Question

A6-10. Suppose the Indian central bank (RBI) increases its target overnight interest rate. In doing so it is clearly trying to increase interest rates in the money market (and throughout the economy).

(b) The central bank can change the money supply through an open market operation. In this case, should it buy bonds from, or sell bonds to, the banking system? Briefly describe how this changes the amount of deposit money in the system. If the necessary change in the money supply is 200B INR (Indian rupee) and the banking system has a desired (or required) reserve ratio of 20%, what should be the size of the open market operation? [6]

graph please

Answer 1

Suppose if RBI want to increase the rate of interest, => RBI have to decrease the money supply, since as we know that the interest rate will be determined by the intersection of “demand for money” and the “supply of money”.

Now, through “open market operation” if RBI sale bonds in exchange of money, => the money supply will reduce from the economy. Now, the “∆M=change in money supply” is “∆H/r”, where “H” be the monetary base and “r be the reserve ratio. So, if “∆M=(-200)”, => “∆H” = (-200)*r = (-200)*0.2 =(-40B).

=> So, here RBI have to reduce the “H” by “40B”, leads to reduction in “M” by “200B”.

So, consider the following fig. below.

Here, initially “r1” be the rate of interest and “MS1” be the money supply, => as the RBI reduce the “H” through “open market operation” leads to decrease in “MS” to “MS2”, => the rate of interest also increases to “r2” which is the targeted level of “r”, so here the size of open market operation is "40B".

Here the reserve rate is "20%", => initially the change in money supply was "-40B". Now, as the "H" increases, => in the 2nd round the decrease in the "MS" is "-40B*(1-20%)" and in the 3rd round the reduction is "40B*(1-20%)^2" and the process will continue untill the entire effect of "H" die. So, if we sum up we get the total money supply reduction is "-200B".