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# Central bank/Monetary policy

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Central banks make key decissions regarding monetary policy. The main targets are:

Setting of interest rates - the cost of money

The cost of money is controlled by the means of setting interest rates. Those are the rates at which commercial banks can borrow money from the central bank. It is a very delicate instrument - only minute changes either way can cool down or overheat the economy. Low interest rates make loans cheaper, thus increasing consumer spending and the investments made by companies. A higher interest rate, on the other hand, might tend to lock up liquidity in the financial system by making saving more attractive.

Controlling the volume of credit

Central banks can influence other banks' lending by setting a liquid assets ratio. This implies that banks have to deposit a certain amount of their liquid assets at the central bank. A high ratio will reduce the credit volume in the economy.

Management of the money stock

In theory the bank could influence the volume of money by expanding or contracting the supply of cash (ie notes and coins - the central bank is the only institution which is allowed to issue currency.) In practice, however, it is very difficult for the bank not to supply the cash that other banks are demanding, so that it is not an effective method of restricting supply. The reverse is not true - expanding the issue of cash might very well lead to an increase in money supply, potentially fuelling inflation. This is very often the case in developing countries, where central banks are often forced by the government to throw on the printing press and supply it with money. The result is a high rate of inflation or even hyperinflation?.

A stable exchange rate

By actively intervening (buying and selling) on the foreign exchange market the central bank can influence the exchange rate of the national currency. The goal, however, is to keep the exchange rate stable in order to preserve the equilibrium in the [balance of payments]? and to upkeep consumer confidence. Interest rates can also be used to control the exchange rate - a high interest rate will cause an influx of investment capital into the country and vice versa.

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Last edited June 10, 2001 4:16 am (diff)
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