No answer will be accepted if it does not support by economic intuition
Each question carry 10 marks
Q.1 If Central bank follows a fixed interest rate policy then it has no independent monetary
policy. True/false? Explain your answer.
True
We can show easily that central bank can either control rate of interest or control the money supply.
In case central bank chooses to fix the interest rate then it will lose its control over money supply.
In fact, central bank uses money supply to keep the rate of interest constant. For example, if for
some reason (such as increase in uncertainty) demand for money increases, which puts an upward
pressure on the rate of interest (since agents sell bonds to acquire money, Price of bonds will
decrease and rate of interest will increase). To keep the rate interest constant, central bank will
increase the money supply (money supply is endogenous). To achieve certain target such as full
employment, central bank cannot change the money supply, which defy its basic stance of keeping
the rate of interest constant. In short, central bank has no independent monetary policy, i.e., it
cannot change money supply to achieve certain objective.
