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 answer
Explanation
The correct answer is B, 2 and 3 only. Buying securities puts money into the economy and raising the cash reserve ratio takes it out, but raising the bank rate reduces money supply instead of increasing it.
The bank rate is the rate at which the central bank lends to commercial banks for the long term. When it rises, borrowing becomes costlier, banks raise their own lending rates and credit shrinks, so money supply falls. In open market operations the central bank buys or sells government securities; when it buys them from the public it pays out money, so bank deposits and money supply rise. The cash reserve ratio is the share of deposits a bank must keep with the central bank; raising it leaves banks less to lend.
A is wrong because statement 3 is also correct. C and D are wrong because they include statement 1, which reverses the effect of the bank rate.
Exam tip: to fight inflation the central bank raises rates and CRR and sells securities; to expand money it does the reverse.
Practice Questions
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