Question

4) Monetary Policy
a. What is an ‘open market operation’ by the central bank (CB)?
b. If the Fed wanted to increase the money supply, what kind of open market operation would it use?
c. How should changing the money supply (monetary policy) affect the real economy?
d. What, specifically, would the CB do, and in which economic circumstances, in order to stabilize the
economy?
e. What is a risk of using monetary policy to try to stabilize the real economy?

Answer 1

a. Open market operation is one of the tools of central bank to stabilize the economy. Open market operation method refers to the sale and purchase of government securities and other credit instrument by the central bank. Central bank mak purchases or sales of only government securities both long term and short term . b. If central bank wants to increase money supply, central bank purchases government securities from open market either by paying cash or cheque. It will increase credit creation of commercial banks . It stimulates investment and employment opportunities. Thereby it increases money supply among public and commercial banks. c. There are two type of monetary policy 1.Expansionary monetary policy: As a part of expansionary monetary policy , central bank will rise the interest rate to increase money supply. There will be a corresponding reduction in market interest rate. It reduces cost of borrowing. It encourages investors and business firms to borrow money for investment from commercial banks. It stimulate investment and business activities and result into increased employment, output and money income 2. Contractionary monetary policy : Central bank will hike the interest rate to reduce money supply . It makes corresponding increase in market interest rates. It rises cost of borrowing. Money has become dearest to borrowers . Businessmen , investors, speculators curtail borrowing and it results decline in investment and business activities. It reduces money supply in the economy d. During inflationary situations, central bank enacts or implements contractionary or dearest monetary policy to reduce money supply .During recessionary situations, central bank will implement expansionary fiscal policy to increase money supply in the economy e. Monetary policy do not guarantee economic growth. They takes time to begin working. It creates a risk of hyperinflation . If economy is facing recessionary pressure, even central bank enacts expansionary policy , it become ineffective to stabilize economy during a liquidity trap situation.