Monetary policy

Monetary policy tools are used by government to control the amount of money in circulation. When the government want to reduce the amount of money in the economy it sell security to the public at a higher rate than the market rate. Investors who want to take advantage of this high rate buy government bonds and treasury bills which has the effect of reducing money supply in the economy. Further more the government can direct banks to increase the lending rate thereby discouraging investors from borrowing funds.

However if investors become less sensitive to changes in interest rate then the objective of monetary policy would not be achieved and such policy would be ineffective in controlling the flow of money in the economy (mishkin, 2001). Question 5 The excess reserve held by bank does not earn any interest which means that the bank is incurring opportunity cost. The bank would have lend out that money and earn interest or invest such fund in marketable security and earn interest or dividend.

Therefore the bank is loosing interest and divided which is the opportunity cost of holding excess reserve. Money and banking 2 Question 6 The money multiplier is a ratio of change in money to change in bank reserve. It is used to indicate the magnitude of change in money supply resulting from an addition in reserve by banks. A simple money multipliers equation can be described as M = mR Where M = change in money supply m = money multiplier R = number of excess reserve. Therefore the money multiplier has an inverse relationship with excess reserve.

Where reserve increase by one unit then the money supply increase by m units. For instance where the money multiplier is 3 and we increase reserve by 2 units then the money supply should increase by 6 units. In looking at determinant of money multiplier then we can express the multiplier as m = ? (c,e,r) m = 1+ c r + e+ c Where m = multiplier c = current ratio r = required reserve ratio e = excess reserve ratio Suppose that c = 0. 75, r = 0. 1 and e = 0. 001 then the multiplier will be Money and banking 3

m = 1. 75 0. 851 = 2. 06 Suppose all other factors remain constant but e increases from 0. 001 to 0. 005. the effect that such increase will have on multiplier can be illustrated below m = 1. 5 0. 605 = 2. 48 When excess reserve increase relative to deposit it means that banks will have less fund to give loan which will cause a decline in deposit, money supply and fall in money multiplier. Question 7 The government can use open market operation (OMO) as one of it monetary policy tools to control money supply.

Through this method the government uses the discount rate to encourage or discourage investment. Where the government raises the discount rate above the market rate then more people will prefer to buy government security which has the effect of reducing the money supply in the economy (Poole, 1978). Money and banking 4 Reference Poole, W. (1978). Money and the economy a monetarist view. Reading, Mass. [u. a. ]: Addison-Wesley. Mishkin, F. S. (2001). The economics of money, banking, and financial markets. The Addison-Wesley series in economics. Boston, Mass. [u. a. ]: Addison Wesley.