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Quantitative Methods of Credit Control by the Central Bank

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Estimated time: 28 minutes
  • Introduction
  • Bank Rate
  • Repo Rate & Reverse Repo Rate
  • Monetary Policy Committee
  • Open Market Operations
  • Cash Ratio Reserve
  • Statutory Liquidity Ratio
  • Key Points: Quantitative Methods
CISCE: Class 12

Introduction

Quantitative Methods
Affect the total volume of credit — all sectors equally, without discrimination. Focus of this note.

CISCE: Class 12

Bank Rate

The Bank Rate is the minimum rate of interest at which the RBI lends money to commercial banks or rediscounts their approved bills of exchange and government securities.

Economic Situation RBI Action Effect
Excess Demand / Inflation ↑ Raise Bank Rate Credit contracts → Prices stabilise
Deficient Demand / Deflation ↓ Lower Bank Rate Credit expands → Economy revives
Important Facts about Bank Rate in India
  • Bank rate is now primarily signalling rate— it signals RBI's long-term outlook on interest rates
  • Since the RBI stopped discounting bills of exchange, the bank rate is not an active instrument in India
  • It now acts as a penal interest rate— charged by banks when they fall short of CRR/SLR requirements
  • In practice, the repo rate has replaced the bank rate as the main monetary tool

Real-Life Analogy: Think of RBI as a wholesale supplier and commercial banks as retailers. The bank rate is the "wholesale price" that banks pay the RBI. If wholesale costs rise, retailers (banks) raise their selling prices (interest rates) to customers, making loans more expensive and reducing borrowing.

CISCE: Class 12

Repo Rate & Reverse Repo Rate

Since the bank rate is no longer actively used, the repo rate is the RBI's primary monetary policy tool today. It replaced the bank rate for managing liquidity and interest rates.

Repo Rate is the rate of interest at which the RBI lends short-term funds to commercial banks, against government bonds. RBI buys the government. bonds from banks and agrees to sell them back at a fixed rate. It injects liquidity into the banking system.
Pawn Shop Analogy: Imagine pledging your gold at a pawn shop to get cash, with an agreement to buy it back later. Banks do exactly this — they pledge government bonds with the RBI to get short-term cash. The interest charged on that cash = Repo Rate.
 
Reverse Repo Rate is the rate at which the RBI borrows short-term funds from commercial banks by selling government bonds to them. Banks park excess funds with the RBI to earn interest. It absorbs excess liquidity from the banking system.
Fixed Deposit Analogy: When banks have excess cash, they "deposit" it with RBI and earn interest, just like you put money in a bank FD. The interest RBI pays = Reverse Repo Rate. Higher reverse repo → banks prefer to park money with RBI → less lending → less inflation.
Feature Repo Rate Reverse Repo Rate
Who borrows? Banks borrow from the RBI RBI borrows from banks
Collateral Banks pledge to the government. bonds to RBI RBI sells the government. bonds to banks
Purpose Injects liquidity into the system Absorbs excess liquidity
If Raised Loans costlier → Credit shrinks Banks park more with RBI → Less lending
Rate Level Always HIGHER Always LOWER than Repo
June 2022 4.90% 3.35%
 
Repo & Reverse Repo Rate History
Date Repo Rate Reverse Repo Rate
March 31, 2004 6.0% 5.0%
July 30, 2008 9.0% 8.0%
March 21, 2009 4.75% 3.75%
October 21, 2011 8.5% 7.5%
January 15, 2015 7.75% 6.75%
August 1, 2018 6.5% 6.25%
May 22, 2020 (COVID low) 4.0%  3.35% 
June 8, 2022 4.9% 3.35%
Repo Rate reached a 20-year low of 4% in May 2020 (8th successive cut since August 2018)
CISCE: Class 12

Monetary Policy Committee

The Monetary Policy Committee (MPC) is a 6-member committee of the RBI, headed by the RBI Governor, responsible for setting the benchmark repo rate to keep inflation within the target range.
Inflation Target: MPC aims to maintain 4% annual inflation with a tolerance band of ±2% (i.e., between 2% and 6%)
RBI Members Government Members
RBI Governor (Chairperson) External Expert (Economics)
Deputy Governor (Monetary Policy) External Expert (Banking/Finance)
One RBI Board Nominee External Expert (Monetary Policy)
 
Why Was MPC Created?
  • Before 2016: Only the RBI Governor & internal team controlled monetary policy decisions
  • After 2016 (MPC): Decisions taken by a 6-member committee — binding on RBI
  • Bring diversity of views and independence of opinion
  • Decisions by majority vote; the Governor has a casting vote in case of a tie
  • Meets at least 4 times a year to review macroeconomic conditions
CISCE: Class 12

Open Market Operations

Open Market Operations refer to the buying and selling of government and other approved securities by the RBI in the money and capital markets to regulate the volume of credit in the economy.
Sponge Analogy: Think of RBI as a sponge for money. When there's too much money (inflation), the RBI sells securities — soaking up excess money from banks. When there's too little money (recession), the RBI buys securities — squeezing money back into banks.
Situation RBI Action Effect on Banks Outcome
Inflation / Boom Sells securities Cash reserves fall Credit ↓, Prices stabilise
Recession / Deflation Buys securities Cash reserves rise Credit ↑, the economy grows

Effects of Open Market Operations

  1. Effect on Reserves of Commercial Banks
    OMO directly changes the cash reserves of commercial banks, which determines their power to create credit. A change in reserves leads to a multiplied change in total money supply.
  2. Effect on Interest Rate
    Buying/selling securities changes their market price. Since price and yield are inversely related, this affects market interest rates throughout the economy.
  3. Effect on Future Expectations
    OMO signals RBI's policy stance to the market. Aggressive buying signals an easing policy; aggressive selling signals tightening. This changes the expectations of banks, businesses, and investors — affecting their decisions immediately, even before the actual money supply changes.
  4. Simultaneous Determination of Interest Rate & Money Supply
    The central bank cannot simultaneously fix both the security price (interest rate) and the reserves of commercial banks (money supply) through OMO.
    If the RBI fixes the quantity of securities traded, interest rates fluctuate freely.
    If RBI fixes the price (yield) → money supply/reserves fluctuate freely.
  5. Effect on Balance of Payments
    Selling securities → contracts credit → deflation → domestic prices fall → exports become cheaper for foreigners (export demand rises) → imports decline (foreign goods relatively costlier) → BoP improves.
CISCE: Class 12

Cash Ratio Reserve

CRR is the minimum percentage of total deposits that commercial banks must maintain as cash reserves with the RBI. It is a statutory requirement — banks earn no interest on CRR deposits.
Locked Piggy Bank Analogy: Imagine you receive ₹100. Your parents (RBI) say: "You must always keep ₹4.50 locked with us." You can only use the remaining ₹95.50. If they raise the requirement to ₹5, you have even less to use. Higher CRR = less money banks can lend.

CRR in India — Timeline
Aug 2008: 9.0% — peak level, tight monetary policy
Feb 2013: 4.0% — reduced to support growth
Mar 27, 2020: 3.0% — emergency COVID cut to inject liquidity
Jul 2021: 4.0% — restored post-COVID
May 2022: 4.5% — raised to counter rising inflation

Variable Cash Reserve Ratio
Variable CRR allows the central bank to change the cash reserve ratio as needed, making it a flexible tool. It was first used by the Federal Reserve System of the USA in 1935.

  • First used: USA (Federal Reserve System), 1935
  • India's first use: March 1960 — commercial banks asked to maintain an additional deposit equal to 20% of the increase in their total liabilities with RBI
  • Legal basis: Banking Companies Act, 1949 (amended 1962) — gave RBI power to raise cash reserves to 3% of total liabilities
  • Allows RBI to respond quickly to changing economic conditions by varying the ratio frequently
Variable vs Fixed CRR: Unlike a fixed ratio, variable CRR can be adjusted upward or downward, giving RBI flexibility to tighten or ease credit as the economic situation demands.

Limitations of Variable CRR

  1. Excessive Reserves: Ineffective when banks already hold very large excess cash reserves — they can still lend despite a higher CRR.
  2. Large Foreign Funds: Not effective when banks hold large foreign currency funds, as these can compensate for reduced domestic reserves.
  3. Only for Big Changes: Suitable only for large adjustments in reserves. Not ideal for small or marginal changes in credit.
  4. Business Sentiment: Effectiveness depends on the general mood of the business community — if confidence is low, even lower CRR may not boost investment.
  5. Discriminatory: Favours bigger commercial banks, which are better able to absorb CRR changes than smaller banks.
  6. Uncertainty: Frequent changes in CRR create unpredictability in banking operations, making it difficult for banks to plan their lending.
CISCE: Class 12

Statutory Liquidity Ratio

SLR is the minimum percentage of total deposits that commercial banks must maintain with themselves in the form of cash, gold, or approved government securities. This is in addition to CRR.
Emergency Fund Analogy: Like keeping an emergency fund in your own locker (not giving it to anyone), banks must keep SLR funds in their own vault as cash, gold, or safe investments. It ensures banks always have enough money to meet customer withdrawal demands.

SLR Rate History in India
Period SLR Rate
April 2008 – February 2012 24%
August 2012 23%
June 2014 22.5%
August 2017 19.5%
June 8, 2022 18%
CISCE: Class 12

Key Points: Quantitative Methods

Quantitative methods control the overall volume of credit in the economy without discrimination.

Bank Rate / Repo Rate:

  • ↑ Rate → borrowing becomes costly → credit contracts (controls inflation)
  • ↓ Rate → borrowing becomes cheaper → credit expands (controls deflation)

Open Market Operations:

  • Sale of securities → reduces bank reserves → less credit
  • Purchase of securities → increases bank reserves → more credit

CRR & SLR:

  • ↑ CRR/SLR → banks lend less
  • ↓ CRR/SLR → banks lend more

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