Monetary policies and how they affect various sectors of the economy Term Paper

Monetary policies and how they affect various sectors of the economy - Term Paper Example A proper monetary policy is essential for the growth of the economy. The rate of interest and the inflation rate in the economy are the major factors which would determine what monetary policy would be implemented in the economy. The rate of interests existing in an economy is under the control of the central bank. The monetary policy is governed by the principles of demand and supply. In order to control to taper the amount of liquidity in the economy the central bank would increase the rates of interest of the bonds. As a result people would cut down on their spending and would park their funds in the bonds. This is done because the opportunity cost of spending would be very high. The aggregate demand as a result would come down and therefore the total production of the economy would come down. This would lead to a reduction in the amount of liquidity in the economy. On the other hand when the central bank wants to increase the amount of liquidity it reduces the rates of interest. As a result the people stop keeping the money in the banks and start spending. Thus the amount of liquidity in the economy increases. Thus through the conduct of the monetary policy the central bank not only controls the money market in the economy but also influences the commodity market. This happens because the aggregate demand of the economy would depend on the amount of money that the individuals have with them for spending. The central bank however does not come into direct contact with the general public. However, they regulate the money supply through interaction with the commercial banks. The inductive effect falls on the common people (Mankiw 482). The apex banks generally change the short term interest rates more frequently which affect the long term rate of interests. The central bank would take the help of various tools to tackle the monetary policy of the country. These tools have been explained subsequently. Open Market Operations The most popular tool used by the cen tral bank of a country is through the buying and selling of the bonds and government securities. This method helps the bank to increase or decrease the amount of liquidity in the economy depending on the inflationary pressures. The short term interest rates are manipulated by the central banks and thereby influencing the supply of money in the economy. When the central banks want to increase the amount of liquidity in the economy it goes to the open market and buys the government securities. The cash going out of the fund of the central bank actually comes out into the economy thereby increasing the monetary base. On the other hand when the central bank wants to reduce the money supply it sells the bonds or the securities in the market and the money comes into the possession of the central bank. The monetary base of the economy gets reduced and thereby liquidity is controlled by the central bank (Arnold 311). The chief reasons for conducting such open market operation are to control the level of inflation in the economy. However, the government takes the help of the debt instruments for conducting this technique. These instruments are generally the short term ones. Changes in Reserve Requirements Every bank operating in an economy has to maintain necessary reserve requirements with the central bank of the country. Being the apex body of all the banks the central bank is the regulatory controller of the commercial ba