The monetary policy involves all the actions of the central bank on the economy of any country. The monetary affect the growth of a country. The monetary policy also has an influence on the interest rate of a specific country. It is a regulatory measure by the central bank. This paper will critically look on the monetary policy and economic models that are applied to make the monetary policy successful.
There are certain goals of the monetary policy that have been developed over time. The goals were developed by Federal Reserve act. These goals are; promotion of price stability, ensuring that there is full employment in the economy and stability of interest rates. The policies have been ...view middle of the document...
The depository institutions keep on trading these balances that are in the Reserve banks. The Federal Reserve exercises its control to influence supply and demand of balances in the reserve banks (Bofinger,2001).
There are certain tools of the monetary policy that make this policy effective. One of the tools is creation of the money by the banks. Money is printed by the central banks of a country but the commercial banks create credit that is available to all the interested parties. Credit is created from the balances that have been deposited by other people and the banks get income inform of interest charged. The amount that the bank can lend depends on the reserve ratio. The reserve ratio is set by the central bank. The reserve ratio is the amount of money that must be kept by the bank in an account opened I central bank. This amount cannot be given as credit. The bank must keep this amount for the purpose of those who make withdrawals. It the banks create credit with all the deposits it means that those who have accounts cannot make withdrawals (Mankiw,2005).
The discount rate is another tool of the monetary policy. This is the amount that is charged to the financial institutions by the Federal Reserve. The central bank charges other financial institutions in form of the discount rate. The discount rate affects the amount of interest rates that will be charged by these institutions. If the discount rate is high, the interest rate charged by the central banks also becomes higher. The central bank controls money supply by using the discount rate. The discount rates depend with the current situation of the country. When the central bank wants to increase money supply in an economy, the discount rate is set at a low level (Walsh, 2010).
When the discount rate is low the financial institutions lower the interest rates that they charge their customers. The customers are able to get loans easily from the financial institutions at the low rates. It the central bank wants to lower the money supply in a country, the discount rate is increased. With a higher discount rate, the banks increase the interest rate. Many people will not borrow from the banks because of the high interest rates (Bofinger,2001).
Open market operations is another effective tool of the monetary policy. Open market operations involve buying and selling of government securities. The value of the securities depends on the interest rates. According to Keynesian theory, there is an inverse relationship between the prices of the securities and the interest rates. The prices of the bonds are high when the interest rates are low. When the central banks want to increase money supply, the central bank buys securities that are held by people. People sell their securities to the central bank and get money in return. This increases money supply and most of the people in the economy hold larger balances (Mishkin, 2007).
When the central bank wants to lower the amount of interest rates, the...