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Difficulty: MediumCentral Banking Functions and Monetary Policy Tools

When an economy experiences persistent demand-pull inflation driven by excess liquidity, which open market operation (OMO) measure should the central bank implement to contract the money supply?

  1. Sell treasury bills and government securities to commercial banks and the publicAnswer
  2. B
    Purchase government bonds from financial institutions to boost commercial bank reserves
  3. C
    Lower the statutory cash reserve ratio required for commercial banks
  4. D
    Reduce the bank rate to lower borrowing costs for commercial financial institutions

Answer

Selling treasury bills and government securities to commercial banks and the public
To combat demand-pull inflation, the central bank aims to reduce liquidity in the economy. By selling government securities through open market operations, buyers pay cash to the central bank, directly withdrawing money from commercial bank reserves and public circulation.

Step-by-Step Solution

1
Identify the economic condition and macroeconomic goal
The economy suffers from demand-pull inflation caused by excess money supply, requiring a contractionary monetary policy stance.
Contractionary monetary policy reduces circulating money to decrease aggregate demand and stabilize prices.
2
Analyze the operational mechanism of Open Market Operations (OMO)
The central bank buys or sells government securities in the open financial market.
Selling securities draws money out of commercial bank vaults and buyer deposits into the central bank, whereas buying securities pays out cash to market participants.
3
Select the correct OMO action that reduces money supply
Selling treasury bills absorbs excess liquid funds from banks and the public.
With reduced cash reserves, commercial banks must restrict credit creation, effectively controlling demand-pull inflation.

Key Concept

Contractionary Open Market Operations
Estimated Time:1m 0s
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Topics

Central Banking Functions and Monetary Policy Tools

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