In order to maintain stable prices, a central bank must
A maintain low interest rates.
B keep unemployment low.
C tightly control the money supply
D sell indexed bonds.
The correct answer and explanation is:
Correct Answer: C – Tightly control the money supply
Explanation:
A central bank plays a crucial role in maintaining stable prices within an economy, and one of the most effective ways to do so is by tightly controlling the money supply. Price stability means preventing excessive inflation (rising prices) or deflation (falling prices), both of which can disrupt economic growth and financial stability.
How Money Supply Affects Prices
When there is too much money circulating in the economy, people and businesses have more to spend, which increases demand for goods and services. If supply cannot keep up, prices rise, leading to inflation. On the other hand, if the money supply is too restricted, there may not be enough money for transactions, leading to decreased demand and potentially causing deflation, where prices drop and economic activity slows.
Monetary Policy Tools to Control Money Supply
A central bank uses various monetary policy tools to regulate the money supply:
- Open Market Operations (OMO): Buying and selling government securities to influence liquidity.
- Interest Rate Policy: Adjusting interest rates to control borrowing and spending.
- Reserve Requirements: Setting the amount banks must hold in reserves to influence how much they can lend.
- Discount Rate: Changing the rate at which banks borrow from the central bank.
By managing these tools effectively, the central bank can stabilize prices and ensure economic growth remains steady. Failure to control the money supply can lead to hyperinflation (as seen in countries like Zimbabwe) or severe recessions.
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