Answer to Question #207525 in Macroeconomics for jai

Question

Q. In order to promote digitalization of Indian banking system, the government encourages banks to open more ATMs in rural India, making withdrawals from bank accounts more convenient. Assume the RBI does not change the money supply. [4 marks]

 

a) According to the theory of liquidity preference, what happens to the interest rate, aggregate demand? Draw a diagram

b) If the RBI wants to stabilize aggregate demand, how should it change the money supply?

Answer 1

There are 2 tools through which the economic condition, inflation, money supply and demand are regulated. The fiscal policy (FP) is a tool in hand of government in which government expenditure and taxes are included. In monetary policy (MP), the Central Bank regulates the money supply, inflation rate, exchange rate through it.

a.

According to the ‘liquidity preference theory’, when government encourages bank to set up more ATMs, it shifts Money demand (MD1) to MD2, but Money supply (Ms) remains fixed, so, ‘i’ increases from i1 to i2, depicted in the graph:

b.

In order to get back to initial equilibrium, the RBI can reduce money supply by using contractionary MP. It can increase bank rate, repo rate, cash reserve ratio (CRR), etc.