Essay on steps taken by rbi and govt of india to control inflation &

maintaince of smooth supply of money in the economy . also dicuss

open market operation of rbi
RBI has simply increased interest rates in order to decrease the
money supply in market that will lead to decline in price rise.
Money Controlling Measures Adopted by the RBI!
(i) Bank Rate- In Section 49 of the RBI Act. 1934 however, the bank
rate is defined as the standard rate at which it (the Bank) is
prepared to buy or rediscount bills of exchange or other commercial
papers eligible for purchase under this Act.
(ii) Open Market Operations (OMO)- The open market operations
policy has two dimensions: (i) it directly increases or decreases the
loanable funds or the credit-creating capacity of banks: and (ii) it
leads to changes in the prices of government securities and the term
structure of interest rates.
(iii) Cash Reserve Ratio (CRR) - According to the RBI Act of 1934,
scheduled commercial banks were required to keep with the Reserve
Bank of India a minimum cash reserve of 5 per cent of their demand
liabilities and 2 per cent of their time liabilities.
(iv) Statutory Liquidity Ratio (SLR) (v) Selective Credit Control Scheme (SCCS) - Provisions of selective
credit control in terms of Sec. 21 and 35A of the Banking Regulation
Act empower the RBI to implement selective credit control. The main
instruments of SCC are:
1. Minimum margins for lending.
2. Ceiling on the level of credit against stocks of selected
commodities
(vi) Credit Authorization Scheme (CAS)
(vii) Discretionary Control of Refinance from RBI

(viii) Ceilings on RBI Refinance

(ix) Regulation of Interest Rates on commercial banks deposits and
loans and other interest rates
(x) Differential Interest Rates (DIR) Scheme
(xi) Quantitative Ceilings on Direct Allocation (rationing) of the
volume and direction of bank credit
(xii) Fixation of average and marginal credit deposit ratio
(xiii) Moral Suasion, and above all
(xiv) Credit planning
From time to time, according to the need felt, all these measures
have been operated by the RBI in varying degrees of magnitude and
effectiveness.

The basic objectives of the RBIs current monetary policy have been:
(i) To control inflation and bring about relative price stability,
(ii) To promote economic growth, and
(iii) To provide social justice in the allocation of bank credit.
In fact, under the credit squeeze policy, the Reserve Bank has
employed a series a monetary measures with the following
objectives:
(i) To improve interest rates on deposits and raise the cost of money
lent to commercial banks.
(ii) To increase the cost and reduce the availability of refinance from
the Reserve Bank.
(iii) To curb overall loanable resources of banks.
(iv) To enhance the cost of credit to borrowers from banks.

Some of the most important measures that must be followed to

control inflation are:
1. Fiscal Policy: Reducing Fiscal Deficit 2. Monetary Policy: Tightening
Credit 3. Supply Management through Imports 4. Incomes Policy:
Freezing Wages.
Inflation occurs due to the emergence of excess demand for goods
and services relative to their supply of output at the prevailing prices.
Inflation of this type is called demand-pull inflation.
1. Fiscal Policy: Reducing Fiscal Deficit:
The budget deals with how a Government raises its revenue and
spends it. If the total revenue raised by the Government through
taxation, fees, surpluses from public undertakings is less than the
expenditure it incurs on buying goods and services to meet its
requirements of defence, civil administration and various welfare
and developmental activities, there emerges a fiscal deficit in its
budget.
It may be noted here that the budget of the government has two
parts:
(1) Revenue Budget,
(2) Capital Budget.
In the revenue budget on the receipts side revenue raised through
taxes, interests, fees, surpluses from public undertakings are given
and on the expenditure side consumption expenditure by the
government on goods and services required to meet the needs of
defence, civil administration, education and health services,

subsidies on food, fertilizers and exports, and interest payments on

the loans taken by it in the previous years are important items.
In the capital budget, the main items of receipts are market
borrowings by the government from the Banks and other financial
institutions, foreign aid, small savings (i.e., Provident Fund, National
Savings Schemes etc.). The important items of expenditure in the
capital budget are defence, loans to public enterprises for
developmental purposes, and loans to states and union territories.
The deficit may occur either in the revenue budget or capital budget
or both taken together. When there is overall fiscal deficit of the
Government, it can be financed by borrowing from the Reserve Bank
of India which is the nationalised central bank of the country and has
the power to create new money, that is, to issue new notes.
Thus, to finance its fiscal deficit, the Government borrows from
Reserve Bank of India against its own securities. This is only a
technical way of creating new money because the Government has
to pay neither the rate of interest nor the original amount when it
borrows from Reserve Bank of India against its own securities.
It is thus clear that budget deficit implies that Government incurs
more expenditure on goods and services than its normal receipts
from revenue and capital budgets. This excess expenditure by the
Government financed by newly created money leads to the rise in
incomes of the people. This causes the aggregate demand of the
community to rise to a greater extent than the amount of newly
created money through the operation of what Keynes called income
multiplier.
In the opinion of many economists, the expansion in money supply
by monetisation of fiscal deficit leads to inflation in the economy by
causing excess aggregate demand in the economy, especially when
aggregate supply of output is inelastic. To some extent the creation
of new money may not generate demand-pull inflation because if the
aggregate output increases, especially of essential consumer goods

such as food-grains, cloth, the extra demand arising out of newly

created money would be matched by extra supply of output.
However, when there is too much resort to monetisation of fiscal
deficit, it will create excess of aggregate demand over aggregate
supply. There is no wonder that this has contributed a good deal to
the general rise in prices in the past and has been an important
factor responsible for present inflation in the Indian economy.
To reduce fiscal deficits and keep deficit financing (which is now
called monetization of fiscal deficit) within a safe limit, the
Government can mobilise more resources through raising:
(a) Taxes, both direct and indirect,
(b) Market borrowings, and
(c) Raising small savings such as receipts from Provident Funds.
National Saving Schemes (NSC and NSS) by offering suitable
incentives. The Government borrows from the market through sales
of its bonds which are generally purchased by banks insurance
companies, mutual funds and corporate firms.
The increase in Government expenditure made possible by
borrowing without being matched by extra taxation causes
aggregate demand to rise not only by the increase in government
expenditure but also by the multiplier effect of increase in
Government expenditure. If in response to increase in aggregate
demand, aggregate supply does not increase sufficiently due to
capacity constraints to meet the rise in aggregate demand, the result
is inflation is the economy.
Therefore, to check inflation the Government should try to reduce
fiscal deficit. It can reduce fiscal deficit by curtailing its wasteful and
inessential expenditure. In India, it is often argued that there is a
large scope for pruning down non-plan expenditure on defence,

police and General Administration and on subsidies being provided

on food, fertilizers and exports.
Though it is easy to suggest cutting down of Government
expenditure, it is difficult to implement it in practice. However, in our
view, there is a large-scale inefficiency in resource use and also a lot
of corruption involved in the spending by the Government
expenditure which can be curtailed to a good extent.
Thus, both by greater resource mobilisation on the one hand and
pruning down of wasteful and inessential Government expenditure
on the other, the fiscal deficit and consequently inflation can be
checked. In its recommendation for India IMF has suggested that
fiscal deficit in India should be reduced to 3 per cent of GDP if
inflationary pressures are to be controlled.
2. Monetary Policy: Tightening Credit:
Monetary policy refers to the adoption of suitable policy regarding
interest rate and the availability of credit. Monetary policy is another
important measure for reducing aggregate demand to control
inflation. As an instrument of demand management, monetary policy
can work in two ways.
First, it can affect the cost of credit and second, it can influence the
credit availability for private business firms. Let us first consider the
cost of credit. The higher the rate of interest, the greater the cost of
borrowing from the banks by the business firms. As anti-inflationary
measure, the rate of interest has to be kept high to discourage
businessmen to borrow more and also to provide incentives for
saving more.
It has been asserted by some economists who are pro-private sector
that higher interest rate discourages private investment and
therefore lowers rate of economic growth. It has therefore been
pointed that for reducing inflation through raising interest rate some
growth has to be sacrificed.

In their words, according to them, there exists tradeoff between

inflation and growth. However, in our view the contradiction
between growth and inflation has been exaggerated. In fact inflation
itself adversely affects long-term growth as it discourages savings on
the one hand and encourages nonproductive type of investment
such as spending on gold, jewellery, real estate. Besides, inflation
sends many people below the poverty line.
Further, investment depends more on expected profits or what J.M.
Keynes called marginal efficiency of capital (MEC) and on
technological change (which raises productivity) rather than on
interest rate alone. Raising interest or cost of borrowing will affect, if
at all short-term growth. In the medium term to achieve sustained
growth control of inflation is necessary.
Since the mid-sixties the dear money policy (that is, higher interest
rate policy) has been pursued in India to curb the inflationary
pressures in the Indian economy. As mentioned above, the higher
rate of interest on saving and fixed deposits will induce more savings
by the households and help in cutting down aggregate consumption
expenditure.
Besides, higher rates of interest will discourage more investment in
inventories and consumer durables and will help in reducing aggregate demand. Not only has the bank rate had to be raised but also
the deposit and lending rates of commercial banks if full effect of the
monetary measures is to be achieved.
It is noteworthy that a recent monetary theory emphasizes that it is
the changes in the credit availability rather than cost of credit (i.e.,
rate of interest) that is a more effective instrument of regulating
aggregate demand. There are several methods by which credit
availability can be reduced.
Firstly, it is through open market operations that the central bank of
a country can reduce the availability of credit in the economy. Under
open market operations, the Reserve Bank sells Government

securities. Those, especially banks, who buy these securities, will

make payment for them in terms of cash reserves. With their
reduced cash reserves, their capacity to lend money to the business
firms will be curtailed. This will tend to reduce the supply of credit or
loanable funds which in turn would tend to reduce investment
demand by the business firms.
The Cash Reserve Ratio (CRR) can also be raised to curb inflation. By
law banks have to keep a certain proportion of cash money as
reserves against their deposits. This is called cash reserve ratio. To
contract credit availability Reserve Bank can raise this ratio. In recent
years to squeeze credit for checking inflation, cash reserve ratio in
India has been raised from time to time.
Another instrument for affecting credit availability is the Statutory
Liquidity Ratio (SLR). According to statutory liquidity ratio, in addition
to CRR, banks have to keep a certain minimum proportion of their
deposits in the form of specified liquid assets.
And the most important specified liquid asset for this purpose is the
Government securities. To mop up extra liquid assets with banks
which may lead to undue expansion in credit availability for the
business class, the Reserve Bank has often raised statutory liquidity
ratio.
Selective Credit Controls:
By far the most important anti-inflationary measure in India is the
use of selective credit control. The methods of credit control
described above are known as quantitative or general methods as
they are meant to control the availability of credit in general.
Thus, bank rate policy, open market operations and variation in cash
reserves ratio expand or contract the availability of credit for all
purposes. On the other hand, selective credit controls are meant to
regulate the flow of credit for particular or specific purposes.

Whereas the general credit controls seek to regulate the total

available quantity of credit (through changes in the high powered
money) and the cost of credit, the selective credit control seeks to
change the distribution or allocation of credit between its various
uses. These selective credit controls are also known as Qualitative
Credit Controls. The selective credit controls have both the positive
and negative aspect.
In its positive aspect, measures are taken to stimulate the greater
flow of credit to some particular sectors considered as important:
(1) Changes in the minimum margin for lending by banks against the
stocks of specific goods kept or against other types of securities.
(2) The fixation of maximum limit or ceiling on advances to individual
borrowers against stock of particular sensitive commodities.
(3) The fixation of minimum discriminatory rates of interest
chargeable on credit for particular purposes.
3. Supply Management through Imports:
To correct excess demand relative to aggregate supply, the latter can
also be raised by importing goods in short supply. In India, to check
the rise in prices of food-grains, edible oils, sugar etc., the
Government has often taken steps to increase imports of goods in
short supply to enlarge their available supplies.
When inflation is of the type of supply-side inflation, imports are
increased to augment the domestic supplies of goods. To increase
imports of goods in short supply the Government reduces customs
duties on them so that their imports become cheaper and help in
containing inflation. For example in 2008-09 the Indian Government
removed customs duties on imports of wheat and rice and reduced
them on oilseeds, steel etc. to increase their supplies in India.

At times of inflationary expectations, there is a tendency on the part

of businessmen to hoard goods for speculative purposes. The
attempt by the Government to import goods in short supply would
compel the hoarders to release their hoarded stocks.
This will have a favourable impact on prices of these goods.
However, the country can sufficiently increase the imports of goods
if there are either enough foreign exchange reserves which can be
used to spend on imports or if sufficient foreign aid is available to
import the goods in short supply.
4. Incomes Policy: Freezing Wages:
Another anti-inflationary measure which has often been suggested is
the avoidance of wage increases which are unrelated to
improvements in productivity. This requires exercising control over
wage-income. It is through wage-price spiral that inflation gets
momentum.
When cost of living rises due to the initial rise in prices, workers
demand higher wages to compensate for the rise in cost of living.
When their wage demands are conceded to, it gives rise to cost-push
inflation. And this generates inflationary expectations which add fuel
to the fire.
To check this vicious circle of wages-chasing prices, an important
measure will be to exercise control over wages. However, if wages
are raised equal to the increase in the productivity of labour, then it
will have no inflationary effect. Therefore, the proposal has been to
freeze wages in the short run and wages should be linked with the
changes in the level of productivity over a long period of time.
According to this, wage increases should be allowed to the extent of
rise in labour productivity only. This will check the net growth in
aggregate demand relative to aggregate supply of output.
However, freezing wages and linking it with productivity only
irrespective of what happens to the cost of living has been strongly

opposed by trade unions. It has been validly pointed out why freeze
wages only, to ensure social justice the other kinds of income such as
rent, interest and profits should also be freeze similarly. Indeed,
effective way to control inflation will be to adopt a broad- based
incomes policy which should cover not only wages but also profits,
interest and rental incomes.

What are the Open Market Operations (OMOs)?

OMOs are the market operations conducted by the Reserve Bank of
India by way of sale/ purchase of Government securities to/ from the
market with an objective to adjust the rupee liquidity conditions in
the market on a durable basis. When the RBI feels there is excess
liquidity in the market, it resorts to sale of securities thereby sucking
out the rupee liquidity. Similarly, when the liquidity conditions are
tight, the RBI will buy securities from the market, thereby releasing
liquidity into the market.
DEFINITION OF 'OPEN MARKET OPERATIONS - OMO'
The buying and selling of government securities in the open market
in order to expand or contract the amount of money in the banking
system. Purchases inject money into the banking system and
stimulate growth while sales of securities do the opposite.
INVESTOPEDIA EXPLAINS 'OPEN MARKET OPERATIONS - OMO'
Open market operations are the principal tools of monetary policy.
(The discount rate and reserve requirements are also used.) The U.S.
Federal Reserve's goal in using this technique is to adjust the federal
funds rate - the rate at which banks borrow reserves from each
other.

Open market operations is a measure used by the central bank of the

country to manage money supply. Through OMOs, central bank
either purchase or sell government bonds in the open market. The
primary tool for implementing monetary policy, OMOs facilitate
changes in short-term interest rates and money supply depending on
the prevailing economic scenario.
In case, the liquidity condition of the economy is weak, the central
bank purchases government securities and hence infuses money into
the system. Otherwise, it sells securities in case of excess liquidity in
the system.
The central bank performs open market operations considering the
targets for various economic parameters such as interest rates,
exchange rates or inflation. Also, the measure is used as a tool for
Open Market operations in India
Before, the financial reforms of 1991, cash reserve ratio (CRR) and
statutory liquidity ratio (SLR) were the prime tools used by the
central bank to control money supply and interest rates in the
market. But soon, both the parameters lost their importance and
implementation of open market operations scaled immensely as
OMOs are deemed comparably effective in correcting market
liquidity.
The Reserve Bank of India in India performs OMO in two ways :
1. Outright Purchase (PEMO): Through PEMO, RBI out-rightly
engages in purchasing and selling of securities for expanding or
contracting the money-supply for a long-term.
2. Repurchase Agreement ( REPO): RBI through REPO engages in
securities sale or purchase with a condition to repurchase.

Working of OMOs :
Whenever, RBI engages in OMOs to purchase government securities
through either PEMO or repo agreement, its financial assets on the
balance sheet increase by the amount of purchase. For the same, the
central bank writes a cheque to the bank or participating institution
from which RBI has purchased the securities.
The institutions then deposit the cheque in their account held with a
commercial bank, which then sends the cheque for clearance to the
RBI. With this, liabilities side of thebalance sheet of RBI increases as
the amount of reserves of the bank with the central bank increases.
According to the relationship, M3=MB*m (where M3 is money
supply, MB is monetary base and m is a multiple figure), with an
increase in the monetary base (MB) or monetary liability; money
supply or M3 increases by multiple m. Conversely, in case of
securities sale by the RBI, money supply decreases in the market
with decrease in the monetary base or liability of the central bank.