sientify the four major instruments of monetary policy What

sientify the four major instruments of monetary policy. What are the four principal tools of monetary poliey? Explain how they can be used. What is the difference between the Federal Reserve Banks\' purchases of securities from the commercial banking system and those from the public? Give an example. Differentiate between expansionary and restrictive monetary policies. 9. Complete the accompanying table Level of output APG APS MPC MPS

Solution

8. Four major instruments of Monetary Policy:

1. Open market operation: Open market operation is the sale and purchase of government securities in the open market by the central bank. By selling the securities, the central bank withdraws cash balances from the economy. And, by buying the securities, the central bank adds to cash balances in the economy. During inflation, central bank sells government securities and reduce the money supply and on the other hand, during deflation, central bank buy government securities.

2. Cash reserve ratio: It refers to the minimum percentage of a bank\'s total deposits required to be kept with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law. When the flow of credit is to be increased, minimum reserve ratio is reduced and vice-versa.

3. Bank rate: The bank rate is the rate at which the central bank gives credit to the commercial banks. The increase or decrease in the bank rate is often followed by increase or decrease in the market rate of interest. Accordingly, the cost of credit changes the market. During inflation, the cost of capital is increased by increasing the bank rate. This reduces the flow of credit, as desired. On the other hand, during deflation, the cost of capital is reduced by reducing the bank rate. This increases the flow of credit.

4. Statutory liquidity ratio: Every bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets, called SLR. The rate of SLR is fixed by the central bank. To decrease the flow of credit, the central bank increases SLR and vice - versa.

Tools of Monetary policy:

1. Open market operation: Open market operation is the sale and purchase of government securities in the open market by the central bank. By selling the securities, the central bank withdraws cash balances from the economy. And, by buying the securities, the central bank adds to cash balances in the economy.

2. Reserve requirement: It is the minimum reserve that every commercial bank has to hold in the form of money of their deposits.

3. Discount rate: It is the minimum interest rate set by the Fed for lending money to other banks.

4. Federal Funds Rate: It is the interest rate at which depository institutions like banks lend their reserve balances to other depository institutions for overnight without any collateral security.

When Fed purchase securities from the commercial banks then it injects additional money in the economy as holding of commercial bank increases which increases the lending of bank and thus raises money supply by more amount. On the other hand, When Fed purchase securities from public then it will not increase money supply by amount as it is increased by purchasing from commercial banks.

Expansionary Monetary Policy includes decrease in reserve requirement, purchase of government securities, lower bank rate, lower liquidity ratio.

Contractionary Monetary Policy includes increase in reserve requirement, bank rate, liquidity rate and sale of government securities.