Money, Banking and Monetary Policy: Instruments and Transmission Mechanism Questions

Question 1

Define monetary policy.

Accepted Answer

Monetary policy is the policy of the central bank to regulate money supply, interest rates and credit conditions to achieve macroeconomic objectives.

Question 2

What is CRR?

Accepted Answer

CRR is the Cash Reserve Ratio—the percentage of deposits that banks must keep with the central bank as reserves.

Question 3

What is OMO?

Accepted Answer

OMO (Open Market Operations) is the buying and selling of government securities by the central bank to manage liquidity.

Question 4

What is repo rate?

Accepted Answer

Repo rate is the rate at which the central bank lends short-term funds to commercial banks against securities.

Question 5

State one function of money.

Accepted Answer

One function of money is medium of exchange/unit of account/store of value (any one).

Question 6

What is transmission mechanism?

Accepted Answer

Transmission mechanism is the process through which monetary policy changes affect interest rates, credit, aggregate demand and finally output and prices.

Question 7

Write any three functions of a central bank.

Accepted Answer

Functions of a central bank include:

1) Issue of currency and management of money supply.
2) Banker to government and banks; lender of last resort.
3) Regulation of credit and supervision for financial stability.

(Any three functions can be written.)

Question 8

List any three instruments of monetary policy.

Accepted Answer

Instruments of monetary policy include:

1) Open Market Operations (OMO).
2) Policy rate (repo/bank rate).
3) Cash Reserve Ratio (CRR) / Statutory Liquidity Ratio (SLR).

(Any three instruments can be written.)

Question 9

Differentiate between expansionary and contractionary monetary policy (any three points).

Accepted Answer

Difference:

| Point | Expansionary policy | Contractionary policy |
|---|---|---|
| Aim | increase output and employment | control inflation |
| Tools | lower rates, reduce CRR, buy securities | raise rates, increase CRR, sell securities |
| Credit | increases | decreases |

(Any three points can be written.)

Question 10

Explain how OMO affects money supply (any three points).

Accepted Answer

OMO affects money supply as follows:

1) When central bank buys securities, it injects money into the banking system (liquidity increases).
2) More liquidity allows banks to lend more, expanding credit and money supply.
3) When central bank sells securities, it absorbs money, reducing bank reserves and credit creation.

(Any three points can be written.)

Question 11

Write any three objectives of monetary policy.

Accepted Answer

Objectives of monetary policy include:

1) Price stability (control inflation).
2) Economic growth and employment support.
3) Financial stability and smooth functioning of payments/credit.

(Any three objectives can be written.)

Question 12

Mention any three limitations of monetary policy.

Accepted Answer

Limitations of monetary policy include:

1) Time lags and weak transmission to lending rates.
2) Ineffectiveness during low demand/liquidity trap situations.
3) Supply-side inflation cannot be controlled easily by monetary tools alone.

(Any three limitations can be written.)

Question 13

Explain monetary policy and its instruments with a suitable table.

Accepted Answer

Monetary policy refers to the actions taken by the central bank to regulate money supply, interest rates and credit conditions in order to achieve macroeconomic goals such as price stability, growth, employment and financial stability.

The central bank uses various instruments to influence liquidity and the cost of credit:

| Instrument | Meaning/Action | Expected effect |
|---|---|---|
| OMO | buy/sell government securities | changes liquidity and interest rates |
| Policy rate (Repo) | changes borrowing cost for banks | affects lending rates and demand |
| CRR | changes reserve requirement | higher CRR reduces lending |
| SLR | changes liquidity holding in banks | affects credit availability |
| Selective credit controls | sector-wise credit restrictions | controls speculative/priority credit |

For example, to control inflation the central bank may raise policy rate or CRR to reduce credit and spending. To support growth, it may lower rates and inject liquidity.

Thus, monetary policy tools influence the economy by affecting interest rates, bank credit and aggregate demand.

Question 14

Describe the monetary policy transmission mechanism with a flowchart and explanation.

Accepted Answer

The transmission mechanism is the chain through which a central bank’s policy actions influence the real economy (output and employment) and the price level.

When the central bank changes policy rate or liquidity, banks adjust their deposit and lending rates, which changes borrowing costs and credit availability. This affects consumption and investment spending, causing aggregate demand to change, and finally affecting output, employment and inflation.

```mermaid
flowchart LR
  A[Policy action
(repo/OMO/CRR)] --> B[Bank rates & liquidity change]
  B --> C[Credit availability changes]
  C --> D[Consumption & investment change]
  D --> E[Aggregate demand changes]
  E --> F[Output & employment change]
  E --> G[Inflation/price level changes]
```

If policy is tightened (higher rates/CRR), borrowing becomes costlier, demand falls and inflationary pressure reduces, though output may slow. If policy is eased, credit expands and demand rises, supporting growth.

Thus, understanding transmission explains how monetary policy decisions affect the economy step by step.

Question 15

Differentiate monetary policy and fiscal policy with examples and a comparison table.

Accepted Answer

Monetary policy and fiscal policy are two major tools of macroeconomic management. Monetary policy is conducted by the central bank to regulate money supply and interest rates, whereas fiscal policy is conducted by the government through taxation and public expenditure.

| Point | Monetary policy | Fiscal policy |
|---|---|---|
| Authority | central bank | government |
| Main tools | repo rate, OMO, CRR, SLR | taxes, public spending, budget deficit |
| Direct impact | credit conditions and interest rates | aggregate demand via spending and taxes |
| Example | raising repo rate to control inflation | increasing government spending to boost demand |

For example, if inflation rises, the central bank may increase policy rates to reduce borrowing and spending. If unemployment is high, the government may increase public expenditure or reduce taxes to raise demand.

Thus, both policies aim to stabilize the economy, but they work through different instruments and authorities.

Money, Banking and Monetary Policy: Instruments and Transmission Mechanism

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