Explain how the Reserve Bank of India (RBI) uses open market operations to control the money supply in the economy.
Answer
The RBI buys government securities to inject money, increasing the money supply; it sells securities to withdraw money, decreasing the money supply.
Step-by-step solution
- State that open market operations (OMO) involve the buying and selling of government securities by the RBI.
- Explain that when the RBI purchases securities, it pays the sellers, which adds cash to their bank balances.
- The added cash raises banks’ reserves, enabling them to lend more, thereby expanding the money supply.
- Conversely, when the RBI sells securities, buyers pay cash to the RBI, reducing banks’ reserves.
- Lower reserves limit banks’ ability to lend, so the money supply contracts.
- Summarise that by adjusting the volume of securities bought or sold, the RBI can fine‑tune the overall money supply.
Common mistake: Confusing OMO with changes in the repo rate
Concept tested: Open market operations
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Related questions
- 1 Total reserves of commercial banks are Rs. 2,00,000. The required reserve ratio is 10%. The RBI conducts an open‑market sale of government securities worth Rs. 20,000 to these banks. Assuming banks lend out all excess reserves, calculate the net change in the money supply after the multiplier effect.
- 2 If the required reserve ratio set by the RBI is 4%, what is the maximum increase in the money supply that can result from an injection of Rs. 10,000 by the commercial banks?
- 3 Explain two ways in which commercial banks create credit in the economy. For each way, give a brief example illustrating the process.
- 4 Define 'liquidity' as it relates to money and illustrate the definition with one practical example.
- 5 Which of the following is NOT a function of money?
- 6 Which of the following activities is part of the tertiary (service) sector of the Indian economy?