UPSC Prelims 2022 Q3: Indian Economy – Monetary Policy & Money Supply
With reference to the Indian economy, consider the following statements:
1. If the inflation is too high, Reserve Bank of India (RBI) is likely to buy government securities.
2. If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.
3. If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy
dollars.
Which of the statements given above are correct?
- (a) 1 and 2 only
- (b) 2 and 3 only
- (c) 1 and 3 only
- (d) 1, 2 and 3
Answer: (b) 2 and 3 only
Explanation
How the RBI responds to inflation and currency moves
| Statement | Verdict | Reason |
|---|---|---|
| 1. High inflation → RBI buys G-Secs | Wrong | Buying securities injects money and fuels inflation. To fight inflation the RBI sells securities (OMO sales) to absorb liquidity |
| 2. Rupee falling fast → RBI sells dollars | Correct | Selling dollars from reserves raises demand for rupees and slows the fall |
| 3. US/EU rates fall → RBI may buy dollars | Correct | Lower rates abroad push capital into India; the rupee rises, so the RBI buys dollars to stop sharp appreciation and build reserves |
RBI tools at a glance:
| Goal | Action |
|---|---|
| Reduce liquidity (fight inflation) | Sell G-Secs, raise repo rate, raise CRR |
| Support a weak rupee | Sell dollars |
| Stop a sharp rupee rise | Buy dollars |
Answer: (b) 2 and 3 only.
Why each option is right or wrong
- (a) Incorrect. Statement 1 is false; buying G-Secs adds money and would worsen inflation.
- (b) CORRECT. The RBI sells dollars to support a weak rupee and buys dollars when foreign inflows surge.
- (c) Incorrect. Statement 1 is false, and it leaves out the true Statement 2.
- (d) Incorrect. Statement 1 is false, so 'all three' fails.
Key point
High inflation → RBI sells G-Secs. Weak rupee → sells dollars. Lower foreign rates → inflows → RBI buys dollars.
Remember
To fight inflation the RBI sells securities; to support the rupee it sells dollars.
Common mistakes
- Mixing up OMO purchases (add liquidity) with OMO sales (absorb liquidity).
- Not linking lower foreign interest rates to capital inflows into India.
- Thinking the RBI fixes the rupee; it only smooths volatility.
Exam tip
To mop up money, sell; to release money, buy. That rule covers both G-Secs and dollars.
Sources
- RBI — Open Market Operations and Foreign Exchange Intervention FAQs
- NCERT Class XII — Introductory Macroeconomics, Ch 3 and Ch 6