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: The Raghuram Rajan Committee on financial sector reforms has recommended that RBI should focus on inflation, rather than other objectives. This has raised considerable controversy. One counter-argument that is made is: RBI is already focused on inflation, so nothing needs to change. RBI governors and deputy governors are known to make rousing speeches about the importance of fighting inflation. But RBI has behaved in a manner which displays a profound disregard for inflation. All through the past year, India’s central bank has cared foremost about pegging the rupee to the dollar, and did not care about the inflation this could create.

Money supply growth accelerated from 15% to above 20% since the beginning of 2007. With GDP growth below 10%, it is not surprising that inflation accelerated. To put it rather simplistically, if GDP is expected to grow at 10% and inflation of 5%, then if money supply grows by much more than 15%, there will be pressure on prices to rise. It can be higher by a couple of percentage points, as India’s economy is in a monetisation phase, but not by a rate much higher than that.

In thinking about RBI reform, it is interesting to ask: what would the behaviour of RBI have been if it was a central bank that cared about inflation? The growth in money supply has come because of its very high net purchase of dollars to prevent rupee appreciation. If RBI had cared about inflation, it would have been reducing its dollar purchases, and thus keeping down reserve money growth, which grew at 31% last year. This would have had a clear impact on the growth of broad money supply, or M3. A lower growth rate of money supply would have given lower inflation of non-tradeables.