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.] [6]

PLEASE INCLUDE DIAGRAM

Answer 1

(a) Interest rate can be increased using contractionary monetary policy only, by lowering money supply (by Open market sale of government securities and/or by raising required reserves ratio and/or by raising discount rate). When money supply falls, the money supply curve shifts toward left, intersecting money demand curve (which is assumed unchanged) at higher interest rate and lower quantity of money. In following graph, MD0 & MS0 are initial money demand & money supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. When money supply is lowered, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rte r1 and lower quantity of money M1.