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Difficulty: Very hardCentral Bank: Functions and Monetary Policy Instruments

To curb severe inflationary pressure and mop up excess liquidity from the commercial banking sector strictly through quantitative monetary policy instruments, which set of measures must the Central Bank adopt?

  1. Selling treasury bills in the open market, increasing the cash reserve ratio, and raising the bank rateAnswer
  2. B
    Selling treasury bills in the open market, issuing moral suasion circulars, and imposing margin requirements on commercial loans
  3. C
    Purchasing treasury bills in the open market, lowering the cash reserve ratio, and raising the minimum rediscount rate
  4. D
    Imposing direct credit ceilings on commercial bank lending, reducing special deposits, and lowering the discount rate

Answer

Selling treasury bills in the open market, increasing the cash reserve ratio, and raising the bank rate.
The correct response combines three purely quantitative policy measures applied in a contractionary direction: selling securities in the open market absorbs cash reserves from commercial banks, increasing the cash reserve ratio decreases the proportion of deposits available for lending, and raising the bank rate makes central bank credit more expensive, thereby raising commercial interest rates and contracting the total money supply.

Step-by-Step Solution

1
Identify the economic objective
The target is to reduce money supply (contractionary policy) to combat severe inflation.
Inflation is driven by excess money supply and liquidity in circulation.
2
Filter by instrument classification (Quantitative vs. Selective)
Quantitative instruments affect the overall volume/cost of credit general to the entire banking system (Open Market Operations, Cash Reserve Ratio, Bank/Discount Rate, Liquidity Ratio). Selective instruments target specific sectors or use persuasion (Moral Suasion, Selective Credit Ceilings, Margin Requirements).
The prompt explicitly requires measures strictly restricted to quantitative monetary policy instruments.
3
Determine the required direction of each quantitative instrument
Selling securities (takes cash out of banks), increasing cash reserve ratios (locks up more commercial bank deposits), and raising the bank rate (discourages commercial bank borrowing from the central bank).
All three quantitative actions work together to diminish commercial bank reserves and suppress credit expansion.

Key Concept

Quantitative Monetary Policy Instruments vs. Selective Controls
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Topics

Central Bank: Functions and Monetary Policy Instruments

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