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MONEY AND BANKING - Assignment Example

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The central banks around the world set a target interest rate to influence growth and control inflation. The interest rate target i.e. GDP growth rate and inflation rate are incumbent on the money supply of the economy. Central banks across the world such as the US Federal…
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Download file to see previous pages the lending rate or the reserve requirement, which will allow banks to borrow funds at a lower rate from the central bank and also increase their own fund capacity. Banks borrowing at lower rates will pass the benefit to its client, resulting in lower lending rates of bank. If the cash reserve ratio (CRR) falls, the commercial banks will have to keep a lesser amount of reserve in the central bank. Therefore, they will pass the reserve to their customer as loans through a lower lending rate and demand for loan will also be increased, which directly increases the demand for reserve of the commercial banks to their central bank. It implies that there will be a credit growth, i.e. more loans are offered at a low interest rate. The credit expansion will lead to increased borrowing by corporate and retail segments for investment purposes (Mishkin, 2007). Money borrowed by companies will be invested in their business expansion that leads to increased money supply in the economy. The retail segment borrowing also lead to increased money supply as they borrow funds to buy homes, cars, home decor, etc that leverages these sectors to produce more. This results increased growth. Usually interest rate target and money supply are inversely related i.e. if interest rate is lowered, demand for bank reserve will increase and accordingly money supply will rise through lower lending rate of the commercial banks (Gowland, 2013).
The above figure represents the effect of interest rate on money supply in an economy. The x axis shows the interest rate and the y axis represents the quantity of money supply. With given level of interest rate of 7% the MS line is the red line which intersects with the money demand line MD. The MD follows the general rule of a demand curve i.e. downward sloping. When the interest rate is reduced to 6%, the MD rises, which pushes the money supply line to a new equilibrium. There is a shift in the MS line from red to ...Download file to see next pagesRead More
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