The Reserve Bank of India (RBI), which is India's central bank and the bank, is one of the most important players in the Indian economy and financial markets. It is in charge of monetary policy which has a big impact on liquidity and interest rates in the financial system. Let's look at some of the basics of monetary policy and how it impacts the average investor.

The RBI has several goals of which controlling inflation is one of the most important. When inflation is rising and threatening to spin out of control, as it is today, the RBI 'tightens' monetary policy which means reducing the amount of liquidity (floating money) in the economy. Though the RBI's policies may take upto a year to show their full effect they are perhaps the most effective way of reducing inflation.

How the RBI conducts monetary policy

The RBI has several tools for conducting monetary policy: two of the most important are the cash reserve ratio (CRR) and the liquidity adjustment facility (LAF).

The CRR is the proportion of their deposits which banks have to keep with the RBI. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system which reduces demand in the economy and therefore helps curb inflation. Thus recently the RBI raised the CRR from 7.5 per cent to 8 per cent which sucked Rs 18,000 crores out of the banking system.

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The LAF can be thought of as a way for the RBI to lend and borrow to banks for very short periods, typically just a day. The repo rate is the RBI's lending rate and reverse repo rate is the RBI's borrowing rate. These two rates help the RBI influence short-term interest rates in the rest of the financial system.

Currently the RBI has left the repo/reverse repo rates untouched but if inflationary pressures remain strong it may be forced to increase them.

Impact on interest rates

What impact does monetary policy have on the different interest rates in the economy like the home loan rate? The RBI doesn't directly control these interest rates but in general a tighter monetary policy leads to higher interest rates.

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This relationship isn't iron-clad though, and major banks like SBI [Get Quote] and ICICI [Get Quote] have stated the recent CRR hike wouldn't necessarily lead to higher interest rates. However if the RBI continues to tighten policy further by raising the CRR again or raising the repo/reverse repo rates, it's possible that banks will respond by raising interest rates on various loans including home loans.

Impact on stock markets

If you watch investment channels or read business papers, you will know that the financial markets pay obsessive attention to the actions of the RBI. This is with good reason since any changes in monetary policy has an immediate impact on financial markets.

In general a tighter policy will hurt investor sentiment and stock prices. There will be less liquidity floating around and higher interest rates will raise the cost of capital for companies hurting their bottom lines and stock prices. Companies which have high levels of debt are especially vulnerable.

A tighter policy will harm some sectors like banking and real estate more than others. For example banks don't earn interest on the reserves they keep with the RBI; therefore an increase in the CRR immediately hurts their bottom line. Similarly if tighter policy leads to higher interest rates, this will reduce demand for housing as home loans become more expensive.

Impact on exchange rates

The RBI's monetary policy will also have an impact on exchange rates. In particular if Indian interest rates rise because of tighter policy, the demand for Indian interest-paying assets will also rise, leading to an increase in the value of the rupee.

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This helps with inflation since imports will now be cheaper in rupee terms. For example if the price of oil is $100 per barrel and the rupee rises in value from Rs 42 to Rs 38 per dollar, the rupee price of a barrel of oil will fall from Rs 4,200 to Rs 3,800.

On the flip side, the  rising rupee will have a negative impact on export-oriented companies; for example major IT stocks which have done quite well recently may fall.