Monetary Policy – Reserve Bank of India

The core objective of monetary policy is price stability.

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The core objective of monetary policy is to bring about price stability. If prices are prevented from going up (inflation) or down (deflation) too fast, this will protect the purchasing power of the currency. Price stability is said to exist if prices rise by just under 2 per cent per year in the medium term.

Consumers and businesses alike must be able to trust that prices will, on average, rise only very gradually if at all – in other words, that inflation is kept under control. Stable prices, or price stability, means that one year from now a rupee will buy roughly the same as it buys today. Strongly rising (inflation) or falling (deflation) prices lead to insecurity and will harm the economy. Hence price stability is a necessary precondition for a healthy economy.

To maintain price stability the Reserve Bank of India uses monetary policy as a tool to control inflation. 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.

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.

Thus monetary policy is an important tool in the hands of the Central Bank (RBI) to control inflation.

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