Monetary policy can be defined as the available tools that a country's central bank uses to direct the money supply of its economy and increase economic growth and employment through such operations as altering interest rates or changing bank reserve requirements. Tools of Monetary Policy Monetary pRead more
Monetary policy can be defined as the available tools that a country’s central bank uses to direct the money supply of its economy and increase economic growth and employment through such operations as altering interest rates or changing bank reserve requirements.
Tools of Monetary Policy
Monetary policy is employed by central banks in practice through various tools and devices. Some of the very common tools include:
Open Market Operations
The central bank buys or sells government securities, like bonds, in the open market. When the central bank purchases securities, it adds money in the economy; hence, there is more money. When it sells securities, it takes off some money in the economy, hence less money.
Reserve Requirements
Imagine the central banks as the headmaster of all banks. Central banks have rules for how small an amount of money each commercial bank should reserve in their vaults. A teacher might say, You should always carry at least 5 pencils in your bag. Changing such conditions influences the central bank on how much money commercial banks can lend and the quantity of money that they may produce.
Discount Rate
This discount rate is a special interest rate that allows commercial banks to borrow money from the central bank. It can be thought of as the special rate the central bank gives to commercial banks. If the central bank changes this discount rate, then how much it costs to borrow money for commercial banks changes. This affects how much they lend out to people and businesses, which in turn can affect the economy in general.
Interest Rate
Another tool that the central banks use is the interest rate to increase borrowing costs as well as curtail or boost economic activities. For example, by changing the benchmark interest rate of the central bank-overnight lending rate-the central bank can influence market interest rates that are used to calculate borrowing costs for everybody and for all businesses.
The managed float exchange rate is one such system, in which the value of the currency is primarily decided by market forces but at times is interfered with by the government or the central bank in order to stabilize or reach certain economic objectives. Thus, this is a middle-of-the-road system comRead more
The managed float exchange rate is one such system, in which the value of the currency is primarily decided by market forces but at times is interfered with by the government or the central bank in order to stabilize or reach certain economic objectives. Thus, this is a middle-of-the-road system combining both the characteristics of a free-floater as well as that of a fixed-exchanger, whereby there is the flexibility provided while, at the same time, the extreme fluctuations can be curbed.
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