Money Market Instruments — UPSC Mains Model Answer

Under the Liquidity Adjustment Facility (LAF), commercial banks borrow short-term funds from the RBI by pledging eligible government securities as collateral, at the prevailing repo rate. This overnight or short-term borrowing window allows RBI to inject or absorb liquidity from the banking system with precision. The reverse repo rate, set below the repo rate, governs the rate at which banks park surplus funds with the RBI.

A reduction in the repo rate lowers the cost of funds for commercial banks, theoretically incentivising them to reduce their own lending rates. Since the introduction of External Benchmark-Based Lending Rates (EBLR), retail and MSME loans are directly linked to the repo rate, improving transmission speed. However, transmission to deposit rates and corporate lending remains uneven, constrained by bank-specific liquidity positions and credit risk assessments.

Structural rigidities — such as high non-performing assets, risk aversion among banks, and sticky deposit rates — can blunt the impact of repo rate changes on actual credit flow. The RBI's Monetary Policy Committee (MPC) must therefore complement rate decisions with open market operations and communication strategies to anchor expectations effectively.

The repo rate signals the RBI's stance on inflation and growth, influencing bond yields, exchange rates, and capital flows. Calibrating it requires balancing price stability under the flexible inflation targeting framework with the imperative of supporting economic growth.