Money
Reserve Bank is the only institution which can issue currency. When commercial banks need more funds in order to be able to create more credit, they may go to market for such funds or go to the Central Bank. Central bank provides them funds through various instruments. This role of RBI, that of being ready to lend to banks at all times is another important function of the central bank, and due to this central bank is said to be the lender of last resort. The RBI controls the money supply in the economy in various ways. The tools used by the Central bank to control money supply can be quantitative or qualitative. Quantitative tools, control the extent of money supply by changing the CRR, or bank rate or open market operations. Qualitative tools include persuasion by the Central bank in order to make commercial banks discourage or encourage lending which is done through moral suasion, margin requirement, etc.
Open Market Operations refers to buying and selling of bonds issued by the government in the open market. This purchase and sale is entrusted to the Central bank on behalf of the government. There is another type of operation in which when the central bank buys the security, this agreement of purchase also has specification about date and price of resale of this security. This type of agreement is called a repurchase agreement. The interest rate at which the money is lent in this way is called the repo rate. Similarly, instead of outright sale of securities the central bank may sell the securities through an agreement which has a specification about the date and price at which it will be repurchased. This type of agreement is called a reverse repurchase agreement.
In open market operation if Central Bank is buying government securities, how this will impact the money supply in the market?
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → Increase.
When the central bank buys a government bond in the open market, it pays the seller, for instance by a cheque drawn on itself. That money reaches the banks and adds to their reserves, so they can lend more and the money supply increases. Such buying and selling of government bonds is an open market operation.
Selling a bond does the reverse: it reduces the reserves, and the money supply falls. The passage describes open market operations but leaves out this step, which comes from the working of the operation.
Why the other options are incorrect
Option (1) Decrease. — Incorrect. The money supply falls when the central bank sells securities, because the buyers’ payments drain reserves from the banks.
Option (2) Remain constant. — Incorrect. A purchase always adds reserves to the banking system, so the money supply cannot stay the same.
Option (3) May increase or decrease. — Incorrect. The direction is fixed by whether the central bank buys or sells; a purchase raises the money supply.
NCERT (2025-26): “3.4 Policy Tools to Control Money Supply … Another important tool by which the RBI also influences money supply is Open Market Operations. Open Market Operations refers to buying and selling of bonds issued by the Government in the open market. This purchase and sale is entrusted to the Central bank on behalf of the Government. 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.…” |