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).

(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

PLEASE INCLUDE GRAPH

Answer 1

RBI can change the amount of money floating in the market by modifying the Cash Reserve Ratio and Repo Rate.

Repo Rate is the interest rate charged by RBI on lending the money to commercial banks. If the interest rate charged by RB is high, commercial banks in turn would also charge high interest rate and thus the interest rate in the money market would increase.

b) Cental Bank can change the money supply in the market through open market operation as well. In order to raise the money supply in the economy, central bank should purchase the bonds and thus increasing the money supply.

In order to reduce the money supply, central bank should sell the bonds thus reducing the mony supply.

As the interest rate falls from i1 o i2, the money supply increases from MS1 to MS2.