Answer to Question #2585 in Macroeconomics for Ridwan
1) Reserve requirement. The Central Bank may require commercial banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limits the supply of money.& The assumption is that commercial banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public. That’s why when reserve requirement raises money supply in country decreases and vise versa.
2) Exchange Rate. The balance of payments can be in deficit or in surplus. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real exchange rate. The real exchange rate affects the current account balance because of its impact on external competitiveness. Though buying foreign exchange Central Bank increases the money supply in national economy, and selling it Central Bank increases the money demand.
3) Open Market Operations. The Central Bank buys or sells securities to the banking and non-banking public (that is in the open market). In the first situation Central Bank increases the money supply in the market and in the second – it tries to decrease the money demand.
4) Interest rate. Because the Central Bank& is the final provider of cash to the system it can choose the interest rate at which it will provide these funds each day. The interest rate at which the Central Bank supplies these funds is quickly passed throughout the financial system, influencing interest rates for the whole economy. When the Central Bank changes its dealing rate, the commercial banks change their own base rates from which deposit and lending rates are calculated. A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage the money demand rising The opposite occurs when interest rates are increased.
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