Explain how the Reserve Bank of India can use open market operations to curb rising inflation. Illustrate your answer with a short example involving the sale of government securities worth ₹2 lakh to commercial banks. Discuss the effect on the money supply and the repo rate.
Answer
The sale of government securities by the RBI removes ₹2 lakh from the banking system, thereby reducing the reserves of banks. This contraction in reserves reduces the money multiplier and consequently the money supply. As the supply of money falls, the repo rate is likely to rise, which helps in curbing inflation.
Step-by-step solution
- When the RBI sells government securities to commercial banks, banks pay cash to the RBI.
- The cash paid leaves the banking system, decreasing the reserves that banks hold at the RBI.
- With lower reserves, the banks’ ability to create new loans (credit) is reduced, which contracts the money multiplier.
- Consequently the overall money supply in the economy falls.
- A lower money supply raises the cost of borrowing, reflected in a higher repo rate.
- The higher repo rate dampens spending and investment, helping to bring inflation down.
Common mistake: Assuming the money supply increases or neglecting the change in bank reserves
Concept tested: OMO impact on money supply and interest rates
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