Tools of Monetary Policy - Essay Example

We consider these one by one in what follows. i) The required reserve ratio To understand the operational mechanism of this particular monetary policy tool, it is imperative to understand what the monetary base of an economy is. Essentially, the monetary base of an economy is defined as being the sum total of all cash holdings and reserves in the economy, i.e., the monetary base MB = C+R where C = currency/checkable deposits and R = total reserves. Further, R = RR+ER where RR is the required reserves and ER is the excess reserves.

Required reserves are determined through the required reserve ratio (r) which is set by the central bank. The central bank sets the ratio of total deposits that commercial banks and other financial lending institutions have to hold as reserves. The excess reserves are the reserve holdings maintained by these banks for liquidity concerns or prudence over and above the stipulated required reserve holdings. The required reserve ratio is the policy tool by regulating which the central bank can control the amount of excess reserves and thus loanable funds of the banks.

Thus by controlling these reserves the money supply in the economy can be regulated. If the central bank intends to undertake expansionary monetary policy it can do so by relaxing the reserve requirement and consequentially increasing the amount of loans that can be made in the economy. If on the other hand it needs to conduct contractionary monetary policy, it can do so by making the reserve requirement more stringent. ii) The discount policy 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. Discount policy affects the money supply of an economy through two channels: first, by affecting the discount rate on loans and thus in turn affecting the amount of loans indirectly and secondly, by altering the amounts of the short term loans directly. In case of the first channel, that is changing the discount rate, this may or may not have an impact on money supply depending on the position of the demand for reserves (RD).

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 equilibri