Question

Explain (3) conventional monetary policy tools used by the Central bank of a country to control the money supply and interest rates in the financial markets? (400) words

Answer 1

The most important function of a central bank of the country is to exercise monetary policy. It is the policy to control the money supply in the economy. The following are the three conventional or traditional tools of monetary policy used by the Central bank of a country:

1. Open market operations : Central banks control the money supply by exercising open market operations. In this tool the central bank sells and buys the securities in the market. It will purchase securities to increase the money supply in the economy and it will sell to decrease the money supply.
2. Changing reserve requirements : Commercial banks have to keep a certain portion of their assets in central bank in the form of cash reserves.CRR facilitate interbank settlements. Increasing or decreasing CRR is helpful to control money supply. Raising CRR decreases the money available for banks to lend to people. This will decrease the money supply in the economy. Decreasing CRR causes inflation in the economy.
3. Changing the discount rate : This tool is also known as bank rate policy. Bank rate is the rate at which the commercial banks borrow from central banks. Increasing or decreasing the bank rate is a tool to control inflation. When the central bank increases bank rate, it will be costly for a commercial bank to borrow from central bank. This will automatically increase the bank's lending rate. This will cause a decline in the credit creation and thereby the money supply will be decreased. A decrease in the bank rate causes lending easily and thereby leads to inflation.