Question

What is monetary policy? What are the tools used to achieve its targets? Explain the process by which the Bank of Canada, for instance, achieves its target rate of interest.

Answer 1

Monetary policies are the actions taken by central banks to control the monetary as well as financial status with the goal of attaining low inflation and sustainable growth in the economy. The techniques that are used by the central bank under monetary policies to alter the money supply include the reserve requirements, discount rate, and the open market operations.

--Reserve requirements refers to the portions of deposits that banks are required to hold in cash, either in their vaults or on deposit at a Reserve Bank. A fall in reserve requirements is expansionary because it raises the funds available in the banking system to lend to consumers and businesses. A hike in reserve requirements is contractionary because it decreases the funds available in the banking system to lend to consumers and businesses.

-- Discount rate refers to the interest rate that the Reserve Banks charge commercial banks for short-term loans. Lowering the discount rate is expansionary because it influences other interest rates. The lower rates will encourage lending and spending by consumers and businesses. In similar way, raising the discount rate is contractionary because the discount rate influences other interest rates. The higher rates will discourage lending and spending by consumers and businesses

--Open market operations (OMO) refers to the buying and selling of government securities in the open market for the purpose of expansion or contraction of the amount of money in the banking system, facilitated by the Federal Reserve (Fed).On contrary, when the central bank is interested in controlling inflation, it sells government bonds to the public and commercial banks.

Bank of Canada implements monetary policy by an increase or fall in the target for the overnight rate. It is the rate of interest at which main financial institutions lend and borrow one-day (also known as overnight) funds among themselves. It results to changes in other market rate of interest and thus leads to the changes in the demand for money, the demand for credit, and the demand for bank notes.