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Monetary policy - Coggle Diagram
Monetary policy
Discount rate
Is an administered, rather than a market, interest rate.
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When changed, may indicate a monetary policy shift.
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Demerits
Encourage bank to take more risks. Created moral hazard. problem. Other financial institutions may also take similar actions because they too expect the
central bank’s “bail out”.
When the central bank sets the discount rate at a particular level, large fluctuations will occur in the spread between market interest rates and the discount rate as market interest rates and the discount rate as market interest rates change.
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Effect
When the discount rate rises, the public may interpret this as a signal that the central bank is moving to a more contractionary policy, even if that is not the case.
The increased discount rate would increase the cost of borrowing from the central bank (cost effect)
Reserve requirement
Reserve requirement is a regulation making it an obligation for depositing institution to keep a
certain fraction of their deposits in an account with the central bank or as cash in their vault.
A rise in reserve requirement reduces the amount of deposits of
monetary base and will lead to a contraction of money supply and vice versa.
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Effect
Inflation
Increase reserve requirement, decrease cash reserves of bank, ability to give loans and purchasing activities
Deflation
Decrease reserve requirement, decrease cash reserves of bank, ability to give loans and purchasing activities
Merits
To control the money supply and interest rates, reserve r requirement policy affects
all banks equally.
Have a powerful effect on the money supply. Small changes in the reserve
requirement will result in large changes in the money supply.
Demerits
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The raising the reserve requirements can cause immediate liquidity problems for banks
with low excess reserves.
The change in reserve requirements is too powerful tool because small changes in the money supply and interest rates are hard to engineer by varying reserve requirements.
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