Question

Explain the four tools of monetary policy and how the central bank impacts the overall economy. Make sure to include a graph of how changes in the money supply impact interest rates?

Answer 1

Ans

The four tools are

1 Bank rate. It is the rate charged by central bank to banks when they borrow money from central bank

2 required reserve ratio=It is the ratio of demand deposits which the banks keep with the central bank in the form of cash to meet emergency cash demand.

3 Statutory liquidity ratio=This is used by central bank to keep some further proportion of demand deposits as liquid assets to meet liquidity requirements

When central banks try to increase money supply they lower these ratios. This decreases interest rate and thus investment and consumption rise. Hence AD rises which inturn increases output, production and employment.

When central bank wants to decrease money supply it increases these 3 instruments. This has exactly opposite effects of decreasing outout, employment and production

4 other instrument is open market operations. Here central bank purchases securities to raise money supply and sells securities to decrease money supply. The results are similar as in case of other instruments

In fig an increase in money supply from Mso to Ms1 reduces interest rate from r1 to ro