Question

Briefly describe the 3 traditional tools used by a central bank to affect the money supply and identify which is the most powerful and commonly used method and which is the weakest method. Address whether any part of the T account for commercial banks change with each tool.

Answer 1

Monetary policy tools of central bank -

1. Discount rate - It is the rate at which central bank discounts or gives the loan to commercial banks. Increase in discount rate leads to increase in interest rate by commercial banks and makes borrowing costly. This is done during inflation to decrease money supply while during the depression, the discount rate is lowered.
2. Reserve requirement - It is the amount of liquid cash out of total deposits which a commercial bank is asked to keep for emergency lending. If central bank increases reserve requirement, the bank needs to keep more cash and amount of loan decreases. This is a contractionary monetary policy used during expansion while during the recession, the reserve requirement is lowered.
3. Open Market Operations - Central banks buy and sell government bonds to change the money supply. During the recession, it buys bonds and increases the money supply in the economy while during expansion, central bank sells the bond.

The discount rate is the strongest method while reserve requirement is the weakest method. This is because the disount rate will affect whole society while open market operation affects only bondholders. And under reserve requirement, banks have a lot of excess reserves and also they borrow overnight in case of emergency.