Question

Among the most important players in financial markets throughout the world are central

banks, the government authorities in charge of monetary policy. Central banks action affects

interest rates, the amount of credit available, and the money supply, all of which have direct

impacts not only on financial markets, but also on aggregate output and inflation."

Read the above statement car fully and answer the following questions:

Why the central bank is "the most important player in financial markets'? In what

respect the central bank is important compared to other financial institutions in the

economy.

a.

b. How the central bank impact directly the level of aggregate output and inflation in the

economy?

What are some of the mechanisms that the central bank uses to influence interest

rates? Explain.

Answer 1

a) Central Bank is important compared to other financial institutions in the economy mainly because it ensures that a nation's economy stays healthy by regulating the money supply in the economy effectively. The various techniques used by the Central Banks to control the money supply include influencing interest rates, printing currency, modifying reserve requirements etc.

Mechanisms that the central bank uses to influence interest rates and ways in which Central Bank controls aggregate demand and inflation:

1. Modifying the rate at which commercial banks get to borrow from the central bank. The central bank reduces this rate leading to more money available to commercial banks to loan out money, resulting in reduction in interest rates and an increase in the money circulation in the economy. Also, in this case, the aggreagte consumption and demand increases and the inflation level rises. On the contrary, the rate is raised when the Central Bank intends to reduce the money supply in the economy by reducing the money available to commercial banks for loaning out money. This leads to a rise in interest rates charged by commercial banks owing to excess demand of loans. This leads to fall in inflation (contractionary moetary policy).

2. Open market operations: Central Bank buys govt securities from commercial banks when it wishes to inject liquidity into the economy, thereby reducing the interest rates (increase in inflation). Conversely, Central Bank sells the securities to banks when it wishes to tighten the money supply of the econmy, thereby increasing the interest rates. (reduction in inflation).

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