Your money: the role of the central bank in an interconnected world
By Sunil Parameswaran
A central bank such as the Reserve Bank of India (RBI) periodically intervenes in the debt market to influence the interest rates and inflation rate of the economy. If the RBI feels inflation is too high, it will sell government securities and suck money out of the system. This law will drive up interest rates in the economy and businesses will reduce loan-financed capital expenditures, thereby reducing the demand for money.
On the other hand, if the central bank believes the economy is heading into a recession, it will buy government securities from banks and pump money into the system. The additional availability of money will lower interest rates.
Central banks also intervene periodically in the foreign exchange markets. If the rupee depreciates rapidly, RBI will sell dollars in the market. This will increase the supply of dollars and the demand for rupees, lowering the price of the dollar rupee. On the contrary, if the rupee appreciates rapidly, the RBI will buy dollars and inject rupees into the economy. This will increase the demand for dollars and the supply of rupees, thus causing the price of the dollar rupee to increase.
If RBI sells dollars to stem the depreciation of the rupee, it will reduce the money supply in the national economy. This can cause interest rates to rise. To avoid this, after selling dollars, the RBI can buy government securities and inject rupees into the economy. This is called a sterilized intervention.
Likewise, if the RBI buys dollars to keep the rupee from appreciating, it will inject money into the national economy. This will lead to lower interest rates. To avoid this, after buying dollars, the RBI can sell government securities and suck money out of the economy. It is also a sterilized intervention.
Interest rate movements in a foreign economy can stimulate RBI action. If the Federal Reserve reduces the money supply in the United States, interest rates will rise there. This will reduce investment by IFIs in India, as investment in US debt would have become more attractive. Reduced demand for the rupee due to less interest from global institutional investors will cause the rupee to depreciate.
In response, RBI may sell dollars from its reserves to support the Indian currency. On the other hand, if interest rates in the US or the EU were to fall, the IFIs would increase their investments in India. The resulting demand for rupees will make the rupee appreciate. In response, RBI will buy dollars and inject rupees into the system. In these two cases, RBI can choose to intervene in a sterilized or unsterilized manner.
Thus, the economic forces of a foreign country can have implications for domestic interest and inflation rates, as well as the exchange rates of the domestic currency against foreign currencies.
The author is CEO of Tarheel Consultancy Services