Examkin

Question

Difficulty: HardCentral Banking Functions and Monetary Policy Tools

Suppose an economy is experiencing severe demand-pull inflation caused by excessive liquidity and rapid credit expansion across commercial banks. Which combination of monetary policy actions should the Central Bank implement to effectively contract the money supply and restore macroeconomic stability?

  1. Raise the reserve requirement, increase the bank rate, and sell government securities through open market operations.Answer
  2. B
    Lower the reserve requirement, reduce the bank rate, and purchase government securities through open market operations.
  3. C
    Raise the reserve requirement, lower the bank rate, and purchase government securities through open market operations.
  4. D
    Lower the reserve requirement, increase the bank rate, and purchase government securities through open market operations.

Answer

Raise the reserve requirement, increase the bank rate, and sell government securities through open market operations.
To control high inflation and excess liquidity, the central bank must apply contractionary monetary measures. Raising the reserve requirement reduces loanable funds available to commercial banks; raising the discount/bank rate makes borrowing from the central bank more expensive, causing commercial interest rates to rise; and selling government securities directly mops up liquid reserves from financial institutions and the public.

Step-by-Step Solution

1
Identify the macroeconomic problem
The economy faces demand-pull inflation fueled by excess money supply and over-expansion of credit.
Choosing the appropriate policy requires determining whether contractionary or expansionary policy is needed.
2
Determine the required monetary policy stance
A contractionary (tight) monetary policy is required to drain liquidity.
Reducing money supply reduces aggregate demand and stabilizes general price levels.
3
Select and evaluate monetary policy instruments
Raising the cash reserve ratio locks up bank funds, raising the bank rate increases borrowing costs, and selling treasury bills in Open Market Operations (OMO) absorbs excess public cash reserves.
All three measures work synergistically in the same direction to restrict total credit creation.

Key Concept

Contractionary Monetary Policy Tools
Estimated Time:1m 30s
Rate this question

Topics

Central Banking Functions and Monetary Policy Tools

More questions from this topic