Question

3. Why do central banks use monetary policy? What kind of monetary policy do central banks take when an economy is in recession? Name any two tools/activities by central banks to exercise the policy. How do these tools/activities help? Why don’t they always do that?

Answer 1

Monetary policies refers to the policies of central bank to contol or expand the supply of money in the economy. Objectives of using monetary policy are as under -

1) To control inflation

2) To reduce unemployment

3) To promote long term interest rates

There are basically two types of monetary policy. Contractionary monetary policy and expansionary monetary policy. Contractionary monetary policy is used by the central bank to control the supply of money in the economy at the time of inflation.

Expansionary monetary policy is used by the central bank to inject money into the economy. This policy is used by the central bank at the time of recession when flow of money is too low in the economy.

TOOLS OF CENTRAL BANK TO EXERCIE THESE POLICIES-

1) OPEN MARKET OPERATION-

Open market operation refers to the process of purchase and sale of government securities in the open market. This is done to control the supply of money in the economy. At the time of inflation, government sells the securities in the open market to reduce the supply of money and vice versa in recession.

2) RESERVE REQUIREMENT-

Reserves refers to the minimum balance which banks are required to maintain as a minimum percent of their deposits. Resserves are of two types, Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR). At the time of inflation, central bank increases the reserve requirement to lock funds with the banks and at the time of recession reserve requirement is reduced.

Central bank can not always do that because the economy is volatile and the environment and social conditions are constantly changing due to which inflation and deflation become part of financial system, so government has to use appropriate policy at the appropriate time to cope up with the relevant situation.

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