Economics is a highly conceptual subject for the Civil Services Examination. Understanding the relationship between Inflation and the Reserve Bank of India’s (RBI) Monetary Policy is fundamental to answering both Prelims and Mains questions.
What is Inflation?
Inflation is the sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money.
- Demand-Pull Inflation: Occurs when aggregate demand outpaces aggregate supply (“too much money chasing too few goods”).
- Cost-Push Inflation: Driven by an increase in the cost of production (e.g., rising crude oil prices, raw material costs).
The Role of RBI’s Monetary Policy
The RBI utilizes its Monetary Policy Committee (MPC) to control inflation while keeping the objective of growth in mind. The inflation target is set at 4% with a tolerance band of +/- 2%.
Quantitative Tools Used by RBI
- Repo Rate: The rate at which RBI lends short-term money to banks. To curb inflation, RBI increases the Repo rate (Dear Money Policy), making borrowing expensive and reducing money supply in the market.
- Cash Reserve Ratio (CRR): The percentage of deposits banks must keep with the RBI. Increasing CRR reduces the lending capacity of banks.
- Open Market Operations (OMO): Buying or selling of government securities. To control inflation, RBI sells securities to suck excess liquidity from the market.
Previous Year Question (PYQ)
UPSC Prelims 2015: With reference to Indian economy, consider the following:
1. Bank rate
2. Open market operations
3. Public debt
4. Public revenue
Which of the above is/are component/components of Monetary Policy?
(a) 1 only
(b) 2, 3 and 4
(c) 1 and 2
(d) 1, 3 and 4
(Answer: c)