Explain the role of the following in correcting 'excess demand' in an economy:
(i) Bank rate
(ii) Open market operations
Explain the role of the following in correcting 'excess demand' in an economy:
(i) Bank rate
(ii) Open market operations
The situation of excess demand exists when, at the equilibrium level, aggregate demand is more than aggregate supply. This generates inflationary forces and there is no increase in real output. Therefore, the situation needs to be rectified by reducing the level of aggregate demand. For that:
(i) Bank rate is that rate of interest at which the central bank lends to commercial banks. To correct excess demand, the central bank can raise the bank rate. This forces commercial banks to increase lending rates. This reduces the demand for borrowing by the public for investment and consumption. Thereby, aggregate demand falls.
(ii) Open market operations refer to the sale and purchase of securities by the central bank in the open market; excess demand refers to AD exceeding AS at the full employment level of income. In this situation, the central bank can sell securities receiving payments from its buyers. The money flows out of the commercial banks into the central bank. This reduces the lending capacity of the banks and, in turn, reduces aggregate demand.
The situation of excess demand exists when, at the equilibrium level, aggregate demand is more than aggregate supply. This generates inflationary forces and there is no increase in real output. Therefore, the situation needs to be rectified by reducing the level of aggregate demand. For that:
(i) Bank rate is that rate of interest at which the central bank lends to commercial banks. To correct excess demand, the central bank can raise the bank rate. This forces commercial banks to increase lending rates. This reduces the demand for borrowing by the public for investment and consumption. Thereby, aggregate demand falls.
(ii) Open market operations refer to the sale and purchase of securities by the central bank in the open market; excess demand refers to AD exceeding AS at the full employment level of income. In this situation, the central bank can sell securities receiving payments from its buyers. The money flows out of the commercial banks into the central bank. This reduces the lending capacity of the banks and, in turn, reduces aggregate demand.
