Answer to Question #212870 in Macroeconomics for Gina tevi

Question

Explain the THREE instruments of monetary policy. With the use of appropriate economic models, explain and illustrate how the Central Bank can achieve an increase in real GDP with the use of three of the monetary policy instruments you discussed.

Answer 1

Solution:

The three instruments of monetary policy are:

1.). Reserve requirements – These are the amount of funds that banks are required to hold as a reserve with the central bank in order to ensure that they can meet their liabilities in case of emergency withdrawals. It is an instrument used by the central bank to increase or decrease the money supply in the economy and impact interest rates.

 

2.). Open market operations – This is a practice of purchasing and selling treasury securities and bonds in the open market to regulate or control the money supply. It is an instrument that is used to manipulate interest rates and regulate the money supply in the economy. The government purchases treasury securities to increase money and sells them to reduce the money supply in the economy.

 

3.). Discount rate – This is the interest rate charged by the central bank to other banks and financial institutions to borrow at its discount window for loans of reserve funds. The instrument is used to combat recession or inflation by increasing or reducing the discount rate, which manipulates banks borrowing costs and thus the rates that they charge on loans.

 

Using the reserve requirements instrument, the central bank can achieve an increase in real GDP by reducing reserve requirements, hence the lending capacity of the bank increases, there is a reduction in interest and investment increases. Therefore, high investment leads to an increase in the level of real GDP of the nation.

 

Using an open market operations instrument, the central bank can achieve an increase in real GDP by purchasing securities from the open market, which releases funds into the market. This increases the lending capacity of banks; hence the money supply increases. This further leads to a decrease in interest rate, which raises investments, hence raising the real GDP of the country.

Using a discount rate instrument, the central bank can achieve an increase in real GDP by reducing the discount rates, hence there will be an increase in money supply, which ultimately reduces the interest rate. The investment level will increase which will ultimately lead to an increase in the real GDP of the country.