Question

1. How can a central bank influence the supply and demand for money in a

country’s economy? Why do the amount and price of money matter? Describe

some of the connections between a country’s money supply and its international

balance of payments.

Answer 1

Central bank is the ultimate monetary authority of a country which regulate its monetary sector. Central bank uses many instruments like bank rate and reserve ratios to regulate money supply. All those instruments are mainly working thorugh interest rate mechanism.when money supply is high, central bank increase the reserve ratios which commercial banks need to keep with the central bank and thereby reduce the pumping of money to the economy. They decrease interest rate when money supply is low in the economy.

Amount and price of money is significant with regards to the internal and external balance of the economy. For internal balance we need price stability. Money supply is directly related to the price level. For BOP equilibrium also, economy needs to regulate the value of money. Monetary authority balance BOP via depreciation and appreciation.

When money supply increases, interest rate falls and there will be outflow of capital.This leads to BOP deficit.On the other hand when money supply decreases , interest rate rises and there will be inflow of capital to take advantage of the high interest rate.This leads to BOP surplus.So by regulating money supply in the economy ,central bank can maintain internal and external balance.