An economy has one bank, and the public holds no currency. The bank has reserves of Rs 100 and the Cash Reserve Ratio is 25 per cent, so deposits are Rs 400. The RBI now sells government bonds in the open market, which reduces bank reserves by Rs 20, and at the same time cuts the CRR to 20 per cent. What happens to money supply once the bank adjusts?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → It stays at Rs 400.
Given:
Reserves: Rs 100 → Rs 80 (open market sale)
CRR: 25 per cent → 20 per cent
With no currency held by the public, money supply = deposits = reserves × 1/CRR. Here one step cuts reserves and the other raises the multiplier.
\( \displaystyle \text{Before: } 100 \times \frac{1}{0.25} = 400 \)
\( \displaystyle \text{After: } 80 \times \frac{1}{0.20} = 80 \times 5 = 400 \)
Money supply stays at Rs 400. Together the two steps cancel out.
Option (1) It falls to Rs 320. — the bond sale alone would do this.
Option (2) It rises to Rs 500. — the CRR cut alone would do this.
NCERT (2026-27): “3.4 Policy Tools to Control Money Supply … It should be evident by now that if the Central bank changes the reserve ratio, this would lead to changes in lending by the banks which, in turn, would impact the deposits and hence, the money supply. …” “… When RBI buys a Government bond in the open market, it pays for it by giving a cheque. This cheque increases the total amount of reserves in the economy and thus increases the money supply. Selling of a bond by RBI (to private individuals or institutions) leads to reduction in quantity of reserves and hence the money supply. …” “… Thus, reserves of Rs 100 create deposits of Rs (5 × 100)=Rs 500.” |