Explain the methods of the Inflation and deflation RBI class 12
Answers
Answer:
The RBI is the main body that controls the monetary policy in India. They control the flow of money into the market through various instruments of monetary policy. This helps the RBI control the inflation and liquidity in the economy. Let us take a look at the instruments of monetary policy the RBI uses.
Explanation:
Monetary policy is a way for the RBI to control the supply of money in the economy. So these credit policies help control the inflation and in turn help with the economic growth and development of the country. So now let us take a look at the various instruments of monetary policy that the RBI has at its disposal.
1] Open Market Operations
Open Market Operations is when the RBI involves itself directly and buys or sells short-term securities in the open market. This is a direct and effective way to increase or decrease the supply of money in the market. It also has a direct effect on the ongoing rate of interest in the market.
Let us say the market is in equilibrium. Then the RBI decides to sell short-term securities in the market. The supply of money in the market will reduce. And subsequently, the demand for credit facilities would increase. And so correspondingly the rate of interest would also see a boost.
On the other hand, if RBI was purchasing securities from the open market it would have the opposite effect. The supply of money to the market would increase. And so, in turn, the rate of interest would go down since the demand for credit would fall.
2] Bank Rate
One of the most effective instruments of monetary policy is the bank rate. A bank rate is essentially the rate at which the RBI lends money to commercial banks without any security or collateral. It is also the standard rate at which the RBI will buy or discount bills of exchange and other such commercial instruments.
So now if the RBI were to increase the bank rate, the commercial banks would also have to increase their lending rates. And this will help control the supply of money in the market. And the reverse will obviously increase the supply of money in the market.
3] Variable Reserve Requirement
There are two components to this instrument of monetary policy, namely – The Cash Reserve Ratio (CLR) and the Statutory Liquidity Ratio (SLR). Let us understand them both.
Cash Reserve Ratio (CRR) is the portion of deposits with the commercial banks that it has to deposit to the RBI. So CRR is the percent of deposits the commercial banks have to keep with the RBI. The RBI will adjust the said percentage to control the supply of money available with the bank. And accordingly, the loans given by the bank will either become cheaper or more expensive. The CRR is a great tool to control inflation.
A forward-looking assessment of inflation is a critical input for an effective conduct and formulation of monetary policy. The Phillips curve framework relating inflation to economic activity and other determinants such as exchange rate has been used extensively to explore this relationship both in India and across countries. In India, the focus of most of the Phillips curve studies has been on wholesale price index (WPI) as an indicator of inflation. With the move towards consumer price index-combined (CPI-C) based flexible inflation targeting beginning 2014, determinants of CPI inflation and its forecasts assume critical importance (RBI, 2014a; RBI, 2016). A key objective of this paper is, therefore, to understand the drivers of CPI inflation in a more robust framework. While some studies have modelled the inflation process for CPI for industrial workers (CPI-IW) and back-casted CPI-C, we are not aware of any study on the CPI-C inflation process per se. As the dynamics of these two price indices could be different, this paper, therefore, models both the CPI-IW and the CPI-C inflation processes and attempts to draw policy implications.
The focus of the Phillips curve studies has typically been on the national level relationship, both in the Indian and the cross-country context. More recently, a number of studies have attempted to assess this relationship using the sub-national level data for a variety of reasons. First, the relatively more variability at sub-national levels in both inflation and output indicators, as also more data points, provide a rationale for examining this relationship using the sub-national level data. Second, a possible weakening of the inflation-output relationship at the national level could arise if the central bank is successful in keeping the national inflation close to its target; in such a scenario, swings in economic activity (above or below potential) may be only weakly associated with movements in the national level inflation, thereby weakening the inflation-output nexus. At the same time, the continued dispersion in sub-national data on inflation – not the central bank’s target per se - can still provide the researchers an avenue to explore the inflation-output dynamics. While such sub-national level studies have been undertaken in the context of the US and few other countries, such an endeavour has not been attempted in the Indian context.
Against this backdrop, this paper empirically assesses the Phillips curve relationship for CPI inflation (CPI-IW as well as CPI-C) in India using state-level data in a panel framework. The structure of the paper is as follows: this introductory section is followed (Section II) by a brief review of the literature on the Phillips curve studies. A discussion of empirical methodology, and data sources and properties are in Section III. Empirical results across various specifications are presented and analysed in Section IV, with concluding observations in Section V.
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