Monetary Policy & RBI Tools — Set 17

Correct Answer: B. How policy rate changes affect banks' willingness and ability to lend

The credit channel of monetary policy transmission works through banks' balance sheets: when RBI raises the repo rate, banks' borrowing costs rise, reducing their willingness to lend, their profitability shrinks, and their balance sheets weaken (if holding long-duration bonds). This leads to tighter credit conditions in the economy, reducing investment and spending beyond just the interest rate effect.

Correct Answer: C. New Zealand

New Zealand was the first country in the world to adopt a formal inflation targeting framework, doing so in 1990 under the Reserve Bank of New Zealand Act 1989. It set the precedent for central bank independence and transparent inflation targeting that was subsequently adopted by many countries including Canada (1991), UK (1992), Australia (1993), and India (2015).

Correct Answer: B. Headline = CPI including all components; Core = CPI excluding food and fuel

Headline inflation is the overall CPI inflation including all components — food, fuel, and core items. Core inflation excludes food (due to supply-side volatility) and fuel (due to global price and policy volatility), reflecting the more persistent, demand-driven part of inflation. The MPC's official target is headline CPI at 4% ±2%, but it monitors core inflation closely as a leading indicator.

Correct Answer: B. High government borrowing forcing RBI to monetise deficit, undermining inflation control

Fiscal dominance occurs when a government's large fiscal deficit forces the central bank to monetise the deficit (buy government bonds with newly created money) to fund the government's needs, even if it conflicts with the inflation target. This undermines monetary policy credibility and independence. The FRBM Act and formal separation of debt management from RBI are aimed at preventing fiscal dominance in India.

Correct Answer: B. Temporarily increasing deposits to appear compliant with CRR at reporting dates

Window dressing refers to the practice of some banks artificially inflating their deposits (by temporarily borrowing from other banks) at reporting dates to appear compliant with CRR requirements. RBI has introduced daily average CRR maintenance requirements to prevent window dressing. Banks must maintain the required CRR on a daily average basis over a fortnight.

Correct Answer: B. Recommending a monetary targeting framework for India (1985)

The Chakravarty Committee (Committee to Review the Working of the Monetary System), chaired by Sukhamoy Chakravarty, submitted its report in 1985. It recommended a monetary targeting approach for RBI (targeting broad money M3 growth), better coordination between monetary and fiscal policy, and gradual reduction of CRR and SLR. It was an important milestone in India's monetary policy evolution.

Correct Answer: C. Capital Adequacy Ratio (CAR)

Capital Adequacy Ratio (CAR or CRAR — Capital to Risk-weighted Assets Ratio) is a prudential regulatory tool that ensures banks hold enough capital against their risk exposures to absorb potential losses. In India, the minimum CAR requirement is 9% (higher than Basel III's 8%). Unlike monetary policy tools which affect the cost/quantity of credit, CAR ensures bank safety and soundness.

Correct Answer: B. Balance of payments crisis led to reforms reducing financial repression and modernising monetary framework

The 1991 balance of payments (BOP) crisis was a turning point for India's monetary and financial sector. It triggered liberalisation reforms including reduction of CRR and SLR from high levels (reducing financial repression), granting operational autonomy to banks, allowing private banks, reforming capital markets (SEBI empowered), and moving toward market-determined interest rates. This set the stage for India's modern monetary framework.

Correct Answer: B. Framework where RBI provides forex support to SAARC nations facing external difficulties

The SAARC Currency Swap Framework allows SAARC member nations to draw funds (in US dollars, euros, or Indian rupees) from RBI under a bilateral swap arrangement when facing short-term foreign exchange difficulties or balance of payments issues. The framework has a total corpus of $2 billion. Sri Lanka, Bhutan, Maldives, and Nepal have used this facility.

Correct Answer: B. RBI printing money to fund government deficit by purchasing government securities

Monetisation of the fiscal deficit occurs when the government, instead of borrowing from the market, gets the central bank (RBI) to print money and buy government securities directly (deficit monetisation or direct monetisation). This increases money supply and is inflationary. India moved away from direct monetisation through the WMA (Ways and Means Advances) system and eventually the 'SLR-linked RBI financing' reform.