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Question

Difficulty: MediumMonetary Policy Framework, RBI Mechanisms, Banking System, and Financial Markets

When the Reserve Bank of India purchases government securities from commercial banks through Open Market Operations (OMO), what is the immediate impact on banking system liquidity and bond yields?

  1. System liquidity increases and bond yields decreaseAnswer
  2. B
    System liquidity decreases and bond yields increase
  3. C
    System liquidity increases and bond yields increase
  4. D
    System liquidity decreases and bond yields decrease

Answer

System liquidity increases and bond yields decrease
When the Reserve Bank of India buys government securities in the open market, it credits funds to the accounts of commercial banks, thereby augmenting overall banking system liquidity. Furthermore, RBI's buying intervention increases demand for securities, raising their market prices and consequently driving down bond yields.

Step-by-Step Solution

1
Analyze the cash flow from RBI's purchase of government securities
RBI pays cash to commercial banks in exchange for securities, directly increasing loanable funds and banking system liquidity.
Open Market Purchases act as an expansionary monetary policy tool to inject primary liquidity.
2
Determine the impact of RBI's market purchase on bond prices and bond yields
Increased demand for government securities pushes bond prices up, causing bond yields to fall.
Bond prices and market interest yields share a strict inverse relationship.

Key Concept

Open Market Operations (OMO) and Bond Yield Mechanics
Estimated Time:1m 0s
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Topics

Monetary Policy Framework, RBI Mechanisms, Banking System, and Financial Markets