Question

If an exporter earns money and deposits that with Reserve Bank of India (RBI), what will be the ultimate impact on country's money supply?

• A. Money supply will depend upon the current exchange rate
• B. Money supply will remain unaltered
• C. Money supply will decrease
• D. Money supply will increase

Hint:

To prevent an unwanted increase in the money supply and control inflation from foreign inflows, central banks often perform sterilization.
This involves selling government securities in the open market to absorb the excess liquidity injected by the foreign exchange purchase.

Answer 1

The Correct Option is D

Step 1: Understanding the Concept:
In macroeconomic theory, changes in a country's foreign exchange reserves directly affect its domestic monetary base and money supply.
When foreign currency enters the country, it must be exchanged for domestic currency before it can be used locally, expanding the domestic monetary base.

Step 3: Detailed Explanation:
Let us analyze the financial transaction step-by-step:
1. An exporter sells goods abroad and earns foreign currency (such as US dollars).
2. To use this income in the domestic economy, the exporter must convert the foreign currency into Indian Rupees (INR).
3. When these funds are deposited with the central bank (Reserve Bank of India), the RBI purchases the foreign currency.
4. In exchange, the RBI issues newly minted domestic currency (Rupees) of equivalent value to the exporter.
5. This process increases the net foreign exchange assets of the central bank, which is a key component of High-Powered Money or reserve money (\(M_0\)):
\[ \text{Reserve Money } (M_0) = \text{Net RBI Credit to Government} + \text{Net Foreign Exchange Assets of RBI} + \dots \] 6. Because reserve money forms the basis of the money supply, this injection of liquidity is multiplied through the commercial banking system via the credit creation process:
\[ \text{Total Money Supply } (M_3) = \text{Money Multiplier} \times M_0 \] Therefore, the ultimate impact of this foreign currency deposit is an expansion of the domestic money supply.

Step 4: Final Answer:
The ultimate impact on the country's monetary system is that the money supply will increase, matching Option (D).