Monetary Policy & RBI Tools — Set 14

Correct Answer: B. Interest rates should respond to both inflation gap and output gap

The Taylor Rule, proposed by economist John Taylor, is a guideline that suggests a central bank should set the nominal interest rate based on: (1) the gap between actual and target inflation, and (2) the gap between actual and potential output (output gap). It formalises how central banks like RBI might balance inflation control with supporting economic growth.

Correct Answer: B. Improving credit discipline and bank balance sheets, enhancing monetary transmission

The IBC, 2016, helps resolve NPAs through time-bound insolvency proceedings, improving bank balance sheets. When banks have fewer NPAs, they are better positioned to transmit RBI rate cuts to borrowers. Healthier bank balance sheets improve the functioning of the credit channel of monetary policy transmission.

Correct Answer: B. Targeting specific interest rate levels across different maturities of government bonds

Yield Curve Control (YCC) is an unconventional monetary policy tool where a central bank targets a specific interest rate (yield) level for government bonds of a particular maturity to keep borrowing costs low. Japan's central bank (Bank of Japan) used YCC to cap 10-year government bond yields. India has not formally adopted YCC but uses OMO/G-SAP to influence yields.

Correct Answer: B. Commercial banks lending to RBI temporarily against government securities

In a reverse repo transaction, commercial banks lend excess funds to the RBI temporarily, with the agreement to receive them back the next day along with interest (at the reverse repo rate). Banks park excess liquidity with RBI through reverse repo when they have surplus funds. This helps RBI absorb excess liquidity from the banking system.

Correct Answer: B. Reducing government control over banks and improving their efficiency

The Narasimham Committee I (1991), headed by M. Narasimham (former RBI Governor), recommended sweeping banking reforms including: reducing CRR and SLR to free up resources for credit, setting up 4-tier banking structure, granting operational autonomy to banks, improving capital adequacy, and better NPA recognition. These recommendations aligned monetary policy tools with market principles.

Correct Answer: B. Keeping interest rates artificially low, forcing banks to hold government bonds through high SLR

Financial repression refers to policies that suppress interest rates below inflation or force financial institutions to hold government securities through high SLR requirements, effectively channelling cheap credit to the government. Historical high CRR (15%) and SLR (38.5%) in India during the 1980s-90s are examples of financial repression. Post-1991 reforms progressively reduced these to market-friendly levels.

Correct Answer: B. Bond prices and interest rates move in opposite directions

Bond prices and interest rates have an inverse relationship: when interest rates rise, existing bond prices fall (because new bonds offer higher rates, making old ones less attractive). Conversely, when interest rates fall, bond prices rise. This is crucial for monetary policy — when RBI raises repo rates, government bond prices fall, affecting bank balance sheets (mark-to-market losses on SLR holdings).

Correct Answer: B. Bonds where principal/interest is linked to inflation index to protect real returns

Inflation-indexed bonds (IIBs) are government securities where both the principal and/or interest are adjusted for inflation, protecting investors from erosion of real value. India has issued Inflation-Indexed National Savings Securities (IINSS). They are linked to the CPI, ensuring that the real return remains constant regardless of inflation movements.

Correct Answer: B. Simultaneous purchase of long-term and sale of short-term government securities to control yield curve

Operation Twist is a monetary policy strategy where the central bank simultaneously buys long-term government securities (to lower long-term yields) and sells short-term securities (to raise short-term yields), reshaping the yield curve. RBI conducted its own version of Operation Twist in 2019-2020 to reduce long-term borrowing costs for the government and economy.

Correct Answer: A. Effect of base year price level on current inflation measurement

The base effect refers to how the price level from the corresponding period in the previous year (the base period) influences the current inflation rate. If prices were unusually high a year ago, the current inflation rate will appear lower (favourable base effect). Conversely, if last year's prices were low, current inflation appears higher (adverse base effect). RBI analysts account for base effects in assessing true inflationary trends.