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A Study of Impact of RBI Policy Rates on Inflation

IndianMoney.com Research Team | Posted On Monday, February 17,2020, 01:06 PM

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A Study of Impact of RBI Policy Rates on Inflation

 

 

RBI is the apex body resaponsible for regulating public and private sector banks, framing the monetary policy and other aspects related to the financial sector. The monetary policy is used to control inflation in the economy (This is called inflation-targeting). Here are some insights on the impact of RBI policy on inflation:

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A Study of Impact of RBI Policy Rates on Inflation

Let us begin by understanding what RBI is and its responsibilities:

What is RBI?

RBI stands for Reserve Bank of India which is responsible for regulating money flow and managing banks in the economy. Also known as the Banker’s Bank and Lender of Last Resort, RBI is central to all financial decisions and transactions made in the country.

The central body was established in the year 1935 on 1st of April in Calcutta but later on, moved to Mumbai in the year 1937.

See Also: Important Credit Control Tools Of RBI: CRR, Repo and Reverse Repo Rates

What is The Objective of RBI?

The primary objective of RBI is undertaking and supervising of different initiatives taken in favor of the financial sector which comprises commercial banks, non-banking institutions, and other financial institutions.

What are The Major Functions of the RBI?

The functions of the Reserve Bank of India can be broadly divided into 6 categories:

  1. Monetary authority
  2. Regulatory and supervisory
  3. Foreign exchange management
  4. Currency issuer
  5. Developmental role
  6. Other related functions

See Also: RBI Credit Policy

The Functions are:

  1. Serves as government’s banker.
  2. Responsible for modernizing the monetary policy to ensure economic challenges are met.
  3. Issues bank notes.
  4. Serves as a custodian of Cash reserves by commercial banks.
  5. Acts as a custodian of the country’s foreign currency reserves.
  6. Acts as a lender of last resort.
  7. Is responsible for accounts settlement and central clearance.
  8. Acts as a controller of credit.
  9. Ensures financial stability in the country.
  10. Acts as exchange control.
  11. Acts as inflation regulator.

One of the important functions of RBI is to regulate and control inflation in the economy. Let us understand how this is done:

What is Inflation?

Inflation is the rise in prices of goods and services with time. It is more money chasing fewer goods. It is essentially the rate at which the price for a given basket of commodities (goods and services) rises over a given period of time. In other words, as inflation increases, the purchasing power of a country’s currency reduces.

See Also: How To Invest If RBI Cuts Repo Rate?

Policies By Reserve Bank of India that Impact Inflation

Interest Rate

  1. Repo Rate (RR): The benchmark interest rate at which the RBI lends money to other commercial banks (both public and private) is called the repo rate. Repo rate is also known as repurchase rate, where money is lent only for the short term. With an increase in repo rate, the interest at which money is lent also increases. The effect of an increase in the repo rate is directly seen on the customers as home loan rates rise.
  2. Reverse Repo Rate (RRR): The rate of interest at which the RBI borrows money from other banks is known as reverse repo rate. Reverse repo rate is an extremely strong and important tool, which the reserve bank of India uses, to bring down the inflation when excessive capital floats in the market.
  3. Bank Rate: These rates influence commercial lending in the economy. Bank rates are the least used tool for inflation control.

Reserve Ratio

  1. Cash Reverse Ratio (CRR): The minimum mandatory deposit each bank needs to make with the Reserve bank of India is called cash reverse ratio.
  2. Statutory Liquidity Ratio (SLR): Another form of the deposit that banks need to make with the Reserve Bank of India in the form of commodities like gold and other securities is called statutory liquidity ratio. A high SLR means the bank will not be in a position to grant loans.

There are two observations that come as impact under these policies:

1. In Case of Interest Rates

Increasing interest rates imply difficulties for banks vis-a-vis borrowing capital from RBI and hence controls the influx of capital in the market. This way RBI decreases the liquidity and controls inflation.

See Also: Monetary Policy: Definition, Objectives, Types, Tools

2. In Case of Reserve Ratios

The increase in reserve ratios implies a decrease in the lending power of banks; hence a reduction in the loan granting power of banks. These ratios help in managing credit levels in the economy.            

Conclusion

RBI is a central body that governs inflation control and other financial reforms. With the above-discussed ratios and rates, RBI exercises control over inflation in the economy and makes necessary and required changes.

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