UPSC CSE Prelims 2023

Correct Option

The correct option is (a) Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-I.

Explanation

The question addresses the relationship between Monetary Policy actions (specifically interest rate adjustments) and the primary objective of Central Banks, which is maintaining price stability (controlling inflation).

Statement-wise Analysis

• Statement-I is Correct: In the post-pandemic period, global economies faced high inflation due to supply chain disruptions, pent-up demand, and geopolitical tensions. To combat this, major Central Banks worldwide (including the US Federal Reserve, the European Central Bank, and the Reserve Bank of India) aggressively raised key interest rates (contractionary monetary policy) to reduce liquidity and curb demand.
• Statement-II is Correct: Central Banks operate on the fundamental economic premise that they can influence the price level in an economy through monetary policy tools. By adjusting policy rates, they influence the cost of borrowing, aggregate demand, and money supply, thereby counteracting rising consumer prices.

Reasoning for the Relationship

Statement-II provides the theoretical justification for the action described in Statement-I. Central Banks carried out interest rate hikes (Statement-I) precisely because they assume that such monetary policy measures are effective in controlling rising consumer prices (Statement-II). Thus, Statement-II explains Statement-I.

Key Takeaway: Central Banks utilize contractionary monetary policy (raising interest rates) to control inflation, based on the principle that higher borrowing costs reduce aggregate demand and cool down price pressures.