UPSC Prelims 2023 Q22: Central Bank Rate Hikes and Inflation Explained
Consider the following statements:
Statement-I:
In the post-pandemic recent past, many Central Banks worldwide had carried out interest rate hikes.
Statement-II:
Central Banks generally assume that they have the ability to counteract the rising consumer prices via monetary policy means.
Which one of the following is correct in respect of the above statements?
- Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-I
- Both Statement-I and Statement-II are correct and Statement-II is not the correct explanation for Statement-I
- Statement-I is correct but Statement-II is incorrect
- Statement-I is incorrect but Statement-II is correct
Answer: (a) Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-I
Statement-wise explanation
- Statement-I: correct — Inflation rose sharply in 2021–22 as economies reopened, supply chains stayed jammed and the Russia–Ukraine war pushed up energy and food prices. The IMF's October 2022 World Economic Outlook described a 'rapid and synchronized tightening of monetary conditions' across the world. The US Federal Reserve began raising rates in March 2022. The RBI raised its repo rate by 250 basis points, from 4.00% in May 2022 to 6.50% on 8 February 2023.
- Statement-II: correct — Central banks believe that raising the policy rate makes credit dearer, slows borrowing and spending, and keeps inflation expectations anchored, and that this cools consumer prices. India's flexible inflation targeting rests on the same belief: the RBI must hold CPI inflation at 4% within a band of 2–6%, and the repo rate is its main tool. This belief is the reason central banks raised rates when prices rose. So Statement-II correctly explains Statement-I.
How to eliminate
Statement-I is a widely reported current-affairs fact. Anyone who followed the news in 2022 knew that the Fed, the ECB, the Bank of England and the RBI were all raising rates, so the option saying Statement-I is incorrect drops out. Statement-II is basic monetary theory: raising rates to fight inflation only makes sense if the central bank thinks monetary policy can lower prices. The word 'generally' softens the claim, so it is hard to call false. That rules out the option saying Statement-II is incorrect. To choose between the last two options, ask 'Why did central banks hike?' The answer is 'to counter rising prices', which is what Statement-II says, so it explains Statement-I. Statement-II does not need to be literally true for every inflation episode. It only has to describe what central banks assume, and that is why it holds.
Know more
How monetary policy fights inflation
When prices rise faster than the target, a central bank raises its policy rate (the repo rate in India). The effect travels through several channels:
- Interest-rate channel: bank lending and deposit rates rise, so people borrow and spend less and save more.
- Expectations channel: a credible hike tells people and firms that inflation will be controlled, so they ask for smaller wage and price increases.
- Exchange-rate channel: higher rates attract foreign capital and support the currency, which makes imports cheaper.
- Credit and asset-price channel: credit grows more slowly and asset prices cool.
| Expansionary | Contractionary | |
|---|---|---|
| Used when | Growth is weak and inflation low | Inflation is above target |
| Policy rate | Cut | Raised |
| Liquidity | Injected | Absorbed |
| Example | RBI cut the repo rate to 4% in 2020 (pandemic) | RBI raised it from 4% to 6.5% (May 2022–Feb 2023) |
India's framework. Under the amended RBI Act, 1934, a six-member Monetary Policy Committee sets the repo rate to keep CPI inflation at 4% ± 2%. The RBI is held to have failed if inflation stays outside the 2–6% band for three consecutive quarters.
The limit. Monetary policy works mainly on demand. In 2021–22, much of the inflation came from supply shocks: oil, food, fertiliser and shipping costs (cost-push inflation). Rate hikes cannot add supply. They can only stop those shocks from spreading into wages and expectations. Because of this, economists argue about the cost of disinflation, meaning lost output and jobs. That is why UPSC uses the word 'assume' in Statement-II.
Transmission lag. A rate change can take several quarters to reach lending rates, and longer to reach inflation. Loans linked to an external benchmark (EBLR) pass changes on faster.
In the news
In 2022–23 the world saw its most synchronised round of interest rate hikes in decades. The US Fed, the ECB, the Bank of England and the RBI all tightened after inflation surged following the pandemic and the Russia–Ukraine war. The Economic Survey 2022-23 (January 2023) highlighted these 'synchronised policy rate hikes' led by the Fed, and the RBI's last hike of that cycle came in February 2023, just before the exam.
NCERT Concepts to Revise
- Contractionary monetary policy: The post-pandemic interest rate hikes in Statement-I are a textbook case of contractionary monetary policy.
- Repo rate: The repo rate is the policy rate the RBI raised during the 2022–23 tightening cycle.
- Monetary policy: Statement-II is about whether monetary policy means can counteract rising consumer prices.
- Inflation targeting: Inflation targeting is the framework that makes central banks respond to rising consumer prices with rate changes.
- Monetary policy transmission: Transmission explains how a policy rate hike is expected to reach consumer prices.
- Cost-push inflation: Much post-pandemic inflation was cost-push, which tests how far monetary policy alone can control prices.