Question

Explain how the reserve bank influences the money supply in the economy (15%). Next, discuss the objectives of the reserve bank in conducting monetary policy (10%).

Answer 1

Money supply remains in hands of central bank for most of the nation hence, saying central banks regulate money supply would be appropriate.

The excess money supply results in inflation and shortages result in deflation. Central banks regulate money supply to control inflation and deflation both.

The Central bank can adopt following measures to control or influence the inflation or interest rates through monetary policies:

·      Central bank (Fed) can reduce the interest rates at which financial institutions borrow from the Fed. How this will impact? As interest rates are reduced the banks or financial institutions will be able to borrow at lower cost from Fed. Suppose, $ 1 Billion was earlier borrowed at 1% p.a which was equivalent to $ 10 million interest cost after reduction in interest rate same $ 1 Billion can be borrowed at 0.75% p.a hence, the cost of borrowing will become $ 7.5 million. Now, banks can go ahead and lend at lower cost to their clients. As client or borrower can borrow at lower cost they can spend more money at lesser cost. The flow of money will increase purchasing power of individuals. Purchasing power will chase the limited supply of goods and prices of goods would rise hence, inflation number will also rise

·      Central bank can relax the reserve requirements. Like Minimum Cash Reserve Ratios, ratio of mandatory holding of treasury bonds or government Securities by financial institutions and banks. This can indirectly improve the supply of money. The tight reserve requirements hold / contain the money supply in the market. The banks or financial institutions cannot lend these monies to their corporate or retail borrowers as reserve ratios are regulatory requirement. If Fed relaxes the financial institutions from restrictive reserve ratios then the natural supply of money will increase. The supply of more money improves the purchasing power of individuals hence the inflation numbers goes up

·      Central bank can go ahead and create the new currencies either electronically or by printing new currencies. New supply of money can be flown by purchase or buy back of existing government and treasury securities. This activity is broadly classified as quantitative easing. This method directly or indirectly increases the supply of currency in the market and helps improving the purchasing power of the individuals and ultimately results in inflation

Central bank can target the inflation number and accordingly it can increase the supply of money in tune to targeted inflation.

Objectives of central or reserve bank in conducting the monetary policy:

-          To regulate the money supply in the market which gives control over inflation or deflation in market to some extent

-          Excessive growth results in inflation hence control over supply of the money can bring down the inflation in economy

-          Stability of economy by ways of supplying and restricting money

-          Regulating money bring real growth in economy which generates employment and real GDP

-          Interest rates are captured in exchange rates hence reserve banks can tune interest rate such that it can serve the objective of desired exchange rates. To much import leads to FX deficit and excess export leads excess FX reserves. Both are not ideal. Hence, high interest rates can demotivate exporters to produce and encourage imports and vice-versa.