The RBI and how monetary policy works

The Reserve Bank of India is the central bank. It manages the currency, the banking system, and the cost of money in the economy. For Prelims, focus on what it does and the tools it uses.

Where the RBI gets its income

The RBI earns mainly from:

• Returns on its holdings of government securities.
• Returns on its foreign currency assets held abroad.

It does not lend directly to private companies. Its lending is to banks and the government. This is a common exam trap.

The main tools

• Repo rate: the rate at which banks borrow from the RBI. Raising it makes borrowing costlier and cools inflation.
• Reverse repo rate: the rate at which the RBI borrows from banks.
• Cash Reserve Ratio (CRR): the share of deposits banks must keep with the RBI.
• Statutory Liquidity Ratio (SLR): the share banks must hold in safe assets like government securities.
• Open Market Operations: buying or selling government securities to manage liquidity.

The MPC

The Monetary Policy Committee sets the repo rate to keep retail inflation within a target band. It has six members, three from the RBI (including the Governor, who chairs it) and three external members appointed by the Government, and meets at least four times a year. Decisions are by majority vote; the Governor holds a casting vote in case of a tie.

The inflation target

Under the flexible inflation targeting framework (in force since 2016), the RBI's mandate is to keep CPI (Consumer Price Index) inflation at 4%, with a tolerance band of +/-2%, so anywhere from 2% to 6% is considered "on target." If inflation stays outside this band for three consecutive quarters, the RBI must explain why to the Government and set out a plan to bring it back, a built-in accountability mechanism, not just a target on paper.

Repo vs reverse repo: the direction that trips people up

A quick way to keep these straight: think of the RBI as a bank for banks. Repo rate is what banks pay the RBI to borrow, so a higher repo rate makes loans (and therefore spending) more expensive across the whole economy, cooling inflation. Reverse repo is what the RBI pays banks to park surplus money with it, used to absorb excess liquidity from the system.