Money, Banking and Inflation

The Reserve Bank of India

• Established on 1 April 1935 under the RBI Act, 1934; nationalised in 1949. HQ: Mumbai.
• Roles: issuer of currency (except one-rupee notes and coins, which the Government issues), banker to the government, banker's bank, regulator of banks, manager of foreign exchange, and monetary policy.

Monetary policy tools

Inflation targeting: the Monetary Policy Committee (6 members, chaired by the RBI Governor) aims for 4% CPI inflation ± 2%.

Inflation – types

• Demand-pull (too much money chasing too few goods) vs cost-push (rising input costs, e.g. oil).
• Deflation = a fall in prices. Disinflation = a slower rise. Stagflation = high inflation with low growth.
• Inflation hurts fixed-income earners and savers. Moderate inflation can encourage investment.

Banking milestones

• Bank nationalisation: 14 banks in 1969 and 6 more in 1980.
• NPA: a loan with interest or principal overdue for more than 90 days.
• Insolvency and Bankruptcy Code, 2016 – time-bound resolution of stressed companies.
• Financial inclusion: PM Jan Dhan Yojana (2014), payments banks, small finance banks, UPI (built by the NPCI).

Background: money and its functions

Money is a medium of exchange, a unit of account, a store of value and a standard of deferred payment. In India, the RBI (established 1935, nationalised 1949) issues currency (except one-rupee notes and coins, which the Government of India issues), regulates banks, manages foreign exchange and runs monetary policy.

Measures of money supply

Money multiplier = M3 ÷ M0. It is higher when people keep more money in banks and banks lend more.

Monetary policy – how the RBI acts

Since 2016, monetary policy has been decided by the six-member Monetary Policy Committee (MPC) – three RBI members including the Governor (who has a casting vote) and three external members. The inflation target (under the amended RBI Act) is 4% CPI inflation with a band of 2–6%, reviewed every five years.

Transmission: banks link loan rates to an external benchmark (usually the repo rate) since 2019, which speeds up transmission.

Banking structure and reforms

Commercial banks (public, private, foreign), Regional Rural Banks, cooperative banks, Small Finance Banks and Payments Banks.

Reforms:

• the Narasimham Committees (1991, 1998);
• the Insolvency and Bankruptcy Code (2016);
• bank mergers (2019–20 – 12 PSBs from 27);
• recapitalisation;
• the 4R approach (recognition, resolution, recapitalisation, reforms);
• the NARCL "bad bank" (2021).

Gross NPAs of scheduled commercial banks fell from about 11.2% (2018) to below 3% recently.

Basel III norms require capital adequacy (India: CRAR at least 9%, plus buffers).

Inflation – types, causes and effects

CPI vs WPI:

• CPI (NSO) measures retail prices paid by consumers. Food has a large weight (about 46% in CPI-Combined). It is the RBI's target measure. A revised CPI series (new base year) is planned.
• WPI (DPIIT, Office of the Economic Adviser) measures wholesale prices. It has no services and a high weight for manufactured goods.

Related terms: headline vs core inflation (core excludes food and fuel); deflation (falling prices); disinflation (falling inflation rate); stagflation (high inflation + stagnation).

Effects: hurts fixed-income earners and savers; redistributes from lenders to borrowers; erodes competitiveness; uncertainty reduces investment. Moderate, stable inflation is considered healthy.

Case study: inflation targeting since 2016

Before 2016, the RBI used multiple indicators, and inflation in 2010–13 was often near or above 9–10%. After formal targeting, average CPI inflation was lower and expectations became better anchored, though shocks (Covid, the Ukraine war, food prices) pushed it above 6% at times. The RBI then raised the repo rate from 4% to 6.5% (May 2022–February 2023). Rate cuts followed from 2025 as inflation eased. The lesson: a credible, rule-based framework helps, but food supply shocks need fiscal and supply-side responses too.

Common misconceptions

• "The RBI prints money to fund all government spending." – Direct monetisation ended with the 1997 agreement and FRBM. The RBI buys government bonds only in the secondary market, for liquidity purposes.
• "Higher CRR always reduces inflation quickly." – It reduces liquidity, but food-driven inflation may not respond much.
• "WPI and CPI move together." – They often diverge, because of different baskets (CPI has a high food weight; WPI has commodities).

How UPSC asks it

Prelims frequently asks about monetary tools, MPC composition, money-supply measures, CPI vs WPI, and banking terms (NPA, CRAR, SLR). Mains themes include the effectiveness of inflation targeting, the twin balance-sheet problem, financial inclusion, and the role of the IBC.

Mains answer framework

Q-type: "Evaluate the flexible inflation targeting framework in India."

• Intro: 2016 amendment; target 4% ± 2%.
• Positives: anchored expectations, transparency, credibility, lower average inflation.
• Criticisms: high food weight → supply shocks; growth concerns; a single instrument.
• Way forward: retain the framework; better supply-side management (storage, buffer stocks); review the CPI basket.
• Conclusion: price stability as a public good for the poor.

Monetary policy framework

Since 2016, the Monetary Policy Committee (six members: three from the RBI including the Governor, and three external members appointed by the government) sets the policy repo rate. The inflation target, set by the government under the amended RBI Act, is 4% CPI inflation with a tolerance band of 2–6%.

Practice question

Q. Distinguish between demand-pull and cost-push inflation, and explain which tools address each. Demand-pull: too much demand relative to supply; monetary tightening and fiscal restraint help. Cost-push: rising input costs (fuel, food supply shocks); supply-side measures such as better storage, imports and removing bottlenecks are more effective.