As per the following news published in The Economic Times on 26th December, 2021: ‘Reserve Bank of India…………….

Question 5:As per the following news published in The Economic Times on 26th December, 2021: ‘Reserve Bank of India has sold government securities worth ₹ 8,710 crore in the secondary market, over the last four weeks, to drain out excessive liquidity’. Identify the likely cause and the consequences behind, this type of action plan of the Reserve Bank.

The correct answer is – The Reserve Bank of India’s action of selling government securities in the secondary market to drain out excessive liquidity is likely due to an increase in the money supply in the economy. The excess liquidity may have been caused by various factors, such as an increase in government spending or a decrease in demand for credit by businesses and households.

When there is excess liquidity in the system, it can lead to inflationary pressures as too much money chases too few goods and services, leading to an increase in prices. By selling government securities, the Reserve Bank of India reduces the amount of money available in the economy, which can help to keep inflation in check.

The consequences of this action plan can be twofold. On the one hand, it can help to curb inflationary pressures by reducing the money supply. On the other hand, it can also lead to an increase in interest rates, as the reduced money supply can increase the demand for credit, leading to higher interest rates. This, in turn, can have a dampening effect on economic growth and investment.

Moreover, the action of the Reserve Bank of India can also affect the prices of government securities in the secondary market. The increase in supply of government securities due to selling by the Reserve Bank can lead to a decrease in their prices, which can impact the returns of investors holding those securities. Additionally, this action may also affect the foreign exchange rates and the balance of payments of the country, as it impacts the demand and supply of rupees in the foreign exchange market.