Context: Maintaining 4 percent inflation is appropriate for India as targeting a lower rate could impart deflationary bias to the monetary policy, said a Reserve Bank paper.
Key Points

• Under the current dispensation, the RBI has been mandated by the government to maintain retail inflation at 4 percent with a margin of 2 per cent on either side.
• There is a steady decline in trend inflation to 4.1-4.3 per cent since 2014.
• A target set too below the trend imparts a deflationary bias to monetary policy.
• A target that is fixed above-trend renders monetary policy too expansionary and prone to inflationary shocks and unanchored expectations.
• Hence, maintaining the inflation target at 4 per cent is appropriate for India.

Monetary Policy

• Monetary policy is the macroeconomic policy laid down by the Reserve Bank of India.
• It involves the management of money supply and interest rates. The central bank tweaks interest rates to achieve macroeconomic objectives such as liquidity, consumption and inflation.
• Legal framework: The Reserve Bank of India (RBI) is vested with the responsibility of conducting monetary policy, explicitly mandated under the Reserve Bank of India Act, 1934.

Inflation Targeting by RBI

• The primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.
• In May 2016, the Reserve Bank of India (RBI) Act, 1934 was amended to provide a statutory basis for the implementation of the flexible inflation targeting framework.
• The amended RBI Act also provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.
• Accordingly, the Central Government has notified 4 percent (+/- 2%) Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021.

Monetary Policy Process

• The amended RBI Act, 1934 also provides for an empowered six-member monetary policy committee (MPC) to be constituted by the Central Government. 

Accordingly, the Central Government in September 2016 constituted the MPC as under

• Governor of the Reserve Bank of India - Chairperson, ex officio;
• Deputy Governor of the Reserve Bank of India, in charge of Monetary Policy - Member, ex officio;
• One officer of the Reserve Bank of India to be nominated by the Central Board - Member, ex officio;
• Three members to be nominated by the Central government. The members will hold office for a period of four years or until further orders, whichever is earlier.
• The MPC determines the policy interest rate required to achieve the inflation target.