Quiz 13: Monetary Policy: Conventional and Unconventional

Business

Importance of central bank The central bank is very important in the modern industrial economy because of the following reasons: The price fluctuation affects the demand for goods, which affects the output, employment, and income in the modern industrial economy. This in turn ultimately leads to a disturbance of equilibrium in the economy. Sometimes, the extreme fluctuation in the price level collapses the economy. To prevent this, the central bank controls the price level through money supply and interest rate. The central bank controls the money supply by controlling the commercial banks. In the modern industrial economy, all the transactions are done through the banks. If the banks are efficient, it smoothens the industrial growth. Central bank ensures the efficiency of commercial banks by continuous monitoring and controlling them. Central bank rescues the commercial banks from bankruptcy.

Assume there is $120 billion of cash and half of this cash is held in bank as required reserve img . It means the required reserve is $60 billion ($120 billion/2). The size of money supply can be calculated by using the following formula: img ……(1) To find the size of money supply at 10 percent required reserve ratio, substitute the respective values in Equation (1): img Hence, the size of the economy will be img . To find the size of money supply at 12.5 percent required reserve ratio, substitute the respective values in Equation (1): img Hence, the size of the economy will be img . To find the size of money supply at 16.67 percent required reserve ratio, substitute the respective values in Equation (1): img Hence, the size of the economy will be img .

Reasons for central bank independence Central bank controls inflation through money supply in the economy. Political parties will pressurize the central bank to increase the money supply in the economy at the time of election to ensure their vote bank. This leads to inflationary situation in the economy. To avoid this kind of unwanted inflationary situation, central bank should have independence. Argument against the central bank independence When the central bank acts independently, then the well-being of the citizen can be affected. Because the economist, monetary authorities, and central bank policy makers are not elected by the people, they would not bother to please the people rather they focus on the stability in the economy. Consequently, this may affect the well-being of the people. Political parties are more concerned about the people's well-being to sustain their vote bank. Therefore, the monetary policies that affect the public's well-being will be curtailed by the political parties, and these policies will be changed in favor of the people. Because of these reasons, some economists hold the view that the independence of central bank will harm the well-being of the people. To ensure public well-being, like fiscal policy, the government should intervene in monetary policy decisions taken by the central bank.