Question

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

(i) Open market operations.

(ii) Bank rate. 

Answer 1

(i) Open Market Operations as an Instrument to Correct Deficit Demand:

Open Market Operations refer to the buying and selling of securities either to the general public or to the commercial banks in an open market. To curtail deficit demand, the central bank purchases securities in the open market. With purchase of securities, the central bank pumps in additional money into the economy. With the additional money the level of Aggregate Demand in the economy increases. Thus, the deficit demand is corrected.

(ii) Bank Rate as an Instrument to Correct Deficit Demand:

Bank rate refers to the rate at which the central bank provides loans to the commercial banks. To curtail deficit demand, the central bank lowers the bank rate. This implies that cost of borrowing for the commercial banks from the central bank reduces. The commercial banks in turn reduce the lending rate (the rate at which they provide loans) for their customers. This reduction in the lending rate raises the borrowing capacity of the public, thereby, encourages the demand for loans and credit. Consequently, the level of Aggregate Demand in the economy increases and deficit demand is corrected.