1. If the inflation is too high, the 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
3. Ans: b
Explanation:
Inflation is generally considered as rise in the prices. To be more correct, inflation is a persistent rise in the general price level rather than a once-for-all rise in it. On the other han, deflation represents persistently falling prices. Depending upon the specific causes, three types of inflation have been distinguished:
- Demand-pull inflation
- Cost-push inflation
- Structuralist inflation
An important cause for demand-pull inflation is the excessive growth of money supply in the economy.
According to Quantity theorists excess money supply results in the increase in aggregate demand for goods and services which leads to inflation.
If RBI buys government securities, money will be infused which leads to increase in money supply which is again inflationary.
Tight /Dear monetary policy means RBI increases the interest rates to decrease the money supply.
Hence, statement 1 is incorrect.
One of the function of central Bank/ RBI is to maintain stability of exchange rates. The Rupee exchange rate is determined by the market demand and supply.
With the objective of curbing volatility in exchange rate, RBI makes sales or purchases of foreign currency in the forex market .
Whenever there is fall in interest rate in US , there will be flight of capital from US or capital inflows into India as a result American firms , Banks , Corporations will invest in high yielding Indian securities. Inorder to buy Indian securities they will have to convert Dollars to Indian Rupees , that will increase the demand for rupee. Such flows lead to appreciation of Rupee because of increase in supply of dollars in the forex market. So a relatively higher interest rate in India as compared to US will lead to depreciation of dollar and appreciation of Rupee.
When rupee appreciates RBI buys dollar creating demand for dollar and when rupee depreciates RBI sells dollar creating demand for rupee to keep the Indian Rupee from depreciating sharply.
Such sales and purchases are not governed by a predetermined target or band around the exchange rate.
Hence, statements 2 and 3 are correct.
Read: Solved Economy PYQs With Explanation 2022 UPSC Prelims