Tools of Monetary Policy - Essay Example

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Explain how discount policy can affect the money supply. The discount rate is one of the monetary policy tools of the central bank of an economy. It is the rate of interest that the central bank charges for short term loans that it forwards to other banks that require such loans to cover shortages in their liquidity requirements…
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Tools of Monetary Policy
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Download file to see previous pages The effect of increasing the discount rate on the money supply is shown below in diagram 1. In part (a), the demand for reserves is not high enough and as a result there are no changes in the equilibrium reserve holdings. In part (b) there is a high demand for reserves and as a consequence, there is a decline in the equilibrium reserve holdings. Figure 1: Impact of increases in the discount rate In the diagram above, there is an increase in the discount rate from to . Consequentially the supply of reserves schedule rises from to . However, observe that in part (a) the demand for reserves are lower than in part (b). In particular the demand for reserves schedule is not high enough in part (a) to substantiate any efficacy of increasing the discount rate. In fact in such a scenario, a decline in the discount rate could have an impact by increasing the equilibrium reserve holdings if the rate is lowered below the bank rate. However, this will make sense if the resulting effect of increased money supply is the desired result. As a result, albeit the increase in the discount rate leads to a rise in the supply of reserves, there is no change in the equilibrium holdings. Thus, there is no discount lending in this case. In part (b) the increase in the supply of reserves leads to a reduction in the equilibrium discount reserve holdings from R0 to R1. Note that in this case lowering the discount rate would have had an impact as well but of the opposite kind. Alternatively, the central banking authority of an economy has to right of denying or controlling the amount of loans directly. Thus it has a control over the money supply of the nation directly via a control over the sanctioning of discount loans. In particular, loans forwarded to financial institutions by the central banks belong to any of the following three classes: a) primary loans, b) secondary loans and c) seasonal loans. Primary loans are the credit supplies to healthy or financially stable banks or financial institutions. Secondary credits are the loans that are forwarded with a designated purpose only in which the credit accepting institution can put the loan in use. Finally, seasonal loans are the short term credit that is forwarded under discount rates generally to help institutions overcome temporary liquidity shortages and emergencies. Thus by controlling the amount of reserves financial institutions have, the central bank can restrict the amount of money supply in the economy. How may central Bank help prevent bank panics by acting as a lender of last resort? Support your answer using examples of such events. Bank runs or panic runs to the bank are caused by the fear that the bank will become insolvent and will fail to return the amount of deposits. The central problem is that this has a cascading effect and actually becomes a self fulfilling prophesy since as the number of people withdrawing their funds increases, the liquidity of the bank decreases. Further with the number of withdrawals rising, other customers fearing insolvency also begin withdrawing their own deposits. Since banks never hold all of the depositors' money as reserves at any point of time, if a large number of customers begin withdrawing all their funds, the bank does become insolvent fast. This phenomenon was a central problem ...Download file to see next pagesRead More
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