Inflation: Chapter test

The Urjit Patel Committee (report of January 2014) recommended that headline CPI (Combined) inflation be the nominal anchor, because it reflects the cost of living faced by households and shapes inflation expectations, whereas the WPI excludes services and reflects producer prices. It proposed a target of 4 per cent with a band of ±2 per cent, a glide path to bring inflation down, and a Monetary Policy Committee. The RBI shifted from WPI to CPI as its key measure in 2014, and the framework was given statutory form through the Finance Act, 2016.

Section 45ZI(5) fixes the quorum at four members, at least one of whom shall be the Governor and, in his absence, the Deputy Governor who is a member of the MPC. The same officer presides in that order under section 45ZI(6). There is no requirement that a fixed number of external members be present, which is why the Act also gives the Governor a casting vote to settle a tie.

Section 45ZI(9) allows the Central Government, if it considers necessary, to convey its views in writing to the MPC from time to time. There is no Government seat, observer or veto in the MPC, and the resolution is not cleared by the Ministry. The MPC's decision is binding on the RBI under section 45ZB(4). The Government's main levers are setting the inflation target every five years and appointing the three external members.

Statements 1 and 2 are correct. Section 45ZB provides a six-member MPC: the Governor (chairperson, ex officio), the Deputy Governor in charge of monetary policy, one officer nominated by the Central Board, and three persons appointed by the Central Government. Under section 45ZC the three are chosen on the recommendation of a Search- cum-Selection Committee of the Cabinet Secretary (chair), the RBI Governor or his representative not below the rank of Deputy Governor, the Secretary of the Department of Economic Affairs and three experts nominated by the Government. So statement 3 is wrong.

Both statements are correct and Statement-II explains Statement-I. Section 45ZI(7) gives each member one vote, and section 45ZI(8) says questions are decided by a majority of members present and voting, with the Governor having a second or casting vote in case of equality. So a 3-3 split is resolved in favour of the side the Governor is on. This mirrors the Urjit Patel Committee's idea of decision by vote, while keeping the Governor's leading role.

Measures 1, 2 and 3 aim to raise domestic availability and cool prices. Stock limits under section 3 of the Essential Commodities Act, 1955 curb hoarding and speculative holding by traders. Lower import duties make imported supplies (for example edible oils or pulses) cheaper and more plentiful. Export restrictions keep more of a scarce commodity at home. Measure 4 works the other way: a higher minimum support price raises the floor price for farmers, which supports supply over time but tends to raise, not lower, prices in the short run.

Statements 1 and 2 are correct. Core inflation strips out the most volatile components, chiefly food and fuel, whose prices swing with monsoons, harvests and global oil prices. What remains moves more slowly and reflects underlying demand pressure, so it helps the central bank judge whether a price spike will persist. Statement 3 is wrong: section 45ZA asks the Government to set the target 'in terms of the Consumer Price Index', and the notification of 25 March 2026 (like those of 2016 and 2021) fixes 4 per cent headline CPI (Combined) inflation, not core inflation.

Statements 1 and 2 are correct. Section 45ZD(1) gives the external members a four-year term without re-appointment, and section 45ZE(1)(e) lets the Central Government remove a member who misses three consecutive meetings without prior leave (after a reasonable opportunity of being heard). Statement 3 is wrong: under section 45ZD(3) the notice of resignation, of not less than six weeks, is given to the Central Government, which appointed the member, not to the Governor.

Statements 1, 2 and 4 are correct (d). Statement 1 is right: the e-rupee (Central Bank Digital Currency, pilots since 2022) is legal tender issued by the RBI in line with its monetary policy. Statement 2 is right: like a currency note, it is a liability on the RBI's balance sheet. Statement 4 is right: it can be swapped one-to-one for bank deposits and cash. Statement 3 is wrong: like any currency, it loses value with inflation; nothing in its design protects it.

Notice the difference from crypto: Bitcoin has no issuer and its price swings, while the e-rupee is just a digital form of the rupee. The RBI runs both a retail (e₹-R) and a wholesale (e₹-W) version, and has added offline and programmable features.

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Statements 1 and 3 are correct (c). Statement 1 is right: NEER (Nominal Effective Exchange Rate) is a weighted average of the rupee against a basket of trading partners' currencies; a rise means the rupee has appreciated. Statement 2 is wrong: REER adjusts NEER for inflation differences. A rising REER means Indian goods are getting dearer abroad, so competitiveness falls, not improves. Statement 3 is right: if India's inflation runs higher than its partners', REER rises even when NEER does not, so the two drift apart.

Notice that the RBI publishes NEER and REER on 40-currency and 6-currency baskets. A REER above 100 suggests the rupee is overvalued against the base year.

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Statements 2 and 3 are correct (b). Statement 1 is wrong: to fight high inflation, the RBI sells government securities through open market operations, pulling money out of the system; buying them would add money. Statement 2 is right: to stop the rupee falling fast, the RBI sells dollars from its forex reserves, which raises the supply of dollars. Statement 3 is right: when US or EU interest rates fall, foreign money flows into India and the rupee tends to rise, so the RBI buys dollars to smooth this and add to reserves.

Notice sterilisation: when the RBI buys dollars it releases rupees, so it may sell bonds to soak them up. India's forex reserves crossed $700 billion in 2024.

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Statements 1 and 2 are correct (a). In an Inflation-Indexed Bond, the principal, and so the interest, is adjusted for inflation. Statement 2 is right: this protects the investor's real return from uncertain inflation. Statement 1 is right: because of this cover, investors accept a lower coupon, which saves the government money on its borrowing. Statement 3 is wrong: there is no tax break; interest and capital gains on IIBs are taxable like any other bond.

Notice that India's IIBs of 2013 were linked to the WPI, and later ones to the CPI, but they drew little interest. Other countries' versions include the US TIPS. The Sovereign Gold Bond (2015) offered a different hedge, linked to gold prices.

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The Reserve Bank of India controls inflation (d). The RBI Act, 1934, amended in 2016, says the primary objective of monetary policy is price stability while keeping growth in mind. The government sets a CPI inflation target of 4%, with a band of 2–6%, and the six-member Monetary Policy Committee sets the repo rate to meet it. Option (a) is wrong: the Department of Consumer Affairs tracks prices of essentials and runs consumer protection. Option (b) is wrong: the Expenditure Management Commission (2014) only advised on government spending. Option (c) is wrong: the FSDC, chaired by the Finance Minister, looks after financial stability, not inflation.

Notice that if inflation stays outside the band for three quarters in a row, the RBI must explain it in writing to the government.

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All three influence Indian bond yields (d). A bond yield is the return investors demand for holding a bond; it moves opposite to the bond's price. Item 1 is right: if the US Federal Reserve raises rates, US bonds pay more, foreign investors sell Indian bonds, and Indian yields rise. Item 2 is right: RBI moves on the repo rate, and its bond purchases through open market operations, move yields directly. Item 3 is right: higher inflation and higher short-term rates make investors ask for a higher return on long bonds.

Notice that Indian government bonds joined JP Morgan's emerging market bond index in 2024, which drew foreign inflows. The 10-year G-Sec yield is India's benchmark interest rate.

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