Question

Consider the following steps taken by the Reserve Bank of India with respect to money supply and arrange them in the correct sequence: A. Increase in lending rates by commercial banks
B. Contraction in credit
C. Increase in bank rate by the Reserve Bank of India
D. Increase in cost of borrowings for commercial banks

• A. A, B, C, D
• B. A, C, B, D
• C. C, D, A, B
• D. C, B, D, A

Hint:

When RBI increases bank rate: \[ \text{Bank rate rises} \rightarrow \text{Bank borrowing cost rises} \rightarrow \text{Lending rates rise} \rightarrow \text{Credit contracts} \]

Answer 1

The Correct Option is C

Step 1: Understanding the Concept:
The Bank Rate is a quantitative monetary policy tool used by the Central Bank (RBI) to control the money supply.
When the RBI wants to reduce the money supply (dear money policy), it increases the bank rate, which initiates a chain reaction through the banking system.
Step 2: Detailed Explanation:
The transmission mechanism of the Bank Rate policy follows these steps:
1. C. Increase in bank rate by the Reserve Bank of India: This is the initial policy action where the cost of funds from the central bank increases.
2. D. Increase in cost of borrowings for commercial banks: Since the RBI is the lender of last resort, an increase in the bank rate directly makes it more expensive for commercial banks to obtain funds.
3. A. Increase in lending rates by commercial banks: To maintain their profit spreads, commercial banks increase the interest rates they charge on loans to businesses and households.
4. B. Contraction in credit: Higher interest rates reduce the demand for loans, leading to less credit being created in the economy, thereby reducing the money supply.
The final sequence is C $\rightarrow$ D $\rightarrow$ A $\rightarrow$ B.
Step 3: Final Answer:
By following the logical economic transmission, we arrive at the sequence C, D, A, B.
Therefore, option (C) is correct.