Previous Year Question
Which of the following measures would result in an increase in the money supply in the economy?
Purchase of government securities from the public by the Central Bank
Deposit of currency in commercial banks by the public
Borrowing by the government from the Central Bank
Sale of government securities to the public by the Central Bank
Select the correct answer using the codes given below:
Only 1
2 and 4
1 and 3
2, 3 and 4
Correct Answer: C
Detailed Solution
An increase in money supply involves an expansion of currency held by the public, deposits and the monetary reserves available within the banking system.
Statement 1 is correct. When the central bank purchases government securities from the public or banks, it makes payment for those securities. The payment enters bank accounts or reaches the public as currency, increasing liquidity and the monetary base.
This is an open-market purchase:
Purchase of government securities → central-bank payment → increase in bank reserves/currency with the public → increase in money supply
Statement 2 is incorrect. When the public deposits currency in commercial banks, the composition of money changes:
Currency held by the public decreases.
Demand deposits with banks increase.
At the initial stage, money is converted from cash held by the public into a bank deposit; the act itself does not automatically increase the total money supply. Banks may subsequently use the deposit base for credit creation, but that is a separate and subsequent process. The statement mentions only the deposit of currency.
Statement 3 is correct. When the government borrows directly from the central bank, the central bank may create or credit new money to the government’s account. Once the government spends this amount, it enters the hands of the public and the commercial banking system, increasing reserve money and potentially the broader money supply.
This can also be understood as a form of monetisation of government borrowing or the fiscal deficit.
Statement 4 is incorrect. When the central bank sells government securities to the public, purchasers use currency or bank deposits to pay for them. The payment moves from the banking system to the central bank, reducing available liquidity.
Sale of government securities → receipt of payment from the public → liquidity absorption → contractionary effect on money supply