Explain the different roles played by (i) the central bank, (ii) Essay

Explain the different roles played by (i) the central bank, (ii) depository institutions, and (iii) depositors in the determina - Essay Example For example, there is a strong proof that when money increases rapidly in an economy, there develops a direct relation between money-supply and long-term price inflation. On the other hand, a decrease in the level of money supply in a country leads to a decrease in economic activity, tightened spending levels and a fall in consumer demand. The quantity theory of money states that money supply has a relationship that is directly proportional in nature to the price level (Friedman, 1956). Different institutions have different but correlated roles to play in the determination of money supply in a country and the global economy. Examples of such institutions are the central bank and depository institutions. Depositors also have a part to play in this. Roles of the central bank Every country has a central bank that monitors and determines money supply in the country’s economy. In the US, the money supply is determined by the US Federal Reserve, the central banking system of the US. Its role is to foster economic growth in the US by regulating the actions of private banks and stabilizing the money supply. The Federal Reserve, also known as Fed, uses the expansive monetary policy as a guide in expanding the US money supply (Shin, 2009). Using the expansive monetary policy, the Federal Reserve channels more reserves to the banking system so as to allow private banks more liquidity and to make sure that they have the required ability to issue loans. In the UK, determination of money supply is the function of the Bank of England while that of the counties under the EU is the European Central Bank (ECB) (Burda and Wyplosz, 1997). In order to stabilize an economy in a country, the central bank has the power to determine the level of money stock through the operation of different monetary policies. These policies include reserve requirements, open market operations and discount rates. The most dominant among the three monetary policies is the open market operations p olicy. According to Howells and Bain (2009), an open market operation is a situation in which the central bank purchases or trades government securities for cash in an effort to contract or expand the total money supply. Money supply in the country will increase if the central bank purchases government securities but it will contract if the central bank sells government securities. The responsibility of the central bank in relation to fractional reserve banking is to hold a particular fraction of all deposits. This can be in account with the central bank or in cash. In order to alter money supply, the central bank alters the percentage of total deposits that needs to be held by commercial banks. In this way, the central bank can increase the monetary base in a country by reducing the reserve requirements or reduce the monetary base by increasing the reserve requirements (Mishkin, 1998). The central banks also determine money supply in a country by controlling discount rates. This is possible because the central bank in every country supplies commercial banks with the money they require to meet consumer demand. Therefore, the central bank can meet and control consumer demand for money by controlling the national interest rates. For example, the consumer demand for money will increase greatly if the interest rates decrease while a decrease in consumer demand for money will arise if the interest rates increase. Roles of depository institutions By definition, depository