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WHAT ARE THE INSTRUMENTS OF MONETARY POLICY?

WHAT ARE THE INSTRUMENTS OF MONETARY POLICY?. Dr. Ghassan F. Abu Al- soud. Paper money is issued by the Central Bank on the basis of computation of estimated demand for cash.

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WHAT ARE THE INSTRUMENTS OF MONETARY POLICY?

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  1. WHAT ARE THE INSTRUMENTS OF MONETARY POLICY? Dr. Ghassan F. Abu Al-soud

  2. Paper money is issued by the Central Bank on the basis of computation of estimated demand for cash. • Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income. • This is necessary because money is a medium of exchange and changes in its demand relative to supply, necessitate spending adjustments. • To conduct monetary policy, some monetary variables which the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-in order to affect the goals which it does not control. • The instruments of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector. The commonly used instruments are discussed below.

  3. Reserve Requirement: • The Central Bank may require Deposit Money 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 limit the supply of money. • The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public.

  4. Open Market Operations: • The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). • One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money.

  5. Lending by the Central Bank: • The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base.

  6. Re-discount rate • Some times it is called the minimum rediscount rate (MRR). • It is the Interest rate that central bank use to discount commercial papers for banks. • The discount rate is the rate used by banks to discount commercial papers to customers. • If the rediscount rate is less than discount rate this will motivate banks to discount commercial papers they own.

  7. The wider the difference between rediscount rate and discount rate the more banks is motivated to discount commercial papers. • This discounting will affect money supply by increasing it. • If the difference between rediscount rate and discount rate is narrower this will discourage banks to rediscount their comm. Papers.

  8. Example of rediscounting • Merchant Mustafa discounted a promissory note worth BD 4500 at National Bank of Bahrain at the rate of 6% and a maturity of 6 months. The National Bank of Bahrain rediscounted it immediately at the Central Bank of Bahrain at 5%. Extracts the followings:1 - How much Mustafa the merchant will take when he discount the promissory note ? Answer: calculate the discount amount as follows • 4500 × (0.06 × 6/12) = 4500 × 0.03 = 135 the discount amount then 4500 - 135 = 4365 dinars the amount Mustafa will take when he discount the promissory note. • 2- How much is the profit of Bank of Bahrain if it rediscounts the promissory note directly at Central Bank of Bahrain?Answer: The difference between the discount rate and the rediscount rate is 1% so profit = 4500 × (0.01 × 6/12) = 4500 × 0.005 = 22.5 BD3 - How much the National Bank of Bahrain will be paid by Central Bank?The answer: 4365 + 22.5 = 4387.5 BD4 - How much central bank will profit from the process?The answer: 135 - 22.5 = 112.5 BD

  9. Direct Credit Control: • The Central Bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions.

  10. Moral Suasion: • The Central Bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. • It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment.

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