Question

Explain the 4 Tools of Monetary Policy and how the Central Bank impacts the overall economy. Make sure to include a graph of how changes in the money supply impact interest rates

Answer 1

monetary policy is a very effective and important tool of a central bank of a country.central bank controls the inflation and supply of money with this tools.

4 major tools of monetary police concerned with central bank is explained as ahead-

1. REPO RATE- repo rate is considered to be very effective tool of the central bank. if government want to increase money supply in the economy then it would decrease the REPO rate and vise versa is also true.
2. OPEN MARKET OPERATION-when central bank wants to increase money supply then it starts purchasing securities from market and as a result the cash flow increase in the money market.and in the contrary situation the bank may sell the securities to decrease the cash supply in the market.
3. MARGIN REQUIRED- if central bank want to increase the cash supply it may lead to decrease the margin required as a result more liquidity would be available in the money market.and if it wants to reduce the money supply then it would lead to increase the margin required.
4. CASH RESERVE RATIO- if central bank want to increase the supply of money then it would lead to decrease the cash reserve ratio as a result the bank will have more cash to lend in the economy.and if it wants to reduce the cash supply in the economy then it would increase the cash reserve ratio.

when central bank increases the supply of money in the economy.- the supply curve shifts to the right and then new equilibrium point is determined. we can get the idea from the following diagram.in short run the supply of money is inelastic(Only central bank can change the supply of money)

WHEN MONEY SUPPLY IS TO BE INCREASED-

WHEN MONEY SUPPLY IS TO BE DECREASED-