Consider the following statements regarding instruments of Monetary Policy: 1. The Central Bank can increase the money supply by increasing the bank rate 2. The Central Bank can increase the money supply by purchasing securities from the public 3. The Central Bank can decrease the money supply by increasing the cash reserve ratio Which of the statements given above is/are correct?
- (a)2 only
- (b)2 and 3 only
- (c)1 and 3 only
- (d)1, 2 and 3
Correct — B, 2 and 3 only. Statement 2 describes an open market purchase. When the central bank buys government securities from the public it pays for them with newly created reserves, so currency and bank deposits in the hands of the public rise and the money supply expands. Statement 3 describes the cash reserve ratio working in the other direction: raising the ratio forces banks to park a larger fraction of their deposits with the central bank, cutting what they can lend and shrinking the deposit creation that follows, so the money supply contracts. Statement 1 has the sign the wrong way round. The bank rate is the rate at which the central bank lends to banks, and raising it makes that borrowing dearer, which tightens rather than loosens the supply of money.
- (a)2 only — It accepts the open market purchase and rejects the cash reserve ratio statement, which is correct as printed — a higher ratio does reduce the money supply.
- (c)1 and 3 only — It keeps the one false statement. Raising the bank rate is a contractionary act; a cut in the bank rate would be the expansionary one.
- (d)1, 2 and 3 — It takes all three and so carries the bank rate error, which is the only thing separating this item from its answer.
Monetary policy instruments split into quantitative and qualitative tools. The quantitative ones are the policy rate corridor, in which the repo rate is now the operative rate and the bank rate is aligned with the marginal standing facility rate, the reserve requirements — the cash reserve ratio and the statutory liquidity ratio — and open market operations, in which the central bank buys or sells government securities outright. The money supply responds through the money multiplier, which is larger when the reserve ratio and the public's currency preference are smaller.
Two questions settle almost any item of this kind. Does the instrument add reserves to the banking system or take them out, and does raising it tighten or loosen? Buying securities adds reserves, so it expands. Raising a reserve requirement removes usable reserves, so it contracts. Raising a lending rate makes borrowing from the central bank dearer, so it contracts. Statement 1 fails on the third of these, and once it is struck out only one code remains.
- An open market purchase of securities by the central bank injects reserves and expands the money supply.
- A higher cash reserve ratio reduces lendable resources and contracts the money supply.
- The bank rate is the rate at which the Reserve Bank lends to banks, and it is aligned with the marginal standing facility rate.
- The money multiplier is the reciprocal of the sum of the currency-deposit ratio and the reserve ratio.
- The statutory liquidity ratio requires banks to hold a minimum share of deposits in specified liquid assets.
Ask whether the instrument adds or removes reserves, and the direction follows.
- Reversing the direction of the bank rate, which is the single most common slip in this topic.
- Confusing the cash reserve ratio, held as balances with the central bank, with the statutory liquidity ratio, held in specified assets.
- Assuming a central bank sale of securities expands the money supply because money changes hands.
Three one-line instrument statements, of which one has its direction inverted — the examiner is testing the sign, not the definition.
When the Reserve Bank of India announces an increase of the Cash Reserve Ratio, what does it mean?
- (a) The commercial banks will have less money to lend
- (b) The Reserve Bank of India will have less money to lend
- (c) The Union Government will have less money to lend
- (d) The commercial banks will have more money to lend
Answer(a) The commercial banks will have less money to lend
Statement 3 of this item, asked on its own. A higher cash reserve ratio leaves banks with less to lend, which is the mechanism by which it contracts the money supply.
The money multiplier in an economy increases with which one of the following?
- (a) Increase in the cash reserve ratio
- (b) Increase in the banking habit of the population
- (c) Increase in the statutory liquidity ratio
- (d) Increase in the population of the country
Answer(b) Increase in the banking habit of the population
The arithmetic behind the same instruments. The multiplier falls as the reserve ratio rises, which is why a change in the cash reserve ratio moves the money supply by more than the reserves it locks up.
- practice — not a real PYQ
An open market sale of government securities by the Reserve Bank of India will
- (a)Increase the money supply
- (b)Decrease the money supply
- (c)Leave the money supply unchanged
- (d)Increase the cash reserve ratio
Answer(b) Decrease the money supply — the sale absorbs reserves from the banking system.
- practice — not a real PYQ
The money multiplier in an economy will be larger when
- (a)The cash reserve ratio rises
- (b)The currency-deposit ratio falls
- (c)The statutory liquidity ratio rises
- (d)The population grows
Answer(b) The currency-deposit ratio falls — more money returns to banks as deposits, so more can be re-lent.