Question

Explain how each of the three traditional tools of monetary policy would be used to address an economy experiencing a high level of unanticipated inflation.

Answer 1

When an economy is facing hyperinflation the central bank adopts contractionary monetary policy by altering following tools:

1. Increasing interest rates
2. Selling government securities and bonds through OMO
3. Increase in reserves requirements so banks have to reserve more cash with central bank

More reserve requirement helps banks to park more cash with central bank and hence decreases mone y supply. Also rise in interest rates make laons unaffordable so money supply in market reduces. Also due to selling of government securities central bank aggregates excess supply of money from market. This helps economy to have reduced money supply which decreases aggregate demand and hence output falls and so do prices causing inflation to cease.