Question

Suppose the Indian central bank (RBI) increases its target overnight interest rate. In doing so it is clearly trying to increase interest rates in the money market (and throughout the economy).

(a) Explain why the central bank must be willing to decrease the money supply to support higher rates in the money market. [Hint: Include a diagram of the money market in your answer

(b) The central bank can change the money supply through an open market operation. In this case, should it buy bonds from, or sell bonds to, the banking system? Briefly describe how this changes the amount of deposit money in the system. If the necessary change in the money supply is 200B INR (Indian rupee) and the banking system has a desired (or required) reserve ratio of 20%, what should be the size of the open market operation?

(c) Suppose we could treat the Indian economy as a closed one. What effect will the results of the policy have on investment, on aggregate expenditure? Include diagrams in your answer.

(d) Although not as open to capital flows as Canada, we can think of India is an open economy. What additional effect will the policy have on aggregate expenditure?

(e) How will aggregate demand be affected, whether we treat the economy as closed or open?

Answer 1

a) Central bank decreases the money supply in the economy to control inflation in the economy by supporting or increasing the interest rates in the money market.If the interest rates are increased the commercial banks will borrow less or no money from the central bank and in turn will have lesser money to lend out to the customers and personal spending will decrease, thus the inflation in the economy decreases.

b)Open market operations is one of the monetary policy tools that the Central bank adopts for controlling the money supply in the economy.When the money supply is more in the economy , central bank sell bonds to the banking system to suck the liquidity from the banking system and as mentioned above banks will have lesser liquidity to lend to customers . This will give lesser purchasing power in the hands of the customer and decrease inflation in the economy