Tuesday, September 22, 2009

The channels through which central banks work

Later on, we will examine in some detail how the Federal Reserve System affects domestic and international economic conditions. It is useful at this point, however, to give a brief overview of the channels through which modern central banks influence conditions in the economy and financial system. Central bank policy affects the economy as a whole by making:
1-Changes in the cost and availability of credit to businesses, consumers, and governments.
2-Changes in the volume and rate of growth of the nation's money supply.
3-Changes in the wealth of investors as reflected in the market value of their security holdings.
The central bank has a number of policy tools at its command which it can use to influence interest rates, the prices of securities, and the level and growth of reserve in the banking system. In the United States the principal policy tools used by the central bank are open market operations, changes in required reserves held by depository institutions, and changes in the discount rate on central bank loans. In turn, changes in interest rates, security prices, and bank reserves influence the cost and availability of credit. If borrowers find that credit is less available and more expensive to obtain, they are likely to restrain their borrowing and reduce spending for both capital and consumer goods. This results in a slowing in the economy's rate of growth and perhaps a reduction in inflationary pressures. Second, if the central bank can reduce the rate of growth of the nation's money supply, this policy will eventually slow the growth of income and production in the economy due to a reduction in the demand for goads and services. Finally, if the central bank raises interest rates and therefore lowers security prices, this will tend to reduce the market value of the public's holdings of stocks, bonds, and other securities. The result is a decline in the value of investors´ wealth, altering borrowings and spending plans and ultimately influencing employment, prices, and the economy's rate of growth.

1 comment:

Dorothy said...

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