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.
Which of the following is the quantitative tool of money supply used by Central Bank?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → Cash Reserve Ratio.
The central bank can change the total amount of money the banks are able to lend, or it can only persuade them to lend more or less. Tools of the first kind control the extent of money supply and are called quantitative tools; the passage names them as the CRR, the bank rate and open market operations.
The cash reserve ratio is the fraction of their deposits that commercial banks must keep as reserves with the central bank; raising it leaves the banks less to lend and so reduces the money supply.
Why the other options are incorrect
Option (1) Moral Suasion. — Incorrect. Moral suasion is persuasion by the central bank to make banks lend more or less. It is a qualitative tool, as the passage says.
Option (2) Margin Requirement. — Incorrect. The passage names margin requirement among the qualitative tools, which work on the direction of lending rather than on the total money supply.
Option (4) Letter of Credit. — Incorrect. A letter of credit is a bank’s guarantee of payment used in trade, issued for a buyer to the seller; it is not a tool of the central bank at all.
Note: This passage is taken from the Money and Banking chapter of the NCERT book, from the part on the policy tools of the central bank, with a few sentences left out. Read that section in full: the tools, and what each does to the money supply, are all there.