In the event that a main bank would have unexpected or immediate needs for additional funds, the Federal Reserve can make short-term loans (McConnell-Brue, 2004, chpt. 15). The discount rate is the rate of interest that the Federal Reserve charges to borrow money (The Federal Reserve, 2007). Tools Used to Influence the Money Supply and Affect Macroeconomic Factors When the Federal Reserve buys securities in the open market, commercial banks’ reserves are increased. This results in banks lending out their excess reserves which in turn will increase the supply of money.
The second tool the Federal Reserve uses is the adjustment of the reserve ratio. The reserve ratio is the ratio of the required reserves the commercial bank must keep to the bank’s own outstanding checkable-deposit liabilities (Brue, 2004, p. 254). By raising and lowering the ratio, the Fed can control how much the commercial banks can lend. For example, if the Fed lowers the reserve ratio, commercial banks will now have more excess reserves allowing them to lend more money to businesses or individuals. Vice-versa, by increasing the ratio, the Fed forces the banks to lend less money due to having smaller excess reserves.
Therefore an increase in the bank rate, indicating a tight monetary policy, would result in expectations that the bank rate will decrease in the future. This expectation results in a depreciation of currency. However, if the market expects the bank rate to further increase to lower domestic inflation, it would result in anticipation of future appreciation of the currency. This expectation results in appreciation of the currency. A Report of the Committee on Fuller Capital Account Convertibility accepted that volatility in exchange rate is caused due to flexible exchange rate policy, inflationary pressure and capital inflow.
Open market operations directly affect the money supply through buying short-term government bonds (to expand money supply) or selling them (to contract it). Benchmark interest rates, such as the LIBOR and the Fed funds rate, affect the demand for money by raising or lowering the cost to borrow—in essence, money's price. When borrowing is cheap, firms will take on more debt to invest in hiring and expansion; consumers will make larger, long-term purchases with cheap credit; and savers will have more incentive to invest their money in stocks or other assets, rather than earn very little—and perhaps lose money in real terms—through savings accounts. Policy makers also manage risk in the banking system by mandating the reserves that banks must keep on hand. Higher reserve requirements put a damper on lending and rein in inflation.
Monetary authorities utilise the short-term interest rate as an instrument for controlling the supply of money and managing liquidity in the banking sector, this refers to monetary policy, which strive to keep inflation stable and to promote economic growth. Monetary policy is conducted by the central banks in many countries and employs the short-term interest rate as the main operational variable. A change in short-interest rate (monetary policy's main instrument) lead to a change in other interest rate such as personal loan interest rate, home loan interest rate, etc. For example, a decision by central bank to cut down short-term interest rate will tend to cause other interest rates to decline and hence, induce economic growth. In contrary, when central bank tightens monetary policy by raising short-term interest rate, banks will typically increase their interest rates by similar or closely related amount.
1. Introduction: Monetary policy is the procedure by which the monetary controller of a country, for example the central bank or currency board, controls the supply of money, frequently targeting an inflation rate or interest rate to assure price stability and complete trust in the currency. Additional aims of a monetary policy are commonly to give a share in economic growth and stability, to minor unemployment, and to preserve predictable rate of exchange with other currencies. Monetary economics offers insight into how to skill an optimal monetary policy. Since the 1970s, monetary policy has generally been made individually from financial policy, which attribute to the taxation and government spending.
The credit is given either specifically or by obtaining instruments like treasury bills, offer, business bills, and so on e. Repo Rate and Reverse Repo Rate Repo rate is the interest rate at which national bank gives cash to the banks as loans. Reverse Repo rate is the interest at which national bank gets money from the banks. The increase in the repo rate and decrease in the reverse repo rate will lead to reduction in the cash supply in the economy.
This in turn affects other short term interest rates. The determining rate immediately impacts the rates at which banks borrow money and the interest rates the banks use to charge their customers on loans. If the rate raise is too high, then money flow drops dramatically and banks and customers curtail lending and borrowing, waiting until a better rate is reached. This effect can have a dramatic impact on the economy and economic spending. Long term interest rates differ from short term interest rates in that they are not directly influenced by the Federal Funds target rate.
Open Market Operations. First, the Fed buys financial instruments to put more money into circulation. With more money available, interest rates tend to decrease, and thus more money is borrowed and spent. Second, the Fed sells financial instruments to put money out of circulation caused interest rates to rise, making loans more expensive and therefore less accessible. Third, the Fed regulate the amount of reserves.
BUSINESS ECONOMICS ASSIGNMENT- 3 Question.1) (a) Analyse both the conventional and unconventional tools used by central banks. Answer. 1) (A) Monetary policy- It is a policy given by the central bank which aims at managing the money supply and the interest rate and represents the demand side economic policy which is used by the government to achieve macroeconomic goals- 1. This policy aims on maintaining the cash supply in the economy. 2.