Model Answer
0 min readIntroduction
Inflation, a sustained increase in the general price level of goods and services in an economy, erodes purchasing power and can destabilize economic growth. Central Banks play a pivotal role in maintaining price stability. In India, the Reserve Bank of India (RBI) is mandated to maintain inflation within a target range (currently 4% with a tolerance band of +/- 2%). When faced with persistent inflation, the RBI employs a combination of monetary policy tools to curb demand and control price rises. These tools primarily operate by influencing the money supply and credit availability in the economy.
(i) Reserve Ratios
Reserve ratios refer to the percentage of a bank’s total deposits that it is required to keep with the central bank as reserves. There are two types: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
- Change during persistent inflation: The RBI increases both CRR and SLR.
- Rationale: Increasing CRR reduces the amount of money banks have available for lending, thereby contracting the money supply. Similarly, a higher SLR forces banks to invest more in government securities, reducing their lending capacity.
- Impact: This leads to higher borrowing costs, reduced credit availability, and a dampening effect on aggregate demand, ultimately helping to control inflation.
Example: In May 2022, the RBI increased the CRR to 8.1% from 4% to absorb excess liquidity in the banking system amidst rising inflation.
(ii) Bank Rate
The bank rate is the rate at which the central bank lends money to commercial banks. It serves as a signal of the monetary policy stance.
- Change during persistent inflation: The RBI increases the bank rate.
- Rationale: A higher bank rate makes borrowing more expensive for commercial banks. This increased cost is then passed on to their customers in the form of higher lending rates.
- Impact: Higher lending rates discourage borrowing for investment and consumption, reducing aggregate demand and curbing inflationary pressures. It also incentivizes savings.
Example: The RBI has increased the bank rate multiple times in 2022-23, in line with its efforts to combat inflation. As of December 2023, the bank rate stands at 6.5%.
(iii) Open Market Operations (OMO)
Open Market Operations involve the buying and selling of government securities by the central bank in the open market.
- Change during persistent inflation: The RBI sells government securities.
- Rationale: When the RBI sells government securities, it takes money out of the banking system, reducing the money supply. Banks pay for these securities, decreasing their reserves.
- Impact: This reduces the amount of money available for lending, leading to higher interest rates and a decrease in aggregate demand, thereby controlling inflation.
Example: The RBI frequently uses OMOs to manage liquidity in the market. In 2023, it actively sold government securities to absorb excess liquidity and manage inflationary pressures. Reverse Repo rate is also used as a tool under OMO.
The effectiveness of these tools can be influenced by factors such as the elasticity of demand for credit, the responsiveness of banks to policy changes, and global economic conditions. Furthermore, supply-side factors contributing to inflation (e.g., supply chain disruptions) may require complementary fiscal policy measures.
| Tool | Change during Inflation | Mechanism | Impact |
|---|---|---|---|
| Reserve Ratios (CRR & SLR) | Increase | Reduces banks’ lending capacity | Contraction of money supply, higher borrowing costs |
| Bank Rate | Increase | Increases cost of borrowing for banks | Higher lending rates, reduced borrowing |
| Open Market Operations | Sell Government Securities | Withdraws money from the banking system | Reduced money supply, higher interest rates |
Conclusion
In conclusion, the Central Bank employs a combination of reserve ratios, bank rate adjustments, and open market operations to combat persistent inflation. These tools work by influencing the money supply, credit availability, and interest rates, ultimately aiming to curb aggregate demand and stabilize prices. The optimal mix of these tools depends on the specific economic context and the nature of the inflationary pressures. A coordinated approach involving both monetary and fiscal policies is often necessary for sustained price stability and economic growth.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.