Question

Identify the monetary measures being referred to in the following statements. Discuss whether the tool would be used during a situation of excess demand or deficient demand.

Encourage commercial banks to park their surplus funds with the Reserve Bank of India (RBI).

Hint:

Banks parking surplus funds with the RBI points to the Reverse Repo Rate. The RBI raises it in excess demand to cut lending and money supply.

Answer 1

Step 1: Understand what is asked:
The statement says the central bank encourages commercial banks to park their surplus funds with the RBI.
We must name the tool and say whether it is used in excess demand or deficient demand.

Step 2: Identify the tool:
The rate at which the RBI pays interest to commercial banks for the funds they keep with it is the Reverse Repo Rate.
To make banks park more funds with the RBI, the RBI raises this rate, so the tool is the Reverse Repo Rate.

Step 3: Trace the effect of a higher Reverse Repo Rate:
Parking money with the RBI now earns a better and safe return for banks.
So banks keep more of their surplus with the RBI and lend less to the public.
Lending capacity of banks falls, credit becomes costly, and the money supply goes down.
Lower money supply reduces spending, so aggregate demand falls.

Step 4: Decide the demand situation:
We need to cut aggregate demand only when demand is more than the available output.
So the RBI raises the Reverse Repo Rate during excess demand.
In deficient demand the RBI does the opposite. It lowers the rate so that banks lend more and demand rises.

Final Answer:
The measure is the Reverse Repo Rate. It is increased in a situation of excess demand to reduce money supply and aggregate demand.