflows.

• LAF Corridor Width: 50 basis points.

• Floor: SDF rate (Repo – 25 bps).

• Ceiling: MSF rate (Repo + 25 bps).

• Symmetric corridor: Equal distance on both sides of Repo.

• Purpose: Anchors short-term interest rates within a defined band.

• Call Money Market: Overnight borrowing and lending between banks.

• Tenure: One day (overnight); Notice money: 2-14 days.

• Participants: Banks (both lenders and borrowers).

• Rate: Call Money Rate (weighted average).

• Significance: Reflects short-term liquidity conditions in banking system.

• Current SDF Rate: 5.00%.

• Relation to Repo: 25 basis points below Repo Rate.

• Introduction: April 2022.

• Purpose: RBI absorbs excess liquidity from banks without collateral.

• Replaced: Fixed Reverse Repo Rate as floor of LAF corridor.

• Current MSF Rate: 5.50%.

• Relation to Repo: 25 basis points above Repo Rate.

• Introduction: May 2011.

• Purpose: Banks borrow overnight from RBI against excess SLR holdings.

• Acts as: Ceiling of the LAF corridor (policy rate corridor).

• 1 Basis Point: 0.01% (one-hundredth of a percentage point).

• 100 Basis Points: 1%.

• 25 Basis Points: 0.25%.

• Usage: Precise measurement of interest rate changes.

• Example: Repo cut of 25 bps means reduction from 5.50% to 5.25%.

• Reserve Money (M0): Also called High-Powered Money or Monetary Base.

• Components: Currency in circulation + Bankers’ deposits with RBI + Other deposits with RBI.

• Created by: RBI (central bank).

• Significance: Forms base for money supply expansion through credit multiplier.

• Money Multiplier: M3/M0 (ratio of broad money to reserve money).

• Dovish: Focus on supporting growth and employment.

• Implies: Lower interest rates, accommodative stance.

• Tolerant: Of moderate inflation for sake of growth.

• Opposite: Hawkish (aggressive inflation control).

• Dovish MPC: Likely to cut rates or maintain loose stance.

• Validity: 5 years.

• Current agreement: April 2021 to March 2026.

• Previous agreement: August 2016 to March 2021.

• Target: 4% CPI with ±2% tolerance band.

• Review: Government in consultation with RBI can revise.

• Yield Curve: Graph plotting interest rates against bond maturities.

• Normal curve: Upward sloping (longer maturity = higher yield).

• Inverted curve: Short-term yields higher than long-term (recession signal).

• Flat curve: Similar yields across maturities (uncertainty).

• RBI monitors: Yield curve for monetary policy signals and transmission.

• Bank Rate: Section 49 of RBI Act 1934.

• Definition: Rate at which RBI provides long-term funds without collateral.

• Current Bank Rate: 5.50% (aligned with MSF rate).

• Use: Penal rate for shortfall in CRR/SLR maintenance.

• Different from Repo: Repo involves collateral; Bank Rate does not.

• Casting Vote: RBI Governor.

• Scenario: When votes are equally divided.

• Governor’s role: Chairperson of MPC + casting vote holder.

• Ensures: Decision is always reached, no deadlock situation.

• All members including Governor have equal voting rights otherwise.