How Does the RBI and the Government Control Inflation in India: Strategies and Implications
In the vast and diverse Indian economy, the control of inflation is a complex task undertaken by the Reserve Bank of India (RBI) and the Government of India. This task is achieved through a variety of monetary policy tools and measures aimed at maintaining price stability while fostering economic growth. This article explores the key strategies employed by the RBI and the government, with a particular focus on recent developments and the ongoing inflation targets.
RBI's Monetary Policy Tools for Controlling Inflation
The RBI employs a set of monetary policy tools to control inflation, including:
1. Repo Rate and Reverse Repo Rate
The Repo Rate is the interest rate at which commercial banks borrow from the RBI. An increase in the Repo Rate makes borrowing from the RBI more expensive, leading banks to raise their lending rates. Conversely, the Reverse Repo Rate is the interest rate at which the RBI borrows from commercial banks. Lowering the Reverse Repo Rate makes it cheaper for banks to park their excess reserves with the RBI, thereby reducing their liquidity and lending capacity.
2. Bank Rate
The Bank Rate is the minimum interest rate at which banks can borrow from the RBI. Higher Bank Rates make it costlier for banks to borrow, which they pass on to borrowers, ultimately reducing the demand for credit and stemming inflation.
3. Open Market Operations (OMO)
Through Open Market Operations, the RBI buys or sells government securities in the secondary market to adjust the money supply. Selling securities reduces liquidity, reducing inflationary pressures; buying securities increases liquidity, potentially leading to inflation.
4. Statutory Liquidity Ratio (SLR)
SLR is the percentage of Net Demand and Time Liabilities (NDTL) that banks are required to keep as liquid assets, primarily in the form of government securities. Increasing the SLR reduces the amount of funds available for lending, thus curbing inflation.
5. Cash Reserve Ratio (CRR)
CRR is the percentage of total deposits that banks must hold in cash with the RBI. Raising the CRR reduces the amount of money banks can lend, thereby limiting inflationary pressures.
The Liquidity Adjustment Facility (LAF) and Market Stabilisation Scheme (MSS) are additional tools used to manage short-term liquidity and curb speculative activities in the market.
Government-Set Inflation Targets with the RBI
With the amendment to the RBI Act in 2015, the Central Government is now responsible for setting the inflation targets every five years, in consultation with the RBI. For the period from August 5, 2016, to March 31, 2021, the targeted inflation rate was set at 4%, with an upper tolerance limit of 6% and a lower tolerance limit of 2%.
The Central Government has listed the following as factors that constitute a failure to achieve the inflation target:
The average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters. Huge deficit in the fiscal year. An over-reliance on external demand to boost economic growth. Reduced outturns in agriculture and industries impacting supply. Failure of the government in implementing necessary structural reforms. Prone or severe situations in the credit market, global financial market, and exchange rate.Impact on the MSME Sector
The performance of the Indian economy heavily depends on the Micro, Small, and Medium Enterprises (MSME) sector, which comprises 45% of the workforce and 40% of India's GDP. The fragile MSME sector, which often struggles with access to financing and operational costs, can be critically affected by changes in interest rates and monetary policy. The efficacy of the RBI's manoeuvres in controlling inflation must therefore be critically evaluated, especially in light of the MSME sector's importance.
Conclusion
The RBI and the government use a range of monetary policy tools to control inflation in India. While these measures can be effective in reducing inflationary pressures, the success of these policies is often contingent on multiple factors, including the health of the MSME sector and broader economic conditions. Understanding these strategies and their implications is crucial for policymakers, business leaders, and investors in the Indian market.