Question

If the Bank of Canada wishes to decrease the money supply, it could:

Select one:

a. increase the reserve requirement.

b. decrease the target for overnight rate.

c. sell a bond.

d. All of these would decrease the money supply.

The correct answer is c. But could you explain why a is wrong?

Answer 1

If you have to select multiple answers, both options (a) and (c) are correct. Increase in required reserve ratio and open market sale of government securities (bonds) will each decrease the money supply.

But if you have to select only 1 answer, then choose option (c). The reason is, even though required reserve ratio and discount rate are monetary policy tools, and the Central Bank can execute a contractionary monetary policy by increasing both these ratios, the primary monetary policy tool in Canada (and US) is open market operations. Central Bank almost always buys or sells bonds to increase or decrease money supply. In contrast, changes in reserve requirement or discount rate are made much less frequently, and these values remain unchanged for a long period of time. Therefore, option (c) is the preferred option over option (a). But option (a) is not incorrect.