Question

List the four tools of monetary policy and briefly describe the usefulness and limitations of each.

Answer 1

The four monetary policy tools are:

1. Open market operations: The central bank sells or purchases government securities. This lead to either an increase or decrease in the money supply . The change in the money supply leads to increase or decrease in the interest rates. Thus, there will be an increase or a decrease in the investment depending upon the nature of the policy i.e. whether it is contractionary or expansionary. The limitation is it leads to price rise when its expansionary.
2. Discount rate: It is the rate at which the central bank provides funds to the banks. Higher discount rate decreases money supply and increase interest rate. Thus, investment decreases.
3. Reserve requirement: It is the amount of reserves that banks keep with the central bank. The change in the reserve requirement by the central bank affects the money supply. The changes in money supply leads to change in the interest rate and thus, the investment changes. The limitation is that it involves lots of paperwork.
4. Fed funds rate: It is the rate that banks charge other banks to keep their excess cash. The changes in the fed funds rate affect the money supply in the economy. The limitation is that it affects other interest rates as well.