In an economy, the Government and the RBI work together to establish stability and growth. The Government uses fiscal policy while the RBI is empowered with monetary policy.

Monetary policy deals with regulation of money supply and interest rates with intention to address issues like inflation, currency appreciation and depreciation and general economic activity. For this purpose, Monetary policy Committee was established which conducts meeting at least four times a year.

Inflation refers to general increase in price of goods and services leading to erosion of purchasing power of money. This could happen due to two factors, namely demand being in excess of supply or, an increase in cost of inputs used for manufacture that causes the final products to become costly.

To tackle inflation, the RBI tries to reduce the demand or increase the supply or both. 

Interest and inflation are closely related as in an economy. To understand how this works, remember that an economy is a function of demand and supply. An increase in demand reflects that people are consuming more goods and services and saving less. This also means that the economic activity or production is increasing. An increased production invites more people to start businesses as economy booms. This leads to businesses buying more machinery and factories by taking loans at cheaper interest rates. This causes prices to rise. 

RBI uses measures like repo rate, reverse repo rate to adjust the economic activity. When prices rise, the RBI increases interest rates. This makes setting up businesses, taking personal loans or spending costlier. It promotes saving. As more and more people save (and spend less on new car or home), consumption goes down. With reduced consumption, the prices which were high begins to come down as demand decreases.

This establishes balance in economy and curbs inflation.