Arrange the following sequence related to the correction of Excess Demand in correct order: (A) Increase in Bank Rate by RBI (B) Problem of excess demand will be corrected (C) Public will borrow less (D) Decreases money supply (E) Loans taken by commercial banks will become costlier/expensive Choose the correct answer from the options given below:
Understanding how monetary policy tools like the Bank Rate are used to manage economic situations such as excess demand is crucial. Excess demand occurs when the aggregate demand in the economy is more than the aggregate supply at full employment level, leading to inflationary pressures.
The central bank, like the Reserve Bank of India (RBI), uses various measures to control excess demand. One such measure involves increasing the Bank Rate. Let's arrange the given sequence of events to see how an increase in the Bank Rate helps in correcting excess demand.
Correcting Excess Demand Using Bank Rate: Step-by-Step Sequence
Let's analyze each statement and determine the cause-and-effect relationship:
- (A) Increase in Bank Rate by RBI: This is the initial action taken by the central bank as part of its monetary policy to curb excess demand.
- (E) Loans taken by commercial banks will become costlier/expensive: The Bank Rate is the rate at which the RBI lends money to commercial banks without any security for long term. When the Bank Rate increases, the cost of borrowing for commercial banks from the RBI goes up. This is a direct consequence of (A).
- (C) Public will borrow less: When commercial banks' cost of borrowing from the RBI increases (E), they are likely to increase their own lending rates to the public (individuals and businesses). Higher interest rates make it more expensive for the public to take out loans, discouraging borrowing. This follows from (E).
- (D) Decreases money supply: Reduced borrowing by the public (C) and potentially reduced lending by commercial banks (due to higher cost of funds) leads to a contraction in the amount of credit available in the economy. This causes a decrease in the overall money supply. This is a consequence of (C) and (E).
- (B) Problem of excess demand will be corrected: A decrease in the money supply (D) and reduced borrowing/spending by the public (C) lowers the aggregate demand in the economy. When aggregate demand falls to match the aggregate supply at full employment, the problem of excess demand is corrected, and inflationary pressures ease. This is the final outcome of the entire sequence.
Putting these statements in a logical flow, the sequence of events starting with the RBI's action and leading to the correction of excess demand is:
An increase in Bank Rate by RBI (A) $\rightarrow$ Loans taken by commercial banks become costlier (E) $\rightarrow$ Public will borrow less (C) $\rightarrow$ Decreases money supply (D) $\rightarrow$ Problem of excess demand will be corrected (B).
Therefore, the correct sequence is (A), (E), (C), (D), (B).
| Step | Statement | Description |
|---|---|---|
| 1 | (A) Increase in Bank Rate by RBI | Central bank action |
| 2 | (E) Loans taken by commercial banks will become costlier/expensive | Impact on commercial banks' borrowing cost |
| 3 | (C) Public will borrow less | Impact on public borrowing due to higher rates |
| 4 | (D) Decreases money supply | Contraction of credit and money supply |
| 5 | (B) Problem of excess demand will be corrected | Desired economic outcome |
Why This Sequence Corrects Excess Demand
The ultimate goal is to reduce the aggregate demand in the economy. By increasing the Bank Rate, the RBI makes it more expensive for commercial banks to get funds. This cost is passed on to the public through higher lending rates, which discourages borrowing and investment. Less borrowing means less money is available for spending. This reduction in spending across the economy leads to a decrease in aggregate demand, thus helping to control and correct the situation of excess demand and the associated inflation.
Revision Table: Key Monetary Policy Tools
| Tool | Mechanism | Effect (to curb Excess Demand) |
|---|---|---|
| Bank Rate | Rate at which central bank lends to commercial banks without security (long term). Increase makes borrowing costly for banks. | Increases commercial bank lending rates $\rightarrow$ Public borrows less $\rightarrow$ Decreases money supply $\rightarrow$ Reduces aggregate demand. |
| Repo Rate | Rate at which central bank lends to commercial banks against security (short term). Increase makes borrowing costly for banks. | Similar effect to Bank Rate, influencing short-term rates. |
| Reverse Repo Rate | Rate at which central bank borrows from commercial banks. Increase encourages banks to deposit funds with RBI. | Incentivizes banks to park funds with RBI $\rightarrow$ Reduces funds available for lending $\rightarrow$ Decreases money supply $\rightarrow$ Reduces aggregate demand. |
| Open Market Operations (OMO) - Sale of Securities | Central bank sells government securities in the open market. | Banks and public buy securities, giving money to RBI $\rightarrow$ Reduces money supply in the system $\rightarrow$ Reduces aggregate demand. |
| Cash Reserve Ratio (CRR) | Percentage of net demand and time liabilities that banks must hold with the central bank. Increase means banks have to hold more reserves. | Banks have less money to lend $\rightarrow$ Decreases money supply $\rightarrow$ Reduces aggregate demand. |
| Statutory Liquidity Ratio (SLR) | Percentage of net demand and time liabilities that banks must maintain in liquid assets. Increase means banks have to hold more liquid assets. | Banks have less money to lend $\rightarrow$ Decreases money supply $\rightarrow$ Reduces aggregate demand. |
Additional Information on Excess Demand and Monetary Policy
Excess demand is a state where the desired aggregate expenditure in the economy exceeds the available output at the full employment level. This gap between aggregate demand and aggregate supply is known as the inflationary gap because it typically leads to a rise in the general price level (inflation).
Monetary policy, controlled by the central bank, is a key tool used to manage aggregate demand. It primarily works by influencing the cost and availability of credit in the economy, which in turn affects investment and consumption spending.
Quantitative tools like Bank Rate, Repo Rate, Reverse Repo Rate, CRR, SLR, and OMOs affect the overall volume of credit. Qualitative tools like margin requirements, moral suasion, and selective credit controls target specific sectors or types of credit.
By increasing the Bank Rate, the central bank makes borrowing more expensive, reducing the capacity and incentive for banks to lend and for the public to borrow. This directly tackles the 'excess' part of demand by reducing the flow of money and credit in the economy, helping to restore macroeconomic stability and control inflation.
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