The RBI makes use of instruments to regulate money supply and bank credit so as to influence the level of aggregate demand for goods and services. The availability and cost of credit are regulated to influence the level and nature of economic activities.
The monetary policy has to reconcile the objectives of economic growth and price stability.
Economic growth requires expansion in the supply of money so that no legitimate productive activity suffers due to finance shortage. Price stability requires restraint on the expansion of credit so that money supply does not become excessive to cause inflation.
Changes in the monetary policy can be made anytime during the year. The Central Bank may adopt an expansionary or contractionary policy depending on the general economic policy of the Government and conditions in the economy.
Monetary policy may also be used to influence the exchange rate of the
HOW IT DOES WORK
Consider that an economy is growing too fast. This is also referred to as overheating of the economy: a situation that typically happens in the boom phase when GDP (gross domestic product) growth exceeds the long-term growth potential of the economy. The producers of goods are not able to make enough goods to meet the rising demand. The resultant demand-supply mismatch creates inflationary pressures in the economy. This situation is regarded as unsustainable, as the high growth translates into higher inflation. In this situation, the RBI raises interest rates to depress spending and reduce the pressure on inflation.