Question

Explain how central bank controls the Monetary Policy

Answer 1

The monetary policy is a tool that is used to control the money supply in the economy which can control the inflation rate in the economy. It is at the disposal of the monetary authorities of the country, which is the Central Bank of the nation. The following are the tools by which the central bank can control the monetary policy of a country.

1. Discount rate: This is the rate at which the central bank lends money to the commercial banks. If this rate is increased, then it is more expensive for the commercial banks to borrow extra credit from the central bank and hence the amount of money in circulation reduces, which causes inflation to reduce. If this rate is decreased, then it is less expensive for the commercial banks to borrow extra credit from the central bank and hence the amount of money in circulation increases, which can increase the aggregate demand.

2. Reserve requirements: Every commercial bank that engages in the lending and deposit of reseves will have to maintain a part of its deposits as reserves which it is not allowed to lend. If the central bank was to reduce the credit in circulation in the market, then it increases the reserve ratio, which leaves the commercial banks with less money to lend. If the central bank was to increase the credit in circulation in the market, then it decreases the reserve ratio, which leaves the commercial banks with more money to lend.  

3. Open market operations: The central bank can also engage in the sale and purchase of government securities in the open market. If the central bank wants to decrease credit in the market, then it will increase the interest rate payable on government securities which will incentivise the people to buy these bonds, and the liquidity in the economy will reduce. If the central bank wants to increase credit in the market, then it will decrease the interest rate payable on government securities which will dis-incentivise the people to buy these bonds, and the liquidity in the economy will increase.

4. Interest on reserves: The central bank can also decide to pay interest on the reserves kept by the commercial banks, which acts as an extra income for the commercial banks. Hence, if the central bank wants to decrease liquidity in the economy, it can increase the interest it pays on the reserves, which incentivise the commercial banks to keep more reserves and lend less to the people. If the central bank wants to increase liquidity in the economy, it can decrease the interest it pays on the reserves, which dis-incentivise the commercial banks to keep less reserves and lend more to the people.