In a podcast I watched recently, the former RBI governor Raghuram Rajan explained that “when dollar supply rises, the RBI buys those extra dollars.” This made me want to simplify how and why this actually happens.
Table of Contents
Why RBI Buys Dollars When Dollar Supply Increases
Imagine this:
Foreign investors are putting money into India, They bring a lot of dollars so, suddenly dollar supply increases in the Indian market.
If RBI does nothing
Then too many dollars = dollar becomes cheaper.
If dollar falls, rupee becomes stronger than what RBI wants.
But RBI doesn’t want the rupee to suddenly appreciate or depreciate too much because it hurts exporters, importers, and overall economic stability.
So, RBI steps in.
What RBI Does: It Buys the Excess Dollars
- RBI starts buying dollars from the market.
- This increases demand for dollars
- Dollar doesn’t fall too much.
- The rupee doesn’t suddenly appreciate.
Basically:
RBI buys the extra dollars – dollar price stays stable – rupee stays steady.
But Wait, If RBI Buys Dollars, It Pays in Rupees
This increases rupee supply in the economy. So, More rupees in the system = inflation risk.
For that RBI uses another tool:
Sterilization
It is the process by which RBI neutralizes the extra rupees.
To prevent inflation, RBI takes back the extra rupees it just released. It does this by:
- Selling government bonds
- Raising CRR/SLR
- Doing Open Market Operations (OMO)
This pulls rupees out of circulation. So, the system stays balanced.
In short, When dollar inflow is high, RBI buys dollars to stop the rupee from appreciating too much and keeps the exchange rate stable.
