Question

2. Identify and define any FOUR monetary policy tools of a Central Bank and briefly explain how it may use EACH to influence the country’s supply of its domestic currency to manage its inflation, interest rate or foreign exchange rate targets.

Answer 1

Monetary Policy is implemented to manage money supply in economy to regulate inflation, unemployment level and foreign exchange rate. Monetary policy is largely classified as expansionary or contractionary.

Central Banks uses following tools to regulate macroeconomic factors:

1. Open Market Operations: Central bank targets short term interest rate through open market operations. Central banks buy and sell short term bonds in open market to reach target interest rate. As central banks buy the bonds, it supplies additional money flow in system and vice versa. As money supply increases in the system, banks provide loan at lower rate to borrower and applicable interest decrease. Similarly, selling of bonds in open market reduces the money supply and interest rate increases.

2. Change in reserve requirements: Banks need to maintain a proportion of customer deposit with the central banks, it ensures returning the deposit as and when customer need it. Central bank changes the reserve requirements to regulate bank lending. As reserve require requirement is eased or lowered banks get more money to lend and money supply increase. Conversely, with increase in reserve requirements, money supply reduces as banks can lend less.

3.Change in discount rate: Central banks act as lender of last resort for banks and provide funds to banks for short duration. To increase the money supply in system, central banks reduces the interest rate charged on loan to banks and vice versa.

4. Launching new lending or asset purchase program: At the time of emergency such as financial crisis of 2008, central banks introduce asset purchase program such as mortgage backed securities or issue treasury notes to fund government expenses.

So, central banks controls money supply in economy to stabilise inflation, exchange rate and unemployment rate etc.