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Difficulty: HardCentral Bank: Functions and Monetary Policy Instruments

To curb rising inflationary pressures without altering the bank rate, a central bank sells government securities to commercial banks in the open market while simultaneously raising the cash reserve ratio. Which of the following correctly classifies these monetary tools and predicts their combined impact on commercial bank reserves and the money supply?

  1. Quantitative instruments; they decrease commercial banks' excess reserves and contract the total money supply.Answer
  2. B
    Selective instruments; they restrict credit allocations to specific economic sectors and reduce overall bank liquidity.
  3. C
    Quantitative instruments; they increase commercial bank liquidity while maintaining constant credit expansion.
  4. D
    Qualitative instruments; they rely on moral suasion to persuade commercial banks to reduce lending voluntary.

Answer

Quantitative instruments; they decrease commercial banks' excess reserves and contract the total money supply.
Open Market Operations (OMO) and the Cash Reserve Ratio (CRR) are quantitative monetary policy instruments because they regulate the overall quantity of money and credit in the financial system. When the central bank sells government securities, commercial banks use their cash balances to pay for them, reducing their excess reserves. Simultaneously, raising the CRR forces banks to sterilize a larger portion of deposit liabilities as required reserves. Together, these actions restrict the credit creation capacity of commercial banks and reduce the total money supply in the economy.

Step-by-Step Solution

1
Classify the monetary policy instruments described in the scenario.
Both Open Market Operations (selling securities) and Cash Reserve Ratio adjustments are quantitative (general) monetary policy tools.
Quantitative tools regulate the overall volume and availability of credit across the entire banking system rather than directing credit to specific sectors.
2
Determine the impact of central bank sales of government securities.
Commercial banks purchase these securities, causing cash to flow from commercial bank reserves to the central bank.
Selling securities drains excess cash liquidity from the commercial banking sector.
3
Determine the impact of raising the Cash Reserve Ratio (CRR).
Commercial banks must hold a higher percentage of their total deposits as legally required cash reserves.
A higher CRR reduces the proportion of deposits available for lending, effectively reducing the deposit multiplier.
4
Synthesize the overall effect on bank reserves and money supply.
Excess reserves drop significantly, leading to a contraction in credit creation and a decrease in the aggregate money supply.
The combination of absorbing liquid reserves and raising mandatory reserve holdings acts as a restrictive monetary stance to curb inflation.

Key Concept

Quantitative Monetary Policy Instruments and Liquidity Contraction
Estimated Time:2m 0s
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Topics

Central Bank: Functions and Monetary Policy Instruments

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