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Monetary policy is an example of macroeconomic policy that is undertaken in pursuit of manipulation and control of macroeconomic variables such as GDP, BOP, and employment among others. This manipulation is done to achieve macroeconomic goals. Monetary policy, therefore, involves control and manipulation of supply of liquidity and also credit supply to the economy. This policy may be used to increase or decrease supply of liquidity. These calls for expansionary measures when the economy is experiencing a depression or recession to germ start the economy. When the economy is experiencing inflation, there is a need to reduce economic activities thus contractionary measures.
Monetary tools include: OMO (open market operations). This is the sale and buying of government securities such as bonds, shares, treasury bills among others. Selling or buying of securities will depend on the performance of the economy. When the country’s economy is experiencing inflation, the central authority through its Central Bank, tend to reduce liquidity in the economy. This is by reducing the flow of money that is in the hands of the citizens within the economy. The government sells its securities to the public. By so doing, the government reduces the amount demanded speculative purposes. This will control the economic performance and, hence, inflation. When the economy is underperforming i.e unreasonable levels of unemployment. The government buys securities thus injecting money to the public .This leads to increased liquidity in the economy. This will increase economic performance thus increasing employment opportunities (Fellner, 1946).
It is a requirement by the Central Bank for all commercial banks to have a certain amount reserved in Central Bank’s accounts. This money held in CB’s account is called the reserve ratio. The Central Bank has the power to manipulate the reserve levels depending on the performance of the economy. When the economy is underperforming, the reserve requirement is reduced thus enabling commercial banks to give more credit to the public. This will boost the economic performance. Similarly, if there are high levels of inflation the CB raises the reserve ratios. This reduces the commercial bank's ability to give credit to the public. This will in turn lowers liquidity levels in the economy.
Discount rate is another tool used by the Central Bank to control flow of money in the economy. This is by either lowering or raising discount rates. When there are high levels of liquidity in the economy, the government tend reduce credit flow in the economy. This is by raising the discount rates thus making credit expensive to the public. It may also lower the discount rate when there is underperformance of the economy. This will allow commercial banks to give credit at a lower interest rate to the public (Hodgman, 1974).
It is a requirement to any commercial bank by the central bank to have enough liquidity in their accounts to cater for their daily transaction. This is to ensure that their customers withdraw at their will. Central bank controls this requirement by either raising or lowering it depending on the economic performance.
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