If the central bank borrows to reduce the currency in circulation, what is the typical effect on interest rates?

If the central bank borrows to reduce the currency in circulation, what is the typical effect on interest rates?

• A. Interest rates fall
• B. Interest rates stay the same
• C. Interest rates rise
• D. Currency depreciation occurs

Answer: (C)

Tightening liquidity by draining currency from the system raises the cost of borrowing. When the central bank borrows to soak up money, banks have fewer reserves, so the money market clears at a higher interest rate. This rise in rates is the usual effect of contractionary monetary policy, as it slows borrowing and spending to curb inflation. The other outcomes—lower or unchanged rates or currency depreciation—don’t align with the reduced money supply and the higher opportunity cost of holding money.

Tightening liquidity by draining currency from the system raises the cost of borrowing. When the central bank borrows to soak up money, banks have fewer reserves, so the money market clears at a higher interest rate. This rise in rates is the usual effect of contractionary monetary policy, as it slows borrowing and spending to curb inflation. The other outcomes—lower or unchanged rates or currency depreciation—don’t align with the reduced money supply and the higher opportunity cost of holding money.