Monetary policy is the responsibility of the Central Bank and involves variations in the level of the supply of money, the interest rates and availability of credit aimed at affecting the level of expenditure, employment and economic activity within the economy.
a. Illustrate and discuss the impact on real GDP when reserve requirement is increase by the Central Bank.
b. List and explain other tools used by the Central Bank to influence the economy.
a. When the reserve requirement is increased by the Central Bank, it means that banks are required to hold a higher percentage of their deposits as reserves. Reserves are the funds that banks keep on hand to meet withdrawals and other obligations. By increasing the reserve requirement, the Central Bank is reducing the amount of money that banks can lend out as loans.
This reduction in lending capacity has a direct impact on the money supply within the economy. When banks have less money to lend, there is less credit available for businesses and consumers to borrow and spend. This decrease in lending and spending will ultimately lead to a decrease in overall economic activity and expenditure.
The decrease in economic activity and expenditure will have an inverse effect on real GDP. Real GDP is a measure of the total output of goods and services produced in an economy adjusted for inflation. When there is a decrease in economic activity, businesses produce fewer goods and services, leading to a decrease in real GDP.
b. Other tools used by the Central Bank to influence the economy include:
1. Open market operations: This involves buying or selling government securities in the open market to influence the money supply. When the Central Bank purchases government securities, it injects money into the economy, increasing the money supply. Conversely, when the Central Bank sells government securities, it withdraws money from the economy, reducing the money supply.
2. Discount rate: The discount rate is the interest rate that the Central Bank charges commercial banks when they borrow funds. By increasing or decreasing the discount rate, the Central Bank can influence the cost of borrowing for banks. When the discount rate is increased, it becomes more expensive for banks to borrow, which can lead to a decrease in overall lending and spending.
3. Interest rates: The Central Bank can also influence interest rates in the economy. By adjusting the policy interest rate (often referred to as the "benchmark" or "base" interest rate), the Central Bank can influence borrowing costs for individuals and businesses. Lowering interest rates can encourage borrowing and spending, stimulating economic activity, while raising interest rates can discourage borrowing and spending, slowing down economic activity.
It is important to note that the impact of these tools on the economy can be complex and indirect. Central banks carefully monitor economic indicators and adjust these tools in response to changes in economic conditions.