Previous Year Question

Under the Reserve Bank of India Act, 1934, the RBI has the principal statutory responsibility for conducting monetary policy and maintaining price stability in the Indian economy.

The RBI Act was amended in 2016 to introduce the Flexible Inflation Targeting Framework and a statutory Monetary Policy Committee. Under this framework, the primary objective of monetary policy is:

to maintain price stability while keeping in mind the objective of growth.

Inflation target

Under the framework applicable in 2022, the Central Government, in consultation with the RBI, prescribed the following inflation target based on the All-India Consumer Price Index:

Thus, the 4% target did not require inflation to remain exactly at 4% every month. The RBI was provided a tolerance band of 2-6%.

How does the RBI control inflation?

When aggregate demand is rising excessively and inflation is high, the RBI may use the following monetary-policy measures:

• increasing the Policy Repo Rate;

• reducing liquidity in the financial system;

• selling Government Securities through Open Market Operations;

• modifying reserve requirements such as CRR when required; and

• controlling inflation expectations through monetary-policy communication.

An increase in the Policy Repo Rate may raise money-market rates and banks’ lending rates. Credit for housing, vehicles, consumer durables and business investment consequently becomes more expensive. Slower growth of consumption and investment may reduce aggregate demand and demand-side inflationary pressure.

The transmission can be represented in simplified form as:

Repo Rate↑ ⇒ Lending Rates↑ ⇒ Borrowing↓ ⇒ Demand↓⇒ Inflationary Pressure↓

Monetary policy cannot directly remove a food shortage, poor monsoon or crude-oil supply shock. It can, however, prevent inflation arising from a supply shock from becoming broad-based and persistent, and can control wage-price spirals and inflation expectations.

Monetary Policy Committee

The MPC consists of six members:

• the RBI Governor;

• the RBI Deputy Governor responsible for monetary policy;

• one RBI officer; and

• three external members appointed by the Central Government.

Decisions are taken by majority vote. In the event of a tie, the RBI Governor has a casting vote.

If average CPI inflation remains outside the 2-6% tolerance band for three consecutive quarters, it constitutes failure to maintain the inflation target. The RBI must then submit a report to the Central Government explaining the reasons, proposed remedial actions and the estimated period within which inflation will return to the target.

Why are the other options incorrect?

The Department of Consumer Affairs monitors the prices of essential commodities and administers supply-side interventions such as the Price Stabilisation Fund. It does not possess the statutory responsibility for controlling overall CPI inflation through monetary policy.

The Expenditure Management Commission was concerned with the efficiency and rationalisation of government expenditure; it is not a monetary authority.

The Financial Stability and Development Council coordinates financial-sector regulators and addresses financial stability. It does not determine the policy interest rate.