Question

Suppose the central bank increases discount rate. Use a graph of the money market to show what this does to the value of money?

Answer 1

When the economy is growing at a rate that may lead to hyperinflation, the Central Bank may increase the discount rate. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase to the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented. Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion.

The net effects of raising the discount rate will be a decrease in the amount of reserves in the banking system. Fewer reserves will support fewer loans; the money supply will fall and market interest rates will rise. If the central bank lowers the discount rate it charges to banks, the process works in reverse.

At a given level of income, the higher the rate of interest, the lower will be demand for money. In Figure 17.2 total demand for money curve Md1 has been drawn at the given level of income Y1.

As with the increase in income, demand for money for transaction purposes increases at all rates of interest, the rise in level of national income will cause a shift of Md curve to the right. At the given level of income Y1, if rate of interest rises we move up the money demand curve Md1 indicating that quantity of money demanded will decrease, and if rate of interest falls, the quantity of money demanded will increase.