Introduction
The economic objectives of growth, stability and development can be achieved in an economy through two major forms of economic measures, monetary measures and fiscal measures. Thus monetary policy and fiscal policy forms the two primary pillar of economic action by the state.
Tools of Monetary Policy
Monetary policy achieves the objective of price stability and growth by controlling the monetary variables in the economy. The monetary authority of the country, the central bank, controls the money supply and demand in the economy through various monetary tools at its disposal. These tools include the interest rate; cash reserve ratio and open market operations . In times of high growth and employment rates the economy tends to get heated up with an inflationary pressure building up on the economy. The central bank at these times takes tight money policy. The interest rate is increased so that credit flow in the economy is squeezed out to some extent which reduces aggregate demand and thus reduces the price level. Another way of controlling inflation is to increase the cash reserve ratio. The cash reserve ratio is the proportion of total deposits of a commercial bank that the commercial bank is required to keep in the form of cash with the central bank. During an inflationary situation the central bank increases the CRR . The commercial banks are forced to keep a higher proportion of money in the form of cash and can advance fewer loans. Thus credit flow in the economy is reduced resulting in lower prices. The central can also take recourse to open market operations. Open market operation of the central bank involves buying and selling of government bonds in the open market. In times of inflation the central bank sells bonds in the market, so the real balance in the economy is reduced. With reduced money supply in the economy the purchasing power is reduced thus putting a downward pressure on prices.
In the occasion of an economic downturn the central bank follows an easy money policy. During a recessionary phase when income and employment is low the central bank takes recourse to monetary expansion. The central bank that is the Fed reduces the interest rate or the bank rate. If the lending rate is reduced there will be more credit flow in the economy. Aggregate demand will increase with increased investment. This will induce more output and employment will also increase subsequently. In a recessionary situation the central bank or the Fed in the US may also reduce CRR which will allow the commercial banks to give out more loans. The central bank may also buy bonds in the open market. This action injects more money into the economy thereby boosting growth.
Demand for Money
We have discussed the monetary policy tools and measures taken by the Fed to maintain growth stability and have control on inflation. But to understand the effect of these measures on the economy we need to understand the factors that affect the money demand. The classical economists express the money demand function as:
MV = PT
Where, M: Real money balance
V: velocity of transaction
P: Price level
T: Transactions
This is also known as the equation of exchange. We can see from the equation that the quantity of money held by people depends on the price level, volume of transactions and the velocity of transaction. If the price level increases the money held by the people also increases. Increase in transactions also increases the demand for money. But if velocity of transaction increases money demand gets reduced.
Alternatively, money demand is also viewed as a function of income and the rate of interest. Increase in income increases demand for money. There is a negative relationship between demand for money and the rate of interest.
Conclusion
The central bank influences the growth and price level in the economy by controlling the demand and supply of money. It can control the supply of money by open market operations and also the CRR. It uses the rate of interest as the tool to affect the demand for money.
References
Branson, W. H. (1989). Macroeconomic Theory and Policy. McGraw Hill.
Mankiw, G. (2013). Macroeconomics. Macmillan.
