Question

Explain the role of the following in correcting ‘excess demand’ in an economy:

(i) Bank rate.

(ii) Open market operations. 

Answer 1

(i) Bank Rate as an Instrument to Correct Excess Demand

Bank rate is the rate at which the central bank provides loan to the commercial banks. To control excess demand, the central bank increases the bank rate. A rise in the bank rate increases the cost of borrowing for the commercial banks from the central bank. The commercial banks in turn raise the lending rate (the rate at which they provide loans) for their customers. This rise in the lending rate reduces the borrowing capacity of the public, thereby, discourages the demand for loans and credit. Consequently, the level of Aggregate Demand in the economy falls and excess demand is curtailed.

(ii) Open Market operations as an Instrument to Correct Excess Demand

Open Market Operations refer to the buying and selling of securities either to the public or to the commercial banks in an open market. To curtail excess demand the central bank sells securities in the open market. By selling the securities in the open market, the central bank withdraws excess money from the economy. This results in a lower Aggregate Demand in the economy and excess demand is controlled.