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:
Contents13
- A1 only
- B2 and 4 only
- C1 and 3
- D2, 3 and 4
Show answer
Answer: (C) 1 and 3
Money supply increases when new money enters circulation:
Statement 1 correct — when RBI BUYS government securities from the public, it pays them with new money, injecting liquidity into the economy. This is called Open Market Operations (OMO).
Statement 3 correct — when the government borrows from the Central Bank (deficit financing/monetization of deficit), RBI essentially creates new money to lend to the government.
Statement 2 is WRONG — depositing currency in banks just moves money from 'currency with public' to 'bank deposits'. The total money supply doesn't change; its composition changes.
Statement 4 is WRONG — when RBI SELLS securities, it absorbs money from the public, REDUCING money supply.
Answer: 1 and 3.
Open Market Operations and deficit monetization are the two primary ways central banks inject new money into the economy, directly affecting inflation and liquidity.
The question tests the conceptual difference between money creation (new money enters the system) versus money movement (existing money changes hands or form).
Students must distinguish between RBI buying securities (money supply increases) versus RBI selling securities (money supply decreases) - a common source of confusion in monetary policy questions.
Money Supply: Definition & Components
Indian Economy money supply
Money Supply: Components & UPSC Framework
Money supply = currency with public + bank deposits
Total money supply can increase or decrease based on central bank actions
Moving money between components (cash to deposits) does NOT change total supply
RBI measures money supply through M1, M2, M3 aggregates
Money supply represents the total stock of money available in an economy at any given time. RBI tracks this through monetary aggregates that capture different levels of liquidity.
Monetary Aggregates in India
Aggregate | Components | Key Feature |
|---|---|---|
M1 (Narrow Money) | Currency with public + Demand deposits + Other deposits with RBI | Most liquid money |
M2 | M1 + Savings deposits with Post Office | Includes postal savings |
M3 (Broad Money) | M1 + Time deposits with banks | Most comprehensive measure |
M4 | M3 + All deposits with post office savings | Broadest definition |
Trap: Moving cash to bank deposits changes composition, not total supply
Trap: Only new money creation increases supply, not money movement
Trap: M3 is the most watched aggregate by RBI for policy decisions
Open Market Operations (OMO)
Indian Economy Purchase of government securities Sale of government securities Central Bank
Open Market Operations: RBI's Liquidity Tool
OMO = RBI buying/selling government securities to control money supply
RBI buys securities → increases money supply (injects liquidity)
RBI sells securities → decreases money supply (absorbs liquidity)
Primary tool for liquidity management in Indian monetary policy
Open Market Operations are RBI's primary tool to manage liquidity in the banking system by trading government securities with banks and financial institutions.
How OMO Works
%%{init: {"flowchart": {"wrappingWidth": 460}}}%%
flowchart TD
s1["`**RBI decides liquidity stance**
Based on inflation, growth, and banking system needs`"]
s2["`**OMO auction announced**
For buying (liquidity injection) or selling (liquidity absorption)`"]
s3["`**Banks/Primary Dealers participate**
Submit bids for securities at competitive rates`"]
s4["`**Money supply changes**
Immediate impact on banking system liquidity`"]
s1 --> s2
s2 --> s3
s3 --> s4OMO Impact on Economy
RBI Action | Money Supply | Bank Liquidity | Interest Rates | Economic Impact |
|---|---|---|---|---|
Buys securities | Increases | More liquid | Falls | Stimulates growth |
Sells securities | Decreases | Less liquid | Rises | Controls inflation |
Key trap: Statement 1 says RBI purchases → money supply increases
Key trap: Statement 4 says RBI sells → money supply decreases
Remember: RBI buying = liquidity injection, RBI selling = liquidity absorption
Deficit Financing & Monetization
Indian Economy Borrowing by the government from the Central Bank
Government Borrowing from RBI: Deficit Monetization
Government borrowing from RBI = deficit monetization = new money creation
RBI prints new money to lend to government → increases money supply
Automatic monetization stopped in India since 1997
Now limited to Ways and Means Advances (temporary, limited)
When government borrows from RBI, the central bank essentially creates new money to fund government spending. This directly increases money supply and was a major source of inflation in India's past.
Deficit Financing Methods
Method | Impact on Money Supply | Inflationary Pressure | Current Status in India |
|---|---|---|---|
Borrowing from RBI | Increases directly | High | Restricted since 1997 |
Market borrowing | No direct impact | Low | Primary method now |
Ways & Means Advances | Temporary increase | Limited | Short-term facility only |
Deficit Monetization Process
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flowchart TD
s1["`**Government needs funds**
To meet expenditure beyond tax revenue`"]
s2["`**Approaches RBI for loan**
Instead of borrowing from market`"]
s3["`**RBI creates new money**
Prints currency or creates digital money`"]
s4["`**Money supply increases**
More money chases same goods → inflation risk`"]
s1 --> s2
s2 --> s3
s3 --> s4Why India Stopped Automatic Monetization
The Fiscal Responsibility and Budget Management (FRBM) Act and RBI reforms ended automatic deficit monetization to control inflation. Now government must borrow from markets, making fiscal discipline necessary.
Key trap: Statement 3 = government borrowing from RBI = new money creation
Remember: Market borrowing ≠ RBI borrowing in terms of money supply impact
Confusion: Ways & Means Advances are temporary, not permanent monetization
Currency Deposits & Money Supply
Indian Economy Deposit of currency in commercial banks
Currency Deposits: Composition vs Total Supply
Depositing cash in banks changes composition, not total money supply
Money moves from currency with public to bank deposits
Statement 2 is wrong - no immediate increase in total supply
Banks can create additional money through lending (money multiplier)
When people deposit cash in banks, the total money supply remains unchanged initially. Only its composition shifts between currency and deposits. However, banks can potentially create more money through the lending process.
What Happens When You Deposit ₹1000 Cash
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flowchart TD
s1["`**₹1000 cash with public**
Part of money supply as 'currency with public'`"]
s2["`**Deposit in bank**
Cash moves from public to bank vault`"]
s3["`**₹1000 bank deposit created**
Now part of money supply as 'bank deposits'`"]
s4["`**Total money supply unchanged**
₹1000 currency + ₹0 deposits = ₹0 currency + ₹1000 deposits`"]
s1 --> s2
s2 --> s3
s3 --> s4Money Multiplier Effect (Secondary Impact)
Banks keep only Cash Reserve Ratio (CRR) with RBI and Statutory Liquidity Ratio (SLR) in approved securities. The rest can be lent out, creating new deposits and potentially increasing total money supply through the money multiplier mechanism.
Currency vs Deposits Impact
Action | Immediate Impact | Money Supply Change | Secondary Effect |
|---|---|---|---|
Cash deposited | Composition change | No change | Potential multiplier effect |
RBI buys securities | New money injected | Increases | Direct liquidity injection |
Cash withdrawn | Composition change | No change | Reduces lending capacity |
Major trap: Depositing cash ≠ increasing money supply (Statement 2 wrong)
Confusion: Don't mix immediate effect with money multiplier effect
Remember: Total supply = currency with public + bank deposits stays same initially