Introduction
Inflation is a sustained rise in the general price level of goods and services in an economy. When inflation rises above a certain limit, it reduces the value of money, hurts savings, and can destabilize the economy.
To tackle this, central banks use monetary policy — the process of controlling the money supply and interest rates — to influence demand, credit, and liquidity. In India, the Monetary Policy Committee (MPC) led by the RBI is tasked with keeping inflation within a target range. The current framework targets 4% inflation with a ±2% band.
What is Monetary Policy?
Monetary policy refers to the decisions made by a central bank to influence the economy by regulating:
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Money supply
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Interest rates
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Credit availability
The main goal is to control inflation, ensure currency stability, support economic growth, and maintain financial stability.
Types of Monetary Policy
1. Expansionary Monetary Policy
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Adopted when the economy is in a slowdown or recession.
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Central bank lowers interest rates and increases money supply to encourage borrowing, spending, and investment.
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Risk: It may cause demand-pull inflation if overdone.
2. Contractionary Monetary Policy
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Used when inflation is too high.
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Central bank raises interest rates and reduces liquidity to discourage borrowing and cool down the economy.
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Helps bring inflation within control, but may slow growth temporarily.
Monetary Policy Tools to Control Inflation
1. Repo Rate
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The rate at which RBI lends money to commercial banks.
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An increase in repo rate makes borrowing costlier, reduces demand, and controls inflation.
2. Reverse Repo Rate
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The rate at which RBI borrows from banks.
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Higher reverse repo attracts banks to park money with RBI, reducing liquidity in the system.
3. Cash Reserve Ratio (CRR)
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Percentage of a bank’s total deposits that must be kept with RBI.
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Increasing CRR reduces money banks can lend, thus curbing inflation.
4. Statutory Liquidity Ratio (SLR)
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Minimum percentage of net demand and time liabilities (NDTL) banks must maintain in the form of government securities.
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Higher SLR means less money available for lending.
5. Open Market Operations (OMO)
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Buying or selling of government bonds by the RBI in the open market.
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Selling bonds reduces money supply, while buying injects liquidity.
6. Liquidity Adjustment Facility (LAF)
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Allows banks to borrow money through repurchase agreements.
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Helps manage short-term liquidity mismatches and control interest rates.
Inflation Targeting Framework in India
In 2016, India adopted a Flexible Inflation Targeting (FIT) framework via the Monetary Policy Committee (MPC).
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The inflation target is set at 4% ± 2% (i.e., between 2% and 6%).
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If inflation remains outside this band for three consecutive quarters, the MPC must explain to the government.
Composition of MPC:
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3 members from RBI (including the Governor)
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3 external experts nominated by the Government
This framework has improved transparency, accountability, and credibility in managing inflation.
Effectiveness of Monetary Policy in Controlling Inflation
1. Successes
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Helped bring inflation from double digits in 2013 to under 5% by 2017.
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Maintained price stability during most of the COVID-19 period despite disruptions.
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Sent clear policy signals to markets and enhanced RBI's credibility.
2. Limitations
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Monetary policy is demand-side; it cannot address supply-side inflation (e.g., rising food or oil prices).
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Policy transmission is often delayed in India due to banking inefficiencies.
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External shocks like war, global commodity prices, and supply chain disruptions can override policy effects.
Case Study: COVID-19 and Inflation Control
During the pandemic, RBI followed an ultra-loose monetary policy:
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Repo rate cut to a record low of 4%.
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Liquidity measures worth over ₹10 lakh crore were pumped into the economy.
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Post-COVID, inflation started rising due to global energy prices and supply bottlenecks.
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RBI began tightening in 2022 by raising rates gradually to bring inflation back within the target band.
Challenges Ahead
1. Imported Inflation
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Rising global crude oil and food prices affect domestic inflation despite monetary tightening.
2. Climate Change and Food Inflation
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Unseasonal rains or droughts affect agricultural supply, pushing food prices up.
3. Fiscal-Monetary Coordination
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While RBI controls interest rates, the government controls fiscal spending. If both aren't aligned, inflation may persist.
4. Monetary-Financial Tradeoff
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Excessively tight policy may reduce inflation but also hurt growth and employment.
The Way Forward
1. Improve Monetary Transmission
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Strengthen digital banking and reduce non-performing assets (NPAs) to ensure quicker policy pass-through.
2. Combine with Supply-Side Reforms
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Monetary policy must be supported by agricultural reforms, infrastructure development, and logistics improvements to lower inflation sustainably.
3. Continue Transparent Communication
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Regular policy statements, forward guidance, and data disclosures will enhance market trust.
4. Encourage Financial Literacy
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A financially aware public will better understand how monetary policy affects savings, loans, and prices.
Conclusion
Monetary policy is a critical tool for controlling inflation, preserving economic stability, and ensuring sustainable growth. The RBI’s role in managing interest rates, liquidity, and credit directly affects inflation expectations and consumer behavior.
While monetary policy alone cannot eliminate inflation — especially from supply shocks or external factors — it remains a first line of defense. Coordinated action with fiscal policy, improved governance, and enhanced institutional credibility will determine the effectiveness of inflation control in the future.