Question

16) Sketch the flow diagram that describes the relationship between banks, central banks, borrows and savers. Explain how, if the central bank lowers the policy interest rate this will influence the lending interest rate and amount of borrowing.

Answer 1

. A Central bank is the banker of all commercial banks in a nation .It manages money supply , nation's currency and interest rate. Central bank regulate and ,manages the commercial bank Commercial banks should conform to the spirit of Central bank directives .Commercial banks can borrow money from central bank at a certain interest rate. Commercial bank has to keep certain deposits of its total reserves with commercial banks . Savers place their deposits with commercial banks and receive interest payments. Commercial banks should take the deposits and lend to the borrower at certain interest rate Central bank lowers the policy of interest rate during recessionary period. It will increase the money supply in the economy. Increase in money supply boost the aggregate demand in the economy. Higher aggregate demand will rise the general price level and output in the economy . As a part of lowers the policy of interest rate, central bank lowers the bank rate ,cash reserve ratio, statutory liquidity ratio etc. Bank rate is the rate at which central bank provides financial accommodation to commercial banks by re discounting bill of exchange . Cash Reserve Ratio is the minimum fraction of total deposits of customers which commercial banks have to to hold as reserves i with commercial banks.This would encourage the commercial banks to borrow from the central bank. When the central banks lower the interest rate, ,then the commercial banks also reduce their lending rates. Then cost of borrowing would be low When the lending rates charged by commercial banks are lower, businessmen and industrialists would feel encourages to borrow more fund form commercial banks. This would tend to expand bank credit and hence would result in increase in money supply