Money and Banking
Monetary Policy
If the central bank has an interest rate target, why would an increase in the demand for bank reserves lead to a rise in the money supply?
An increase in the demand for reserves will raise the central bank's fund target. So as to preclude such a possibility, the central bank will purchase bonds, thus increasing the amount of non-borrowed reserves. As a result, this shifts the supply curve for reserves to the right, thus maintaining the central bank's funds rate from increasing. The open market purchase will at that time instigate a rise in the monetary base and the money supply.
MS1 MS2
Interest Rate (4%) L2 (Y1)
L1 (Y1)
M/P
As indicated in the diagram, the assumption is that the central bank targets an interest rate of 4% per annum. Considering this, the money demand increases are offset by a change in the money supply. In the diagram above, the initial money supply level is indicated by MS1. The increase in demand level causes a shift of the money demand curve to L2 (Y1). This instance has a tendency of causing the interest rate to increase. When the central bank perceives the increase in the interest rate, it goes on to increase the money supply in reaction to decrease the interest rate back to its targeted rate, in this case assumed to be 4%. If the central bank succeeds in doing this, it causes the money supply to increase to MS2 (Schwartz, 2008).
II. The benefits of central bank lending to banks (rediscount operations) to prevent bank panics are obvious. What are the costs?
The costs are that banks that deserve to go out of business because of bad and ineffective management might survive owing to central bank discounting to preclude anxieties. This may result in an incompetent banking system with several ineffectively operated banks.
III. Compare the use of open-market-operations, central bank lending facilities (rediscounting), and...
The central bank has total control over the volume. Compare this to central bank lending facilities, in which the Fed sets the price at which to borrow but does not have direct control over how much the banks can actually borrow. Secondly, the open market operations are flexible and precise, as they can be used to sanction both small changes and large changes in the monetary base. Open market operations are also easily reversible. This is because the mistakes can be promptly rectified and corrected in a manner that would not have been conceivable with the other tools of monetary policy such as reserve requirements or discount lending. In addition, the open market operations can be implemented quickly. This is because there is no delay in terms of administration for conducting the open market operations. The orders go to the trading section in New York and are implemented instantaneously. With regard to rediscounting, the changes in the discount rate has to be proposed by the central banks or the Fed prior to being approved or sanctioned by the Board Governors. As a result, it is for this particular reason that rediscounting is considered neither easily reversible nor quickly implemented (Ireland, n.d).
As for reserve requirements being a monetary policy tool, they can be reversed, however, not as easily as they have to attain approval from the Congress if there are large changes in reserves. Consequently, large changes in the reserve requirements cannot be undertaken promptly and easily. In addition, if a bank holds a very minimal amount of excess reserves and the fed increases the required reserve ratio, then the bank is forced to quickly be in acquisition of reserves…
