The Reserve Bank of India raises the bank rate. Which chain of effect…

The correct answer is Option (4) → Loans taken by commercial banks become dearer → money supply falls → credit is less easily available and investment falls → equilibrium income falls by more than the fall in investment

A higher bank rate makes loans to commercial banks dearer, so their reserves fall and money supply falls. With credit less easily available, investment falls. A fall in autonomous spending lowers income by a larger amount through the multiplier.

Option (1) Loans taken by commercial banks become dearer → money supply rises → investment rises → equilibrium income rises by more than the rise in investment — Incorrect. Dearer loans to banks reduce money supply.

Option (2) Loans taken by commercial banks become dearer → money supply falls → credit is less easily available and investment falls → equilibrium income falls by exactly the fall in investment — Incorrect. Income falls by more than the fall in investment, because of the multiplier.

Option (3) Loans taken by commercial banks become cheaper → money supply rises → investment rises → equilibrium income rises by more than the rise in investment — Incorrect. A higher bank rate makes loans dearer, not cheaper.

Option (4) Loans taken by commercial banks become dearer → money supply falls → credit is less easily available and investment falls → equilibrium income falls by more than the fall in investment — Correct. Each link of the chain is right, ending in a multiplied fall in income.

This question uses Money and Banking and Determination of Income and Employment together.