Question

3. Why are small and large firms affected differently by instability in the financial system? How does this make it more difficult for central banks to prevent financial crises from negatively affecting the economy?

4. Explain how the central bank changes the interest rate in the economy.

Answer 1

3.
During financial stress(such as the covid 19 pandemic) or say in terms of a financial crisis, the reasons why a small firm(small and medium enterprise) is likely to be volatile to economic adversities because of the following factors -
A) Limited options of financing
B) Relatively weaker finance, skills and networks
C) weak external environment control
While it is noticeable that smaller firms resort to pay related cost cutting because HR decisions are more flexible, while larger firms are more likely to lay off employees owing to rigid HR structures, which are set in place.
Therefore, this is completely inconsistent with what the Central Bank would predict when deciding monetary policy. While certain decisions might completely put the smaller firms in a disadvantageous position in terms of financial stability, the larger firms could steadily recover but that being said, to get back to steady levels of economic growth, the inclusion and performance of Small and Medium enterprises are crucial, which is why this is a tricky job for a central bank.

4.
Through open market operations, the Central Bank buys/sells government bonds/securities. While buying will be increasing the money supply in the economy by swapping out bonds/securities in exchange for cash to the general public , through selling, it will be the exact opposite and hence a decrease in money supply. Thus, increasing money supply increases the availability of money for borrowing and according to the law of demand, decreases the interest rate(brings the price of borrowing down) while decreasing money supply raises it(brings the price of borrowing up).