How Liquidity Affects Inflation

How Liquidity Affects Inflation

Tags:      Gig Economy     Economy     WTO     WTO Public Stockholding     MSP     Economic Growth     Masala Bond     Environmental Performance Index     Forecast of Economic Growth     Functions of the Finance Commission

A liquidity situation that cannot be controlled or managed can have a significant impact on inflation, interest rates, stock markets, and foreign exchange rates. The RBI's task of controlling the liquidity situation has become more difficult due to the high degree of volatility in global market conditions and foreign fund flows. Since the beginning of the year, the Reserve Bank of India (RBI) has made small changes to the monetary policy. In terms of maintaining interest rates, liquidity, and GDP growth, these actions have produced positive outcomes. The inflation rate is still high because of a number of things, but analysts think that the RBI will take more monetary actions and that good rainfall and base effect will bring it down in the next few quarters.

How the RBI regulates the liquidity in the market - The RBI keeps an eye on the liquidity situation on a regular basis and occasionally takes the necessary measures to control it. The short-term and long-term liquidity positions are managed by the RBI through a variety of direct and indirect policies. The RBI controls liquidity using a variety of tools like these:

1. CRR, or Cash Reserve Ratio - The RBI uses the cash reserve ratio (CRR) to control issues with liquidity in the medium to long term. As a percentage of their deposits, banks are required to keep more money with the RBI as a result of an increase in the CRR. The bank's overall liquidity suffers as a result of this decrease in liquid funds.

2. LAF, or the Liquidity Adjustment Factor - As part of financial reforms a decade ago, the liquidity adjustment factor (LAF) was introduced. The large and erratic capital flows (both inflows and outflows) can be managed with the assistance of the LAF in the short term.

3. Repo Rate - The RBI uses the reverse repo rate to lower interest rates in the call/money market and manage short-term liquidity. The current repo rate and the reverse repo rate both contribute to the maintenance of a predictable range of interest rates through the repos. In times of tight liquidity, the call rate will be close to the repo rate, whereas in times of excess visible liquidity, the call rate will be close to the reverse repo rate.