Question

In order to maintain a stable and low inflation, European Central Bank (ECB) would like to increase the interest rates in the economy.  What open market operation (OMO) action should the ECB take? Explain in detail the OMO process and its implications for the cash rate, interest rates, inflation and GDP. Draw the effect of the OMO process using the Money Demand-Money Supply (MD-MS) diagram.

Answer 1

When the European Central Bank wants to increase interest rates in the economy, it needs to pursue contractionary monetary policy. One of the effective tools for conducting contractionary monetary policy is the open market operation.

The European Central Bank would sell bonds in the open market. This would imply that banks purchase bonds and bonds are exchanged for cash. In other words, the liquidity from the banking system is absorbed by the European Central Bank .

When the liquidity in the banking system declines, the inter bank lending rate (cash rates) trends higher. This translates into higher interest rates that banks charge to consumers and businesses. When interest rates increase, the willingness to borrow by consumers and businesses declines.

Therefore, with a decline in leveraged consumption and investment spending, the aggregate demand curve shifts to the left on a relative basis. In other words, the output (GDP) declines and so does the price levels (inflation) in the economy.

The decline in money supply can be shown in the chart below. The initial supply and demand for money is given by the curves S and D respectively. The interest rate is at "i" initially. When the central bank pursues contractionary monetary policy and supply of money declines, the supply curve shifts to the left to S1. As a result, interest rates trend higher from "i" to "i₁." The same chart shows that the quantity of loans demanded declines as interest rates trend higher.