Explain how the Reserve Bank of India can use open market operations (OMO) to curb rising inflation. Illustrate your answer with a short example involving the purchase or sale of government securities.
Answer
RBI sells government securities, which drains liquidity, raises interest rates, and helps control inflation.
The correct answer is RBI sells government securities, which drains liquidity, raises interest rates, and helps control inflation. — Provide a concrete example: RBI announces the sale of Rs. 2000 crore of Treasury bills. Commercial banks purchase these bills, their reserves fall by Rs. 2000 crore, the money supply contracts, and the policy rate rises, helping to contain inflation.
Step-by-step solution
- State the objective of OMO: to influence the amount of money in the banking system.
- Explain that when RBI sells government securities, banks buy them and pay cash to RBI, reducing banks' reserves.
- Reduced reserves mean banks have less excess liquidity to lend, leading to a contraction in credit.
- A lower supply of credit pushes the market interest rate up, discouraging consumption and investment, thereby easing inflationary pressures.
- Provide a concrete example: RBI announces the sale of Rs. 2000 crore of Treasury bills. Commercial banks purchase these bills, their reserves fall by Rs. 2000 crore, the money supply contracts, and the policy rate rises, helping to contain inflation.
Common mistake: Assuming that RBI purchases securities to fight inflation; in fact, buying securities adds liquidity and can be inflationary.
Concept tested: Open market operations as a monetary tool
Published · How this solution was prepared and checked
← All Money and Banking questions