Previous Year Question
With reference to the Indian economy, consider the following statements:
If the inflation is too high, the Reserve Bank of India (RBI) is likely to buy government securities.
If the rupee is rapidly depreciating, the RBI is likely to sell dollars in the market.
If interest rates in the USA or the European Union were to fall, that is likely to induce the RBI to buy dollars.
Which of the statements given above are correct?
1 and 2
2 and 3
1 and 3
1, 2 and 3
Correct Answer: B
Detailed Solution
Statement 1 is incorrect.
When the RBI purchases government securities, it releases rupees into the banking system in exchange for those securities. This can increase banking-system liquidity and the money supply. It is generally an expansionary monetary operation.
When inflation is excessively high, the RBI’s usual objective is to restrain surplus liquidity and aggregate demand. In such a situation, the RBI may sell rather than purchase government securities through Open Market Operations. Banks and other institutions pay rupees to the RBI while purchasing these securities, thereby reducing surplus liquidity in the system.
Therefore, the statement that the RBI is likely to purchase government securities when inflation is too high is incorrect.
Statement 2 is correct.
Rapid depreciation of the rupee means that more rupees are required to purchase one dollar. In such circumstances, the RBI may sell dollars in the foreign-exchange market.
The sale increases the supply of dollars in the market. Simultaneously, the RBI receives rupees from the market participants purchasing those dollars. This can moderate excessive depreciation pressure on the rupee.
The RBI does not seek to maintain a predetermined exchange rate. Its intervention is primarily aimed at containing excessive volatility and disorderly market conditions.
Statement 3 is correct.
If interest rates in the United States or the European Union decline, returns available on financial assets in those economies may also fall. International investors may consequently shift funds towards relatively higher-yielding Indian assets.
When foreign capital enters India, investors sell dollars and purchase rupees. This increases demand for the rupee and can create appreciation pressure. To moderate excessive appreciation and augment foreign-exchange reserves, the RBI may purchase dollars from the market.
When the RBI purchases dollars, it releases rupees and increases domestic liquidity. If the resulting liquidity exceeds the desired level, the RBI may sterilise it through Open Market Operations or other liquidity-management instruments.