Chapter 15.2, Problem 1R

To determine

To evaluate: The significance of loose money policy, tight money policy, fractional reserve banking and reserve requirements.

Explanation of Solution

Loose monetary policy is used when there is recession in the economy due to lack of effective demand and a reduced volume of total money in economic circulation. Thus, an apex bank would adopt various ways and means of injecting more money into the economy by using tools such as lowering interest rates, lowering the minimum reserve rate to be kept by commercial banks towards central banks, lowering the borrowing rates between banks themselves, etc.

Tight monetary policy is used when economic inflation rate is high due to higher circulating money. Therefore, an apex bank will follow various ways and means of extracting excess capital from the economy by using instruments such as rising interest rates, selling securities in the open market and to commercial banks, raising the minimum reserve rate to be held by commercial banks against central banks, raising the borrowing rates between banks themselves etc.

Fractional reserve banking is a scheme in which only a percentage of bank deposits are backed up and available for withdrawal by real cash on hand. It is achieved to boost the economy potentially by freeing up lending money.

Reserve requirements are the quantity of cash that banks will have, at the nearest Federal Reserve Bank or in their vaults, in accordance with their clients' deposits. Set by the Fed governors, reserve requirements are one of the three chief tools of monetary policy the other two are open market operations and the discount rate.

Economics Concept Introduction

Introduction: Monetary policy includes the process of drawing up, announcing and implementing the central bank, currency board or other competent monetary authority of a country's action plan which regulates the amount of money circulating in the economy and the channels through which new money is provided.