Question

1. In your own words, explain the entire process of the transmission mechanism in an expansionary monetary policy. (300-400 words)

2. In your own words explain what is meant by the following statement: ‘Commercial banks are continually faced with the dilemma between profitability and safety’. (250-300 words)

Answer 1

The transmission of monetary policy influence the economic growth and subsistence level of development. When the central bank introduce an expansionary monetary policy through increasing the money supply in the economy. The expansion of monetary policy cut down the rate of interest and expands the level of investment. The central bank participate in market structure using the interest rate by comprises the coins and notes and reserves of financial institutions. The change in interest rate of treasury bills, and other securities. These changes indirectly affect the lending and deposit rates. This monetary policy affects the future expectation and inflation. The asset prices also increases, the exchange rate. When the equity prices falls down the consumption of households reduced. There is increasing rate of prices also occurred. People get more money to consume, thus the consumption pattern improved and the prices also.
There are four main channels for the transmission of monetary policy. The first one is through interest rate effects. It will affect both the cost of credits and cash flows. It alters the marginal cost of borrowing. When the interest rate fall down the cost of borrowing decrease and the investment increased. There is high rate of cash flows. The second channel is domestic asset prices. This includes bonds, stock market and real estate price. The interest rate influences the returns in these securities. The third channel is exchange rate. When the exchange rate influences the stock market, the market attracts more investors. Fourth channel is credit availability. This credit availability increase through the money supply by the monetary authority.
The main objectives of commercial bank is profit seeking. The investment policy depends on this profit. The portfolio management of commercial banks focus on this. Portfolio management means prudent management of assets and liabilities of bank to seek optimum combination of income. The profit of bank earned through securities by central and state government, financial obligations like promissory notes, bill of exchange etc.
Commercial bank operates under risk and uncertainty. It is uncertain about the amount cost of funds about the income. The risk concentrated in customer loans. Under this risky situation maintenance of safety is very important. The profitability of bank is essential for the paying of interest to depositors, wage to staff and dividend to shareholders ad meting other expenses. There is a conflict between profitability and liquidity among the banks. One of the most important ways to increase the expected profit is taking more risk. Through this risk creation leads to the consistency of bank safety. There should be a balance of demand maintained between shareholders, depositors and regulations. The bank solvency attracts more customers to the market through high quality assets also.