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.
Answer
The money supply will fall by Rs. 2,00,000.
The correct answer is The money supply will fall by Rs. 2,00,000. — State that the money supply decreases by Rs. 2,00,000 as a result of the open‑market operation.
Step-by-step solution
- Calculate the money multiplier as the reciprocal of the required reserve ratio: multiplier = 1 / 0.10 = 10.
- Determine the change in reserves caused by the RBI's sale: banks pay Rs. 20,000, so ΔR = –20,000.
- Apply the multiplier to the change in reserves: ΔM = multiplier × ΔR = 10 × (–20,000) = –2,00,000.
- State that the money supply decreases by Rs. 2,00,000 as a result of the open‑market operation.
Common mistake: Using the total reserve amount instead of the change in reserves, leading to an incorrect magnitude of change.
Concept tested: Money multiplier and open market operation
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Related questions
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- 2 Explain how the Reserve Bank of India (RBI) uses open market operations to control the money supply in the economy.
- 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?
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