Sterilisation in the context of monetary policy refers to the activity of the RBI of taking away the excess money supply created due to its foreign exchange market intervention. Here, excess money supply has been occurred when the RBI bought dollars (foreign exchange/currency) from the foreign exchange market while giving rupee.
Why sterilisation?
When high volume of foreign currency occurs in the foreign exchange markets especially due to capital inflows (like foreign investment inflows), the rupee may appreciate. Too much appreciation will discourage exports and encourages imports. To check this situation, RBI buys foreign currencies from the foreign exchange market. In exchange, the RBI has to give rupee. Here, when big volume of currencies is bought, too much of the (newly printed) rupee will have to be given by the RBI, thereby raising money supply. Withdrawing this excess money supply is necessary to stop inflation. This process of excess money supply withdrawal is called sterilisation. For sterilisation, the RBI usually adopts Market Stabilisation Scheme (MSS).
