Explain the role of the following in correcting 'deficient' demand in an economy:
(i) Open market operations
(ii) Bank rate
Explain the role of the following in correcting 'deficient' demand in an economy:
(i) Open market operations
(ii) Bank rate
The situation of deficient demand exists when, at the full employment level, aggregate demand is less than aggregate supply. This creates the problem of involuntary unemployment. For tackling this problem, the level of aggregate demand needs to be increased for which, besides other things, the volume of credit should be increased.
(i) Open market operations refer to the sale and purchase of securities by the Central Bank. In a situation of deficient demand, the Central Bank buys securities in the open market and makes payment to the sellers. The money flows out of the Central Bank and ultimately reaches the commercial banks as deposits. This raises the lending capacity of the banks. People can borrow more and this will raise the aggregate demand.
(ii) Bank rate is the rate of interest which the Central Bank charges from commercial banks for giving them credit. However, the relationship between the rate of interest and demand for credit is inverse. Thus, when bank rate is increased, the rate of interest increases and demand for credit falls. Thus, in the case of deficient demand, bank rate should be lowered. This will lead to a fall in the rate of interest, finally leading to an increase in the demand for credit. This will raise aggregate demand.
The situation of deficient demand exists when, at the full employment level, aggregate demand is less than aggregate supply. This creates the problem of involuntary unemployment. For tackling this problem, the level of aggregate demand needs to be increased for which, besides other things, the volume of credit should be increased.
(i) Open market operations refer to the sale and purchase of securities by the Central Bank. In a situation of deficient demand, the Central Bank buys securities in the open market and makes payment to the sellers. The money flows out of the Central Bank and ultimately reaches the commercial banks as deposits. This raises the lending capacity of the banks. People can borrow more and this will raise the aggregate demand.
(ii) Bank rate is the rate of interest which the Central Bank charges from commercial banks for giving them credit. However, the relationship between the rate of interest and demand for credit is inverse. Thus, when bank rate is increased, the rate of interest increases and demand for credit falls. Thus, in the case of deficient demand, bank rate should be lowered. This will lead to a fall in the rate of interest, finally leading to an increase in the demand for credit. This will raise aggregate demand.
