UPSC Prelims 2012 Q77: Indian Economy – Monetary Policy & Money Supply
Which of the following measures would result in an increase in the money supply in the
economy?
1. Purchase of government securities from the public by the Central Bank
2. Deposit of currency in commercial banks by the public
3. Borrowing by the government from the Central Bank
4. Sale of government securities to the public by the Central Bank
Select the correct answer using the codes given below:
- (a) 1 only
- (b) 2 and 4 only
- (c) 1 and 3
- (d) 2, 3 and 4
Answer: (c) 1 and 3
Explanation
What increases the money supply?
| Measure | Effect on money supply | Reason |
|---|---|---|
| 1. Purchase of government securities from the public by the Central Bank | Increases | The Central Bank pays out money to the public |
| 2. Deposit of currency in commercial banks by the public | No direct increase | Money only changes form, from currency to deposits |
| 3. Borrowing by the government from the Central Bank | Increases | New money is created to lend to the government (deficit financing) |
| 4. Sale of government securities to the public by the Central Bank | Decreases | The public pays in money to the Central Bank |
Open market operations:
| Action by the Central Bank | Effect |
|---|---|
| Buys securities | Injects money |
| Sells securities | Absorbs money |
Answer: (c) 1 and 3.
Why each option is right or wrong
- (a) Incorrect. Statement 3 is also true; borrowing by the government from the Central Bank adds money.
- (b) Incorrect. A deposit of currency does not add money, and a sale of securities reduces it.
- (c) CORRECT. Purchase of government securities and government borrowing from the Central Bank add money.
- (d) Incorrect. Sale of government securities by the Central Bank reduces the money supply.
Key point
Money supply rises when the Central Bank buys securities or lends to the government; falls when it sells securities. Depositing currency only changes the form of money.
Remember
Central Bank buys = money up; sells = money down.
Common mistakes
- Mixing up purchase and sale of securities by the Central Bank.
- Counting a deposit of currency as new money.
- Forgetting that deficit financing creates high-powered money.
Exam tip
Follow the cash. If the Central Bank pays out, money rises; if it takes in, money falls.
Sources
- NCERT Class XII — Introductory Macroeconomics, Ch 3 (Money and Banking)
- Reserve Bank of India — Monetary Policy: Open Market Operations