Interest rate mechanism and inflation control

By Dr. Santosh Kumar Mohapatra*

The basic objective of monetary and credit policy is to maintain a judicious balance between price stability and economic growth. Inflation is defined as too much money chasing a few goods. In other words, demands outstripping supply trigger a spike in inflation. Similarly, supply falling short of demands also triggers inflation. The rise in costs or input costs leads to inflation. Supply constraints/disruptions/bottlenecks/shortages also trigger inflation.

In other words, demand-pull inflation is caused by the overall increase in aggregate demand for goods and services, which bids up their prices. Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of labour and raw materials. Higher costs of production can decrease the aggregate supply (the amount of total production) in the economy. Supply-side rigidities, supply constraints, or supply disruption as seen during pandemics also lead to inflation. Limits on supply have driven the surge in inflation over the past year: a profound change from the decades-long dominance of demand drivers.

When inflation is demand-driven, it is presumed that demand is due to more purchasing power, more credit, or more liquidity in the market. It is also presumed that if people can borrow more, they can purchase more too, so credit should be made costlier by raising the interest rate or liquidity should be sucked from the market.

Hence, in a period of rising demand-driven inflation, the monetary policy aims at curtailing aggregate demand by making the loans/credit costlier through a hike in the lending interest rate and also decrease in the money supply, reduction in liquidity through an increase in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) of banks. When demand slowdowns prices also stop rising. This is known as tight monetary policy or money tightening measures.


The Reserve Bank of India (RBI), the country’s apex bank has several tools in its hands to curb demand and control liquidity in the system. Two of the most important tools are the liquidity adjustment facility (LAF) and the cash reserve ratio (CRR). LAF is a mechanism through which RBI lends to and borrows from banks for a very short period, typically just a day.

The repo rate is known as the benchmark short-term interest rate at which the RBI lends money to the banks against securities. Similarly, the reverse repo rate is the short-term borrowing rate at which RBI borrows money from banks against securities. In other words, the reverse repo rate is the rate at which banks park their excess funds with the RBI in exchange for government securities as collateral.

Repo rate signifies the rate at which liquidity is injected into the banking system by RBI, whereas the reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks. In other words, the repo rate helps commercial banks to get liquidity (i.e., acquire funds) from RBI by selling securities and also agreeing to repurchase the same at later date. It is otherwise known as the sale and repurchase agreement.

The cash reserve ratio or CRR is the number of money banks need to compulsorily park with RBI in cash as a buffer and do not earn any interest on it.

The Marginal Standing Facility (MSF) Rate is a special window for banks to borrow overnight funds from RBI against approved government securities in an emergency situation like an acute cash shortage. In other words, the Marginal Standing Facility (MSF) rate, at which banks borrow emergency funds by paying higher than the repo rate. Scheduled commercial banks can only borrow.

Statutory Liquidity Ratio (SLR) is the minimum proportion of banks’ Net Demand and Time Liabilities, every bank is required to maintain at the close of business every day, in the form of cash, gold and un-encumbered approved securities. In other words, the ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40 per cent. A decrease in SLR also increases the bank’s leverage position to pump more money into the economy.

Bank Rate once used to be the policy rate (the key interest rate based on which all other short-term interest rates move) in India. On the introduction of the Liquidity Adjustment Facility (LAF), discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued. As a result, the Bank Rate became dormant as an instrument of monetary management.

Bank Rate is now aligned to Marginal Standing Facility (MSF) rate, the penal rate at which banks can borrow money from the central bank over and above what is available to them through the LAF window. In other words, MSF assumed the role of bank rate, once the latter became operational in 2011. Bank Rate is now used only for calculating penalties on default in the maintenance of the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).

In the credit policy (declared in April), while retaining the reverse repo rate at 3.35 percent, the Reserve Bank of India (RBI) introduced the Standing Deposit Facility (SDF), an additional tool for absorbing liquidity, at an interest rate of 3.75 percent. The main purpose of SDF was to reduce the excess liquidity of Rs 8.5 lakh crore in the system and control inflation.

In other words, the Reserve Bank of India (RBI) has introduced the Standing Deposit Facility (SDF), allowing banks to park their excess funds at a higher rate but without taking any collateral from the central bank. Bankers said the SDF will help RBI to suck out excess liquidity without offering any securities but also moves overnight rates higher without actually hiking rates.

Bankers said the RBI’s move will push overnight rates higher and make the reverse repo rate redundant for now. With a higher rate offered on SDF, large banks which have excess securities will not mind parking their extra deposits at a higher rate without any collateral. “The SDF will replace the fixed-rate reverse repo (FRRR) as the floor of the Liquidity Adjustment facilities (LAF) corridor.


When the repo rate increases, the interest rate rises, borrowing from RBI becomes more expensive and the bank lends at an enhanced rate. Due to an increase in lending rate, the cost of borrowing, and interest rate obligations are increased. Normally people borrow less, so spend less, demand is squeezed and demand-driven inflation recedes. If RBI wants to make it less expensive for the banks to borrow money, it decreases the repo rate.

When the reverse repo rate is increased, banks feel more interested to keep their money in RBI for better interest incomes rather than to lend which limits credit creation and inflation. When RBI raises CRR, it sucks liquidity from the market. Banks are forced to keep more proportion of deposits in RBI in which they do not get interested. It is costlier for banks. By raising CRR, RBI expected to suck Rs 87,000 crores from the market. An increase or decrease in the SLR has the same impact as CRR.

Just reverse happens when the repo rate or reverse repo rate, CRR, and SLR are reduced. In times of recessionary phase, to stimulate demand and economic activities and growth. Those are reduced. Banks usually hike deposit interest in congruence with the lending interest rate to maintain parity.

The truth is that there is a limit to the efficacy of monetary measures in taming inflation. It deserved to be underlined that the present trends in price rise are driven by supply constraints. Cost-push while the steps actually taken are focused on containing demand.

A report titled ‘A world shaped by supply’ by Black Rock in January 2022 has determined that Corona pandemic creating supply disruptions is the driving force of inflation rather than excess demand. It said that even though economic activity has not fully recovered, economy-wide and sector-specific supply constraints are pushing inflation higher.

However, in the case of cost-push inflation or inflation spurred by supply constraints, RBI has little role to play. The role of government and its fiscal policy is very vital. The government can reduce input costs by providing more subsidies or reducing indirect taxes like GST/VAT/excise or taxes on fuel. Only to some extent, interest rate reduction reduces the cost of production, though affects savers.

However, not only to contain inflation or spur growth, the interest rate should be hiked or decreased. It should be increased or reduced in tandem with the rising or declining inflation rate respectively so that savers get positive real returns (returns/interest -inflation) on their savings while borrowers are made to pay a positive real interest rate on their debt. However, taxes on savings erode value and further affect savers the most. This should be taken care of by the government.


Banks’ profit is linked to the difference between deposit interest rate and lending interest rate including expenses incurred. But, in a scenario where banks’ lending rates are a function of their deposit interest rates (since, unlike Western banks that are dependent on wholesale money markets, banks in India are dependent on retail deposits).

Bank spread is the difference between the interest rate that a bank charges a borrower and the interest rate a bank pays a depositor. A loan spread is a difference between the base lending rate and the final interest rate charged to the borrower.

Repo rate, reverse repo rate, cash reserve ratio, SLR, etc (mainly repo rate) decides the cost of funds for banks. Banks have to add a profit margin and expenses to derive a lending rate. However, the lending rate is not the same for all types of loan portfolios or borrowers. Corporates are charged less interest.

The interest rate on lending was de-regulated by RBI in October 1994. This was as part of the financial sector reforms initiated in India in 1991. Since 1994, RBI has introduced various benchmarks and guidelines with regard to the interest rate on credit.

Prime Lending Rate (PLR), Benchmark Prime Lending Rate (BPLR), Base Rate (BR), and the existing Marginal Cost of Funds Based Lending Rate (MCLR) are the different systems adopted by RBI.

When RBI deregulated banks’ lending rates in 1994 as part of the financial sector reforms, it introduced the concept of Prime Lending Rate (PLR), the rate charged to their best customers or prime customers. Rates for all other customers were to be determined based on their credit risk. Subsequently, to take care of the issues that cropped up in its roll-out, PLR was replaced by the ‘Base Rate’. Here started the problems of micro regulation. The central bank mandated the formula for the Base Rate.

RBI wanted banks to pass on the benefit of lower interest rates to customers when it reduces policy rates and so it introduced a mechanism that is the most transparent until now.

Prime Lending Rate is used as the basis for the determination of interest rate charged by the bank to debtors. Prime Lending Rate does not take into account the estimated risk premium component, which depends on the bank’s assessment of the risk of each debtor or group of debtors. Therefore, the interest rate charged to debtors may not be equal to prime lending rate.


The first step towards deregulation of interest rates, both deposit and lending rates, was initiated by RBI in October 1994. On the credit side, RBI deregulated lending rates for credits above Rs. 2 lakhs. As part of this, banks were required to declare Prime Lending Rate (PLR).

PLR was envisaged as the interest rate chargeable for the most creditworthy borrower. In other words, the rate charged to their best customers or prime customers. This was a floor rate calculated by taking into account various components like the cost of funds and transaction costs. All the loans above Rs. 2 lakhs were extended by linking interest rate to PLR. Banks charged spread over PLR, based on the risk each borrower carried. Rates for all other customers were to be determined based on their credit risk.

Prime Lending Rate had some deficiencies. Both PLR and spread varied widely among banks and lacked transparency. It failed to capture the direction of interest rate movement in market. Appropriate pricing in relation to the creditworthiness of borrowers could not be ensured.


The Benchmark Prime Lending Rate (BPLR) was introduced by the Reserve Bank of India in April 2003 in place of the Prime Lending Rate (PLR) with the aim of introducing transparency and ensuring appropriate pricing of loans, wherein the lending rates truly reflect the actual costs. It was envisaged as a reference rate and was to be computed taking into consideration (i) cost of funds; (ii) operational expenses; and (iii) a minimum margin to cover regulatory requirements of provisioning and capital charge, and profit margin.

There was no restriction on sub-BPLR lending and as per the estimates of RBI, sub-PLR lending was as high as 77 percent of long-term lending in September 2008.

Benchmark Prime Lending Rate had also the deficiencies. The calculation of BPLR lacked transparency. Comparison of BPLR among banks remained difficult for borrowers. Banks resorted to sub-BPLR lending. Home loans and consumer durable loans were outside the purview of BPLR leading to cross-subsidization among borrower categories. For instance, a lender’s benchmark rate is 6%. In this case it would offer an auto loan at 2% higher than the benchmark rate. Similarly, it may provide personal loans at 8% higher than the benchmark rate.

The RBI noticed that banks were keeping BPLR at an artificially high level. The bank was then lending to consumers below BPLR. There was no rule that banks were supposed to lend only at the BPLR mentioned. The central bank felt that banks were misusing it by lending money at rates lower than BPLR to privileged customers/rich corporates. Meanwhile, other retail customers continued to get loans at a higher rate.


Since banks charged different rates to different customers, the base rate came into effect in July 2011, replacing the previous Benchmark Prime Lending Rate (BPLR). The base rate is the minimum interest rate below which a bank cannot lend.

According to the bank, the base rate must be determined by considering the following factors: (1) Average Cost of Funds: This is the interest rate given on the deposits. (2) Operating costs/Unallocatable (3) Overhead Costs: These are the expenses that go into running the day-to-day operations and include several components like legal expenses, depreciation, administrative costs, cost of stationery, et cetera. (4) Negative Carry in the Cash Reserve Ratio: This is the cost that the banks need to incur in order to keep a specific amount of cash reserves with the RBI. (5) The margin of Profit/Average Return on Net Worth: This figure indicates the profitability and net amount obtained.

As a result, the base rates may vary from bank to bank, owing to differences in one of these factors. In most cases, it is the difference in the interest rates provided on deposits. However, Base Rate too failed in attaining the intended goals because of the following reasons:

  1. Freedom given to banks to select either average, marginal or blended cost of deposit made the rate non-transparent and non-comparable for assessment of transmission of interest rate.
  2. Banks often squeezed spread over base rate for new customers but continued without reduction for existing customers. This led to discrimination between existing and new customers.


The above drawbacks in Base Rate paved way for the introduction of the existing Marginal Cost of Funds Based Lending Rate System (MCLR) effective from April 1, 2016.

Just like the base rate, MCLR is the minimum interest rate below which a bank cannot lend. In other words, the interest rate charged simply cannot be less than the MCLR rate prescribed by the RBI, except in cases when the RBI permits the same. The idea behind implementing the MCLR was quite similar to the implementation of the base rate – to improve the transmission of monetary policy and to make the methodology of lending rate selection by banks more transparent.

MCLR is calculated based on the loan tenor, the marginal cost of funds, and operating cost. The loan tenor, i.e., the amount of time a borrower has to repay the loan. The marginal cost of funds is the average rate at which the deposits with similar maturities were raised during a specific period before the review date. This cost will reflect in the bank’s books by their outstanding balance. The operating cost is operational expenses including the cost of raising funds, barring the costs recovered separately through service charges. It is, therefore, connected to providing the loan product as such.


The MCLR and Base Rate may appear to be quite similar on the surface. After all, they were implemented with the same objective in mind and are loosely based on similar principles. However, there are crucial factors in each case that separate the two rates. The differences have been tabulated as shown below:

Base Rate is based on the average cost of funds while the MCLR is based on marginal/incremental cost of funds. Base Rate is calculated by considering the minimum rate of return/profit margin, the MCLR is calculated by considering the tenor premium. While the base rate is also governed by operating expenses, and expenses needed to maintain a cash reserve ratio, the MCLR is also determined by considering deposit rates and repo rates, along with operating costs and the cost of maintaining the cash reserve ratio.


When none of the above-mentioned rates solved the problem and people still complained, the Central bank introduced a new method—external benchmark-based lending rates. Instead of looking at ways to make banks’ internal benchmark rates more transparent, the Central bank ordered the banks will need to link their floating rate loans to an external benchmark.

During the monetary policy announcement in December 2018, RBI indicated that banks will have to shift to external benchmark linked interest rates from April 1, 2019. Though an announcement was made to release guidelines by December 2018, no directions have been issued so far. It suggested that the external benchmark could be a repo rate, or three-month Treasury Bill, or a six-month Treasury Bill.

Most lenders adopted the repo rate by linking the floating rate to the benchmark rates, lenders now link them to an external benchmark. When RBI reduces or increases the repo rate, borrowers now know that the interest rate on their existing loans will rise or fall immediately.


In the case of repo-linked loans, the transmission of RBI’s repo rate change will be faster but it is not necessary that repo-linked loans will be cheaper than MCLR-linked loans all the time. Worth mentioning, the repo rate is near its 15-year low now. So repo-linked loans may look cheaper. When RBI will start increasing repo, the increase in repo-linked interest rate will also be faster. Whereas in MCLR-linked loans, an increase in repo rate will take some time to be passed on to the borrower.

In the case of repo-linked loans, banks add spreads to the repo rate to cover their operating costs and risk premium. This spread varies from bank to bank, hence the final rate imposed on the end borrower also varies despite the rate being linked to the same benchmark. If you believe that your bank is charging a higher spread compared to other banks then you can shift your loan to a different bank with a lower spread provided the difference in rates is at least 50 basis points.



The author is an Odisha-based eminent columnist/economist and social thinker. He can be reached through e-mail at [email protected]


DISCLAIMER: The views expressed in the article are solely those of the author and do not in any way represent the views of Sambad English.


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