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).

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]

Answer 1

The central bank should sell bonds in an open market operation because when central bank sell bonds in open market then the supply of money decrease as a result interest rate will increase. When centre bank sell bonds, the bank pays the central bank to buy bonds by it's deposit account or in simple words banks deposit account will fall and so the excess reserves also fall which decrease money supply and will increase the interest rate.

We have RR=20

Money multiplier=1/RR

MM= 1/0.20=5

So MM=5

Central bank wants to decrease the money supply by 200 billion.

Then size of open market operation should be =200/5=40 billion.

Thus, the size of open market operation should be 40 billion IN to decrease the money supply by 200 billion INR.