Explain how the central bank can decrease the supply of money by using (1) open market...

Explain how the central bank can decrease the supply of money by using (1) open market transactions, (2) reserve requirements and (3) discount rates. Briefly discuss.

Expert Solution

Ans: The Central bank adopts contractionary monetary policy to reduce money supply in the economy. Under this policy, the Central bank uses following instruments.

Open market transactions or operations.

The Central bank sells government bonds and securities to the commercial banks and other financial institutions. As a result , the lending capacity of the commercial banks and other financial institutions is reduced which will reduce money supply in the economy.

Reserve requirements.

Reserve requirement is the certain percentage of total deposits which the commercial bank should keep with it. If the Central bank wants to reduce money supply in the economy, then it will increase reserve requirements. It will reduce the lending capacity of the commercial banks.

Discount rates

Discount rate is interest rate at which the commercial banks borrow money from the Central bank. When the discount rate increases then the cost of borrowing of the commercial banks increases. So that the commercial banks lend money to the public at a higher interest rate. It will lead less demand for money in the market. As a result the money supply will decrease in the economy.

Rahul Sunny answered 2 years ago

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