Question

mishkin frederick.S 11th edition economic,banking &financial markets text book

question:

a. Explain three tools of monetary policy and how each tool affects bank’s reserves?

b. During the financial crisis the Bank of England used Quantitative Easing. Explain what is meant with it, how it affects markets and why it used this tool? Was it effective?

Answer 1

A. Monetary policy is an important tool in the hands of Central banks which can be used to regulate or control money supply which furthers controls important macroeconomic variables like inflation, unemployment, exchange rates etc. which form the epitome of economy. The Central Bank has 3 main monetary policy tools which can be used to used to adjust the size, growth and volatility of money supply in the economy. These are:

1. Discount rate: Changes in the repo and reverse repo rates charges by the Central Banks changes the cost of borrowing for banks which further decides the interest rates charged for the loans and deposits for the end consumers who can be households or businesses. Thus the money supply in money is directly tied to the discount rates charged by Central Banks through monetary policy.

2. Reserve requirements: Similar to discount rates, the reserve requirements set by the Central Bank decides how much funds the banks have to make available to Public. If reserves requirement is high, banks can supply less funds to the end consumers impacting market supply of funds.

3. Open market operations:Depending on the requirements, central bank may be involved in purchasing or selling of Government securities to affect the money supply.

B. Quantitative easing is part of the multiple methods followed by multiple Central Banks usually during economic recession to pump money into the economy through multi channels and thus trying to revive industries and thus the economy. In QE, the Central bank involved in open market transactions wherein it purchases longer-term securities from the open market with the aim of increasing the money supply in the economy and thus encourage lending and investment. Through buying of these securities, the Central Bank helps adds new money to the economy, and also helps to lower interest rates available by bidding up fixed-income securities.QE usually works because buying of security raises the asset prices like government bonds which than spreads out through the wider economy to other assets which gives a boost to economy and thus creates a positive wealth effect for asset holders. This improves the confidence and positivity in the economy which spreads systematically to other parts of economy. QE is usually executed by Central Banks as a last resort to help revive the economy. QE has been used by multiple Central Banks like Bank of England, Bank of Japan to help their economy.