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2513 Mount Tabor, Chandigarh, Chandigarh, 60605

Section 1

1) What are the 3 tools of monetary policy? Name each tool and take me through conventional case brief structure  step by step, how each tool could be used to combat a recession.

The following are the three tools of monetary policy: reserve requirements, discount rates, and open market operations.

Reserve requirements are the part of deposits that commercial banks keep in the form of interest-free deposits in the Central Bank. The norms of the reserve requirements are set as an interest of deposit volume. Reduction of reserve norms during the period of economic recession stimulates the development of the business activity. In this case, the number of actual reserves in the accounts at the Central Bank will exceed the amount of reserve requirements; as a result, banks will be able to provide new loans and acquire securities. If the economy experiences a decline in production, the cost of loans reduces. At the same time, it contributes to the increase in money supply, which leads to the reduction in the interest rate and, accordingly, serves as a stimulus to the growth of investment, as well as real GNP.

Discount rate is the rate at which the Central Bank offers loans to commercial banks. Commercial banks loan from the Central Bank if there is a need to urgently replenish reserves or to exit from a difficult financial situation. The increase in discount rate informs that the Central Bank has the intention to pursue a contractionary monetary policy, as a rule, to combat inflation. The discount rate is considered to be a benchmark for establishing the interbank interest rate (the interest rate at which commercial banks lend to each other) and the interest rates at which commercial banks give loans to the non-banking sector of the economy (households and firms). If the Central Bank announces the increase in the discount rate, the economics reacts very quickly, money (loans) becomes "expensive", and, as a result, the money supply decreases.

Open market operations are the purchase and sale of government securities by the Central Bank at secondary markets. The purchase of securities by the central bank is used as a means of influencing the economic situation during the recession and aims at stimulating it. In fact, FED supplies banks with an abundance of cash resources that can be used for low-cost loans that expand consumer demand, as well as investments in the business. For this purpose, FED redeems government securities, thereby increasing bank money resources; interest rates on bank loans are decreasing, the amount of loans extended and the amount of money in circulation is increasing, which ultimately leads to the increase in consumer demand.

2) Open Market Operations are undertaken by the FOMC. Explain the FOMC and how Open Market Operations work? Your answer must include a discussion of the relationship between bond prices and interest rates.

Bond prices are very sensitive to changes in interest rates because interest rates more than all other indicators determine bond prices. The main task of the Federal Open Market Committee is to approve and change the interest rate. In order to decrease interest rates, FOMC increases the money supply by buying government bonds. If FOMC plans to raise the interest rate, it withdraws money from the sale by selling government bonds. The change in the interest rate, as a rule, has its benefits as well as drawbacks. When the interest rate grows, businessmen and ordinary consumers cut costs and stock prices rise. When the Fed reduces the interest rate, borrowing money becomes cheaper and people begin to spend more. The decrease in the Fed's interest rate may contribute to the growth of inflationary phenomena, while its increase leads to a decrease in business activity and the increase in demand for goods and services.

Section 2

1) Define the Current Account. Define the Capital Account. How do current accounts and capital accounts balance each other? Why is this essential?

The current account shows the result of the country’s interrelation with the rest of the world by means of export and import. In addition, it deals with net investment income and net transfer payments. The capital account reflects capital flows associated with the purchase or sale of tangible or financial assets. Current and capital accounts are tightly connected. The deficit of the balance of payments for the current account is covered by the sale of assets abroad or loans i.e. leads to an inflow of capital into the capital account. Conversely, the current account balance shows that there are surplus funds, and thus generates the export of capital abroad, i.e. leads to the outflow of capital on the balance of capital and credit flows. The balance between current and capital accounts is essential because each international operation involves the exchange of goods, services or assets between the countries. Both elements of this exchange always affect the amount of current account balances and capital flow accounts. Therefore, the balance of the current account and capital account must be zero.

2) Imports are often seen to threaten jobs and GDP growth. Exports are often seen to benefit jobs and GDP. Explain why each of these positions makes sense. Explain why these positions can be wrong; provide an example of both being wrong.

It has been observed that imports threaten jobs and GDP growth because if imported goods are cheaper than the ones provided by the domestic manufacturers, there is no demand in the domestic product, thus the domestic company will be at risk of closure. Exports are often seen to benefit jobs and GDP because the production and sales of quality products always have a demand with the overseas buyers, thus creating working places and increasing GDP. Yet these positions can be wrong. It is about so-called justified imports goods that cannot be produced in their own territory and without which the country's economy cannot function normally. These can be scarce energy resources (oil, gas, nuclear weapons), some types of raw materials, high technology equipment, etc. At the same time, export can harm a country’s GDP if, for example, a country sells abroad raw materials or mineral resources (oil, wood), which have a tendency to lessen or exhaust with time. Thus, when the source of resources disappears, working places disappear as well. In order to keep the balance in the country’s economy, it is essential to make sure that country’s export reimburses its import.

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