What is sterilization, in your opinion? How does the RBI guard against outside shocks by stabilizing the money supply? (Answer in 200 words)
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Sterilization is a form of monetary action in which a central bank seeks to limit or neutralize the effect of inflows and outflows of capital on the money supply. For instance, if it takes Rs 70 to purchase 1 USD and the RBI wishes to keep the exchange rate from rising from its current level, it must sell dollars out of its foreign exchange reserves. Since the dollars will be purchased with rupees, the supply of rupees in circulation will decrease and the supply of dollars in circulation will increase, therefore, the value of the dollar will not rise relative to the rupees. But this action reduces the amount of domestic currency in circulation, which might not be desirable. For example, it may lead to a rise in interest rates. To counteract or sterilize this effect, the central bank may simultaneously purchase domestic (Indian) bonds to put domestic currency back in circulation. Similarly, if a central bank is buying foreign currency to keep the value of domestic currency low, it can sterilize such intervention by selling bonds and removing from circulation domestic currency that was introduced by such foreign exchange market intervention. In India, RBI has the following mechanisms to stabilize money supply against external shocks:
Other than these mechanisms, the absorption or injection of liquidity through the Liquidity Adjustment Facility (LAF) and Cash Reserve Ratio (CRR) also can sterilize liquidity. However, they are to be used in extreme cases, when other options are exhausted. Forex market intervention requires a continuous assessment of exchange market conditions, liquidity conditions, G-sec market conditions, and forward market conditions. The prudent sterilized interventions by RBI have not only ensured that the reserve money growth remains consistent with the requirements of the growing economy but also that money market rates remain aligned with the operating target of the monetary policy, no matter how significant and persistent the liquidity impact of forex interventions may be.
Sterilization refers to a central banks actions to counter balance the effects of foreign exchange interventions on the domestic money supply.
Sterilization in India
In India sterilization emerged post-1991 economic liberalization to manage important exchange impact on the domestic money supply. The reserve Bank of India use tools like market stabilization scheme bonds and open market operations to absorb excessive liquidity, ensuring monetary stability amid increased forest increased forex market activity and growing foreign exchange reserve.
Measures used by RBI to guard against external shocks
1. Open Market Operations (OMO): Buying or selling government securities to regulate liquidity and stabilize the currency.
2. Liquidity Ratio : Requiring commercial banks to maintain a certain percentage of their deposits in liquid assets, ensuring they have sufficient funds to meet withdrawal demands.
3. Monetary Policy Tools: Adjusting interest rates, cash reserve ratios, and statutory liquidity ratios to influence credit growth, inflation, and exchange rates.
4. Foreign Exchange Intervention: Buying or selling foreign currencies to stabilize the exchange rate and manage foreign exchange reserves.
5. Capital Controls: Regulating inflows and outflows of capital to prevent sudden surges or withdrawals.
These tools help the RBI maintain financial stability, manage exchange rates, and mitigate the impact of external shocks on the Indian economy.
Way forward
RBI can enhance its ability to manage external shocks by: monitoring global trends, making timely interventions, adopting a flexible exchange rate regime, maintaining adequate reserves, communicating clearly, collaborating with stakeholders, and regularly reviewing and refining its policy framework to promote financial stability and sustainable growth.
INTRODUCTION-
Sterilization is a method employed by the central bank of a nation to counteract the impact on the money supply caused by a balance of payment surplus or deficit.
This may also include open market operations, which are carried out by the central bank to ensure a balance between foreign exchange operations.
More generally, it can encompass any monetary policy that aims to maintain the domestic money supply constant, regardless of external factors or changes.
QUANTITATIVE METHODS –
These instruments have an impact on the total amount of money and credit available in the economy.
A) BANK RATE–
The rate at which RBI gives credit to commercial bank a low or high banks rate encourages bank to keep a small proportion of their eyes deposit as reserve within result either reduce the law of credit or increase the flow of credit.
B) OPEN MARKET OPERATIONS–
It refers to the buying or selling of securities by the Reserve Bank of India (RBI) in the open market.
(More ratios like credit reserve ratio, statutory liquidity ratio do the same thing they help to regulate the flow of money supply in the market).
RBI plays an important role in controlling external shocks suppose foreigners decide to make an investment in indian bonds the seller of the bond exchanges the foreign currency into rupees from a commercial bank than the commercial bank deposit that currency in RBI which increase the assets and liability in the balance sheet and in order to overcome from the situation RBI sales the security in the open market of the economy against adverse external environment of money supply.
In this way RBI stabilizes the money supply against external shocks.
Sterilization refers to the process by which a central bank offsets the effects of foreign exchange interventions on the domestic money supply. When a central bank buys or sells foreign currency to influence exchange rates, it affects the amount of domestic currency in circulation. To neutralize this impact and maintain control over domestic monetary conditions, the central bank conducts sterilization operations.
The Reserve Bank of India (RBI) uses sterilization to stabilize the money supply against external shocks. When there is an influx of foreign capital, leading to an increase in foreign exchange reserves, the RBI might sell government securities to absorb the excess liquidity. Conversely, if there is an outflow of foreign capital, causing a reduction in foreign exchange reserves, the RBI might buy government securities to inject liquidity into the system. This ensures that the money supply remains stable despite external capital flows.
By managing the liquidity through open market operations (OMOs), the RBI can control inflation and interest rates, thereby stabilizing the economy. This is crucial for maintaining economic stability, as uncontrolled fluctuations in the money supply can lead to inflation or deflation, adversely impacting growth and financial stability.