Monetary Policy Transmission - The RBI has finally decided that it needs to address the problem of inadequate interest rate transmission head-on. It has directed lenders to link all new floating rate loans given to borrowers in the personal, retail and micro, small and medium enterprise (MSME) categories to external benchmarks, including the repo rate, with effect from October 1.

Monetary policy

  • Monetary policy is how a central bank or other agency governs the supply of money and interest rates in an economy in order to influence output, employment, and prices.
  • Monetary policy tools - RBI uses various monetary tools like REPO rate, Reverse RERO rate, SLR, CRR etc. to achieve its purpose.
  • Monetary policy can be broadly classified as either expansionary or contractionary.
  • Expansionary monetary policy - Implemented by reducing statutory bank reserves or lowering key interest rates and improving market liquidity to encourage economic activity.
  • Contractionary monetary policy - Reduces liquidity and increases interest rates which has a negative impact on both production and consumption and therefore, economic growth.

Monetary policy transmission: Monetary transmission refers to the process by which a central bank’s monetary policy signals (like repo rate) are passed on, through financial system to influence the businesses and households.  

How it works? 


Monetary policy transmission

  • There are many monetary policy signals by the RBI; the most powerful one is the repo rate.
  • When repo rate is changed, the interest rate on loans by banks also changes.
  • In an economy, both consumption and investment are often financed by borrowings from banks.
  • Hence this encourages consumption and investment activities of businesses and households.
  • As the repo rate brings changes in market interest rate, the repo rate channel is often referred as interest rate channel of monetary transmission.

Repo rate↓ → Interest rate ↓→Consumption, Investment↑ →Output↑→ Growth↑ Evolution of monetary policy transmission

 Base Rate

  • Loans taken between June 2010 and April 2016 from banks were on base rate. ·
  • During the period, base rate was the minimum interest rate at which commercial banks could lend to customers
  • Banks stopped lending on base rate from April 2016.
  • Base rate is calculated on three parameters — the cost of fund, unallocated cost of resources and return on net worth. Hence, the rate depended on individual banks and they changed it whenever their cost of funds and other parameters changed.  

Marginal Cost of Lending Rate 

  • It came into effect in April 2016.
  • It is a benchmark lending rate for floating-rate loans.
  • This is the minimum interest rate at which commercial banks can lend.
  • This rate is based on four components—the marginal cost of funds, negative carry on account of cash reserve ratio, operating costs and tenor premium.
  • MCLR is linked to the actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up.  

The problem with MCLR-based system

  • Lack of required transmission of policy rates - When the RBI cuts repo rate there is no guarantee a borrower will get the benefit of the rate cut or that it will be transmitted down to him.
  • Secondly, the MCLR system is opaque since it’s an internal benchmark that depends on the way a bank does its business.

How the new system will work Under the new system, a bank is required to adopt a uniform external benchmark within a loan category. RBI has given these options of external benchmark rates to the banks 1.RBI repo rate

  1. the 91-day T-bill yield
  2. the 182-day T-bill yield
  3. any other benchmark market interest rate produced by the Financial Benchmarks India Pvt. Ltd
  • One of these benchmarks will be used to decide the lending rate in addition to the spread.
  • Banks will be free to decide their spread value but it will have to be fixed for the tenure of the loan.
  • However, it can change if the credit score of the borrower changes.
  • The interest rates under the new system will change every month.

How the recent move will benefit MSME borrowers?

  • Better transmission of policy rate cuts - An RBI rate cut will immediately reach the borrower.
  • More transparent system - Since every borrower will know the fixed interest rate and the spread value decided by the bank.
  • It will help borrowers compare loans in a better way from different banks.
  • Standardization and ease of understanding for the borrowers - Same bank cannot adopt multiple benchmarks within a loan category.


  • It may force banks to start cutting the interest rate they pay deposit holders or risk seeing their margins shrink.
  • And while the RBI wants to increase personal consumption and borrowing by MSMEs through these measures, the success of the measures will ultimately be determined by a regaining of confidence by consumers to spend and a conviction by industry to invest.


Read Also: Exchange Rate Driven By Capital Flows - RBI Report Economic Revival Package


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