Answer to Question #165010 in Economics for Lilian

Question

1.Explain of the role of the banking system in the effective implementation of monetary policy

Answer 1

The central bank has a number of tools at its disposal to achieve intermediate goals, such as bank reserves, money supply, and interest rate. These operations, through appropriate instruments, allow achieving the final indicators of a healthy economy: low inflation, increased output, and low unemployment.

In regulating the money supply, the Central Bank should focus on achieving intermediate goals. They are economic instruments that, regardless of banking instruments or ultimate regulatory objectives, stand as intermediate mechanisms between instruments and objectives.

If the Central Bank wants to influence the final objectives, then first of all it changes the banking instruments, which allows it to control the terms of lending or the supply of money through influence on intermediate Objectives.

The task of reducing inflation rates provides for mandatory control over the growth of the money supply. In particular, the growth of the money supply should be limited to a level sufficient to maintain the target level of growth in nominal GDP under the proposed change in the velocity of money circulation (defined as the ratio of nominal GDP to the volume of the money supply).

Central banks cannot exercise direct control over the growth of the money supply. And yet they have the opportunity to indirectly influence its growth by controlling the growth of the monetary base. The base of the money supply, in other words - reserve money, is defined as the total amount of cash in circulation and the reserves of individual banks at central banks. Such reserves are set either in accordance with legal requirements for the availability of reserves (required reserves) or exceed the required level (excess reserves). The money supply base is linked to the total money supply through the so-called money multiplier. The money multiplier is the ratio of the money supply to its base and determines the relationship between a given change in the volume of the money supply and the corresponding change in the money supply itself. For example, a multiplier of two means that an increase in the base volume by 200 million souls will lead to an increase in the money supply by 400 million souls.