RBI Operations and Exchange Rate Policy UPSC Prelims PYQ 2022

With reference to the Indian economy, consider the following statements:

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?

1. 1 and 2 only
2. 2 and 3 only
3. 1 and 3 only
4. 1, 2 and 3

Explanation

Statement 1 is incorrect

• Open Market Operation (OMO) is a monetary policy tool central banks use to control money supply and interest rates. OMO involves the purchasing and selling of government securities (G-Sec) in the open market. When the Reserve Bank feels there is excess liquidity in the market, it resorts to selling government securities, thereby sucking out rupee liquidity (to control high inflation, the RBI would sell government securities to absorb excess liquidity from the banking system). Similarly, when the liquidity conditions are tight, the central bank buys securities from the market, thereby releasing liquidity into the market

Statement 2 is correct

• To counter the depreciation of the rupee in the global market against the US Dollar, the Reserve Bank of India (RBI) would intervene by selling dollars, thereby increasing the supply of dollars relative to the rupee.

Statement 3 is correct

• Lower interest rates in the US or the EU typically lead to a widening interest rate differential between these regions and India. This makes Indian markets more attractive to foreign investors seeking higher returns. As a result, there is an increased inflow of foreign capital into Indian markets.
• The influx of foreign capital increases the demand for Indian Rupees and can lead to a strengthening of the Rupee. At the same time, the supply of foreign currencies, like the US Dollar, increases.
• A stronger Rupee could reduce the cost of imports and improve the trade balance. To manage the effects of a stronger Rupee, which could negatively affect exports and other sectors, the Reserve Bank of India (RBI) may intervene in the foreign exchange market.
• This typically involves buying dollars to stabilise the Rupee and prevent excessive appreciation.

Answer: (b) 2 and 3 only; Difficulty Level: Medium