Question

1. How does a central bank influence the lending capacity of the banks?

2. How do the fluctuations in the exchange rate influence the domestic price level?

3. What is a barter system? The drawbacks of this system are as follows:

4. Why is comparative advantage rather than absolute advantage the basis for trade?

5. Explain the concept of “lender of last resort.” What is discount rate?

Answer 1

Q1) The central bank controls the monetary policy in the country which directly influences the money supply and the lending capacity of the banks. The central bank can increase or decrease the policy rate, the rate at which it lends to the commercial banks. For instance, if the policy rates are reduced, the commercial banks have an incentive to reduce the interest charged on their credit which increases lending. the central bank also decides on the reserve ratio i..e. the proportion of deposits that have to be kept aside by the bank as reserves and can not be used for lending. If the central bank increases the reserve ratio, it reduces the funds available with the banks to lend and thus reduces the bank's lending capacity. the central bank also engages in open market operation buying and selling government securities.If they purchase the securities, the money goes directly into the commercial banks which can be used for further lending and thus the lending capacity of the commercial banks is increased.