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Question

Explain how do 'operations' by the central bank affect money creation by commercial banks.



    Solution

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    An important tool in the hands of the central bank for altering money creation by commercial banks is open market operations. Open market operations refer to the sale and purchase of government securities by the central bank from the public and commercial banks in the open market. Through sale and purchase of securities, liquidity position of commercial banks is affected and this finally results in changes in the capacity of commercial banks to create credit.

    • When central bank sells securities to the commercial banks, the cash reserves of commercial banks will reduce as there is a flow of money out of commercial banks. This will decrease the credit creation and money supply in the economy.

    • When the central bank buys securities from the commercial banks, the cash reserves with banks increase. This will increase the credit and money supply in the economy.


    Economics

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