The primary objective of the Central Bank is to control inflation.
Inflation refers to a sustained rise in the prices of goods & services. It results in a decline in the purchasing power of the people over a period of time.
The Consumer Price Index (CPI) and The Wholesale Price Index (WPI) are the accepted instruments in India for tracking inflation. It measures the average price change in a number of commodities and services. For instance, a sudden decrease in the amount of oil supply, leading to increased oil prices, can cause cost-push inflation. Inflation can occur when-
1) The cost of goods increases because of an increase in the cost of raw materials needed to manufacture such commodities.
2) There is an increased demand in the market for some goods and services. Consumers then become willing to pay even more for these products.
Inflation can be viewed in both positive and negative light. It is viewed as positive when it helps to boost consumer demand and consumption. This influences economic growth by encouraging producers to produce more to meet the increased demand. On the other hand, extremely high inflation can signal an overheated economy. It lowers the purchasing power of people drastically. It increases the cost of borrowing and reduces employment. Inflation also encourages spending. The urge to spend and invest more at the time of inflation tends to boost it even further, which creates a potentially disastrous feedback loop. It discourages saving and reduces economic growth by increasing the cost of living. This means that even as we save and invest, our accumulated wealth buys less and less with the mere passage of time.
Thus, inflation reduces the purchasing power and eats away the real returns on savings and investments.
Central banks use inflation targeting in order to keep economic growth steady and prices stable. The Reserve Bank of India has set a target inflation band of 4% +/- a band of 2%. By raising interest rates or restricting the flow of money supply in the country the RBI aims to keep the inflation in check. A lower interest rate tends to result in more inflation. When the interest rates are low, individuals and businesses tend to borrow more money from the commercial banks. This leads to a smooth flow of money in the economy. The purchasing power of people increases and thus their demand for various goods and services increases. This leads to heightened demand for goods and, in turn, causes inflation. Conversely, an increased interest rate makes people borrow less. Their purchasing power reduces, and so does the demand for commodities. This helps to keep inflation in check.