Page 243 - DECO402_Macro Economics

Macroeconomic Theory

Notes 2. Open Market Operations: Open market operations are related to sale purchase of securities
by the central bank in money market. When prices start rising and there is a need to stop them
then central bank sells securities. Reserves of commercial banks reduce and they are not left
in the situation to give loans to traders’ class. Further investment is discouraged and increase
of prices stops. Opposed to it, when forces of recession start in the economy, then central
bank purchases securities. Reserves of commercial banks increase. They give more loans,
investment, production, employment and demand increases and falling of prices stops.
3. Changes in Reserve Ratios: Keynes had suggested this tool in his book Treatise of Money
and United States of America was the first country which adopted it form of a monetary
method. According to law each bank has to keep some percentage of its deposit in its godown
in reserve and some percentage with the central bank. When prices start rising then central
bank increases the reserve ratio. Banks have to keep more amounts with the central bank.
Their reserves reduce and they give fewer loans. Unfavourable effect is there on the quantity
of investment, production and employment. In situation opposite to it, when reserve ratio
is reduced, then reserves of commercial banks increase. They give more loans and there is a
favourable effect on the economic activity.
4. Selective Credit Controls: Selective credit controls are brought in use to control special type
of credit with specific objectives. For controlling speculative activities inside the economy
these often take the form of changing margin requirements. When in economy or in specific
areas, there is fast speculative activity in some goods and prices start to rise then central banks
raise margin requirements on them. Result is this that those taking loan are given less money
in form of loan on specific securities. For e.g. meaning of increasing margin requirement to
60 percent is that to the pledger of securities worth ` 10,000, 40 percent of its value (` 4000)
will be given as loan. In situation of recession in specific fields, central bank by reducing
margin requirements encourages loan acceptances.

Conclusion

For an effective analytic monetary policy it is important that bank rate, open market operations,
reserve ratio and selective credit control measures are adopted together. But all monetary theorists
have accepted that (i) in depression when trade confidence is at its weakest state, then success of
monetary policy is zero; and (ii) it is successful against inflation. Monetarists say that in comparison
to fiscal policies, monetary policies have more flexibility. They may be applied soon.

Did You Know? By monetary policy is meant credit control measures adopted by the central
bank of a country.

27.4 Expansionary Monetary Policy

Expansionary (or cheap) monetary policy is used to come out of the deflationary gap or recession.
When there is a decline in consumer demand of goods and services and trade demand for investment
goods then deflationary gaps emerge. Central banks start expansionary monetary policy which makes
the conditions of credit markets easy and brings an upward change in the entire demand.
For this objective central bank purchases government securities from open market, reduces reserve
requirements of member banks, reduces discount rates and through selective credit measures

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