In order to encourage investment in the economy, the Central Bank may ______. (Choose the correct alternative)

Question 12 of 67

Q. In order to encourage investment in the economy, the Central Bank may ___________. (Choose the correct alternative)

(a) Reduce Cash Reserve Ratio

(b) Increase Cash Reserve Ratio

(d) Increase Bank Rate

Sikkim CbseCBSE Class XII Board 2019Subjective· 1mImportance★★★★★

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Concept understanding — Money Supply Measures

Money Supply Measures: From Pocket Money to the Whole Economy

Think about the money you actually use. You have some cash in your wallet, maybe a few coins for the bus. You might have a ₹500 note tucked away. But you also have money in your bank account — the kind you can swipe on a card or transfer through UPI. That's money too, even though you never see it as paper.

Now imagine the entire country. Every person, every shop, every company, every government office — all the money they hold in cash and in their bank accounts. That total is what economists call the money supply. It's not just the currency printed by the RBI. It's the total stock of money available in the economy at a given point in time.

Why does this matter?

The money supply affects everything: how much prices rise (inflation), how easily you can get a loan, how much the government can spend, and even the value of the rupee. The RBI controls the money supply to keep the economy stable. But to control it, you first need to measure it — and that's where the confusion begins.

The problem: Not all money is the same

A ₹100 note in your pocket is clearly money. But what about the ₹10,000 sitting in your savings account? You can't hand that to a shopkeeper as a physical note, but you can withdraw it anytime or pay via UPI. So it's almost as good as cash.

What about a fixed deposit of ₹1 lakh? You can't use it to buy lunch today — you'd have to break the deposit, which takes time and may cost you interest. So it's less "money-like" than cash, but it's still a form of stored purchasing power.

The RBI solves this by defining four measures of money supply, each broader than the last. They are called M1, M2, M3, and M4. Think of them as concentric circles: M1 is the narrowest (most liquid), M4 is the broadest (includes less liquid forms).

The four measures (as per NCERT Class 12)

M1 = CU + DD

Where:

CU = Currency held by the public (notes + coins, excluding cash held by banks)
DD = Net demand deposits of banks (the money in your current and savings accounts that you can withdraw on demand)
Net time deposits = Fixed deposits, recurring deposits, etc. — money you cannot withdraw immediately without penalty

What each measure captures

M1 is the money you can spend right now — cash in hand plus money in your bank account that you can withdraw or transfer instantly. This is called narrow money. It's the most liquid.

M2 adds post office savings deposits. In India, post offices also accept savings deposits, and these are quite liquid (you can withdraw them on demand). But they're not part of the commercial banking system, so they're added separately.

M3 is the most commonly used measure for policy. It adds all time deposits (fixed deposits, etc.) to M1. This is called broad money. Why include fixed deposits? Because they can be converted into cash quickly (though with some loss of interest). They represent purchasing power that is just a step away from being spendable.

M4 adds post office deposits (excluding National Savings Certificates, which are less liquid) to M3. This is the broadest measure.

Which one do economists actually use?

In India, the RBI primarily tracks M3 for monetary policy. You'll see it in news headlines: "Money supply (M3) grew by 10% this year." M1 is also tracked for short-term liquidity analysis.

Note

The RBI publishes these numbers every week. As of recent data (you don't need to memorise exact figures), M3 is roughly ₹200+ lakh crore — a number so large it's hard to imagine. But the growth rate is what matters for policy. …

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To encourage investment, the Central Bank implements an expansionary monetary policy, which involves increasing the money supply and reducing the cost of credit. Reducing the Cash Reserve Ratio (CRR) achieves this by freeing up funds for commercial banks to lend, making (a) Reduce Cash Reserve Ratio the correct choice.

The question asks how the Central Bank can encourage investment in the economy. Investment, in this context, primarily refers to businesses borrowing money to expand operations, purchase new equipment, or undertake new projects. For businesses to invest more, they need access to credit (loans) at a reasonable cost (interest rates).

The Central Bank (like the Reserve Bank of India, RBI) uses various tools of monetary policy to influence the availability and cost of money in the economy. To encourage investment, the Central Bank needs to adopt an expansionary monetary policy. This means it aims to:

Increase the money supply: Make more funds available for lending.
Reduce the cost of borrowing: Lower interest rates.

Let's examine each option to see which one aligns with this goal.

Analyze Option (a): Reduce Cash Reserve Ratio (CRR)
- Concept: The Cash Reserve Ratio (CRR) is the percentage of a bank's Net Demand and Time Liabilities (NDTL) that it must hold as reserves with the Central Bank. These reserves cannot be used for lending.
- Impact of Reduction: When the Central Bank reduces the CRR, commercial banks are required to hold a smaller portion of their deposits as reserves. This means they have more funds available to lend out to businesses and individuals.
- Chain Reaction: More lendable funds in the banking system lead to increased competition among banks to disburse loans. This typically results in a reduction in the interest rates banks charge on loans. Lower interest rates make borrowing cheaper for businesses, thereby encouraging them to take out loans for investment purposes.
- Conclusion: Reducing CRR is an expansionary measure that encourages investment.
Lendable Funds = Total Deposits $\times (1 - \text{CRR})$
Analyze Option (b): Increase Cash Reserve Ratio (CRR)
- Impact of Increase: If the Central Bank increases the CRR, commercial banks must hold a larger portion of their deposits as reserves with the Central Bank. This reduces the funds available for lending.
- Chain Reaction: With less money to lend, banks may increase their lending rates to maintain profitability and ration the available credit. Higher interest rates make borrowing more expensive, which discourages businesses from investing.
- Conclusion: Increasing CRR is a contractionary measure that discourages investment.
Analyze Option (c): Sell Government securities in open market
- Concept: Open Market Operations (OMO) involve the buying and selling of government securities by the Central Bank.
- Impact of Selling Securities: When the Central Bank sells government securities in the open market, commercial banks (or the public) buy these securities. The payment for these securities flows from the commercial banks to the Central Bank, effectively withdrawing liquidity (money) from the banking system. …

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Q.In order to encourage investment in the economy, the Central Bank may ___________. (Choose the correct alternative)

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