Question

A6-10. 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.] [6]

(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? [6]

(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. [4]

Answer 1

1 As shown in fig first interest rises only when money supply is decreased from Ms1 to mso

2 it should sell bonds. This will decrease money supply. People pay for securities through checks on deposits. This reduces deposits and money supply. Money multiplier here is 1/20%=5.so size should be equal to 200/5=40 billion

C investment will fall from s1 to so as shown in fig 2.Aggregate expenditure will fall from c+s1 to c+so