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Q24 (IAS/2023) Economy › Money, Banking & Inflation › Exchange rate management Official Key

Which one of the following activities of the Reserve Bank of India is considered to be part of 'sterilization'?

Result
Your answer: —  ·  Correct: A
Explanation

The correct answer is Option 1.

In the context of central banking, sterilization refers to the process used by the RBI to neutralize the impact of excessive foreign exchange inflows or outflows on the domestic money supply. When the RBI buys foreign currency (USD) to prevent rupee appreciation, it injects equivalent liquidity in rupees into the economy, which can cause inflation.

To "sterilize" or offset this effect, the RBI conducts Open Market Operations (OMO) by selling government securities to soak up the excess liquidity. Conversely, it buys securities to inject liquidity when needed. Thus, OMO is the primary tool for sterilization.

  • Options 2, 3, and 4 are regular administrative, regulatory, or developmental functions of the RBI (such as acting as a banker to the government or regulating NBFCs) but do not involve the specific mechanism of neutralizing liquidity impacts arising from foreign exchange interventions.
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Q. Which one of the following activities of the Reserve Bank of India is considered to be part of 'sterilization'? [A] Conducting 'Open Mar…
At a glance
Origin: Mixed / unclear origin Fairness: Low / Borderline fairness Books / CA: 2.5/10 · 0/10
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This is a classic 'Sitter' from the static portion of Macroeconomics. It tests the fundamental mechanism of how a Central Bank manages the 'Impossible Trinity' (Exchange Rate vs. Inflation). If you missed this, your core reading of NCERT or standard reference books (Vivek Singh/Singhania) is superficial.

How this question is built

This question can be broken into the following sub-statements. Tap a statement sentence to jump into its detailed analysis.

Statement 1
Are Open Market Operations conducted by the Reserve Bank of India considered part of sterilization?
Origin: Direct from books Fairness: Straightforward Book-answerable
From standard books
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > The following are the major instruments/tools that RBI uses for conducting its monetary policy: > p. 64
Presence: 5/5
“To ease the threat of currency appreciation or inflation, central banks often attempt what is known as the "sterilization" of capital flows. In a successful sterilization operation, the domestic component of the monetary base/ money supply is reduced to offset the inflow of capital, at least temporarily. In theory, this can be achieved by encouraging private investment overseas, or allowing foreigners to borrow from the local market. But the classical form of sterilization, however, has been through the use of open market operations, that is, selling Treasury bills and other securities by RBI to reduce the domestic component of the monetary base/ money supply. [Reverse repos and outright Open market operation sales demanded the availability of adequate stock of Govt. securities with the RBI, which became a constraining factor in sterilisation operations as the volume of capital inflows expanded.”
Why this source?
  • Defines sterilization as reducing the domestic monetary base to offset capital inflows and names open market operations as the classical form.
  • Specifically cites RBI selling Treasury bills and other securities as the sterilization action.
Indian Economy, Vivek Singh (7th ed. 2023-24) > Chapter 2: Money and Banking- Part I > The following are the major instruments/tools that RBI uses for conducting its monetary policy: > p. 63
Presence: 4/5
“Open Market Operations (OMO): Sale or purchase of government securities by RBI in the open market (secondary market) to banks/financial institutions for absorption and injection of durable liquidity in the economy is called open market operations. If the inflation in the economy is high then, to control the inflation RBI reduces the money supply by selling government securities. And if RBI wants to increase the money supply then it buys government securities from the banks/financial institutions and pays them money in exchange of government securities which ultimately increases the money supply in the economy. There are two types of Open Market Operations (OMOs). • Outright OMOs: They are permanent in nature.”
Why this source?
  • Defines Open Market Operations as RBI buying/selling government securities to absorb or inject durable liquidity.
  • Explains that selling government securities reduces the money supply, the mechanism used in sterilization.
Indian Economy, Nitin Singhania .(ed 2nd 2021-22) > Chapter 7: Money and Banking > 3. Open Market Operations > p. 167
Presence: 4/5
“Open Market Operations (OMOs) refer to the buying and selling of G-Secs in the open market (i.e. in the public) by the RBI. The RBI, by selling G-Secs, reduces the money supply by withdrawing cash balances from within the economic controls, thereby controlling inflation.”
Why this source?
  • States that RBI selling G‑Sec reduces money supply by withdrawing cash balances from the economy.
  • Provides the operational effect (withdrawal of liquidity) that sterilization aims to achieve.
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Statement analysis

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