Finance

Words: 380

Time: 30 minutes

Q) How does RBI control and regulate the monetary supply in Indian economy, and why is this function
crucial for maintaining stable prices and growth? [400 words]

Ans) RBI is entrusted with the responsibility of keeping in check the money supply as well as inflation in the
Indian economy. The correlation is such that, efforts should be made to curtail inflation by making
adjustments to the money supply, at the same time growth of the economy is also to be ensured. To control
and regulate the money supply in the Indian economy, RBI implements various tools from time to time,
which are usually decided upon by the Monetary Policy Committee(MPC).

Some of these tools include:

1) Repo rate: It is the rate at which commercial banks borrow money by selling securities to the central bank.
Whenever RBI wants to reduce the money supply, it increases the repo rate, which in turn makes borrowing
expensive for commercial banks. As a result, fewer funds are available for the banks to give out in the form of
loans, hence a lesser money supply in the economy. Similarly, whenever RBI wants to increase the money
supply, a reverse mechanism is followed.

2) Open market operations(OMO): It is a mechanism in which the RBI issues securities and treasury bills on
behalf of the central government. To reduce money supply, RBI sells securities to banks and financial
institutions. Hence, leaving less loanable funds with banks and financial institutions. The reverse is done to
increase the money supply.

3) Cash reserve ratio(CRR): It is the percentage of the total deposits of customers that need to be maintained
by commercial banks as a reserve either in cash or as deposits with RBI. Increasing the ratio means less
loanable funds available, hence a lesser money supply.

Adjustments in the above-mentioned rates directly impacts the money supply in the economy. In any
economy the prices of any commodity is influenced by the amount of money supply, hence it is crucial to
adjust the money supply so as to keep an check on the prices. But excessive tightening is also not good, as it
can hamper the growth of the economy. Because lesser money supply means, lesser demand for goods and
services, which will eventually lead to lesser production, and a vicious cycle may be created. Hence, it is
always advisable to take a balanced approach which will aid in keeping the prices stable and also ensure
growth simultaneously.