Chapter 15: Problem 20

Explain how to use the discount rate to expand the money supply.

Short Answer

Expert verified

To use the discount rate to expand the money supply, a central bank can lower the discount rate, making borrowing more attractive for commercial banks. As commercial banks borrow more money from the central bank, they have more funds available to lend out to businesses and consumers. With an increased supply of funds, commercial banks may reduce the interest rates on loans, leading to businesses and consumers borrowing and spending more money. This increased economic activity results in the expansion of the money supply. It is essential for the central bank to monitor the impact on the economy to avoid potential risks, such as inflation.

Step by step solution

Understanding the discount rate and its impact on the money supply

The discount rate is the interest rate charged by central banks to commercial banks for borrowing money. A lower discount rate encourages banks to borrow more money from the central bank, which in turn increases the money supply, as banks have more funds to lend to businesses and consumers. Conversely, a higher discount rate discourages borrowing and reduces the money supply.

Reducing the discount rate to encourage borrowing

In order to increase the money supply, the central bank can lower the discount rate. This reduction in the discount rate makes borrowing from the central bank more attractive to commercial banks, as they will pay less interest on the borrowed money. When commercial banks borrow more money from the central bank, they have more funds available to lend out to businesses and consumers.

Commercial banks lending out the borrowed money

When commercial banks have more funds available as a result of borrowing from the central bank at a reduced discount rate, they can lend out more money to businesses and consumers. With an increased supply of funds, commercial banks may also reduce the interest rates on loans, making it more attractive for businesses and consumers to borrow money.

Businesses and consumers using borrowed funds

As businesses and consumers borrow money from commercial banks, they then use these funds to invest, purchase goods and services, or expand their businesses. These actions lead to increased economic activity, higher demand for goods and services, and more money circulating in the economy. As more money is spent, the overall money supply in the economy expands.

Monitoring the impact on the economy

For a central bank to effectively use the discount rate as a tool for expanding the money supply, it needs to carefully monitor the impact on the economy. If the money supply expands too quickly, it could potentially lead to inflation and other economic risks. By monitoring economic indicators such as inflation, GDP growth, and unemployment, a central bank can adjust the discount rate as needed to achieve its policy goals.