In a closed economy, the supply of money may be controlled by the Central Bank in...

In a closed economy, the supply of money may be controlled by the Central Bank in three ways: Reserve requirements , Open market operations, Discount rates.

Outline each of the three ways.

Expert Solution

The central bank regulates the amount of money in circulation to ensure that a nation's economy remains healthy.By adopting the following three ways the supply of money may be controlled in a closed economy:

1.RESERVE REQUIREMENTS

The reserve requirement or cash reserve means the minimum amount of reserves that a commercial bank should hold inorder to ensure that it is able to meet liabilities in case of sudden withdrawals.it normally consists of cash owned by the bank and kept physically in the bank vault plus the amount of commercial banks's balance.The higher the reserve requirement is set,the less funds banks will have available to lend out ,leading to lower money creation and higher purchasing power of money.it is used as a tool by the central bank to increase or decrease the money supply in the economy and influence the interest rates.Reserve requirements are currently 10% in the U.S.When the central bank lowers the reserve requirement on deposits the money supply increases and interest rate decreases.

2.OPEN MARKET OPERATIONS

Another way that is adopted by the central bank to control the money supply is to engage in open market operations i.e buying or selling government securities.Selling securities from the central bank's balance sheet removes money from the system,making loans more expensive and increasing rates in the the same way buying securities adds money to the system making loans easier to obtain and interest rates decline.

3.DISCOUNT RATES

The discount rate is the interest rate set by the central bank on loans extended.When the central bank raises the discount rate ,this decreases excess reserves in commercial banks throughout the economy and contracts money supply in the sameway when it lowers the discount rate this increases excess reserves in commercial banks and expands the money supply

Rahul Sunny answered 2 years ago

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