(a) Explain how the Central Bank controls money supply through the use of: (i) open market operation (ii) bank rate. (b) Outline four functions performed by...

Answer Details

(a) Control of money supply by the Central Bank.

(i) Open Market Operation (OMO). This is the deliberate buying and selling of government securities (treasury bills and bonds) in the open market by the Central Bank to alter the amount of money in circulation. To reduce the money supply, the Bank sells securities; the public and commercial banks pay for them, so cash is withdrawn from the banking system and banks' ability to create credit falls. To increase the money supply, the Bank buys back securities, injecting cash into the system and expanding credit.

(ii) Bank rate (discount rate). This is the rate of interest at which the Central Bank lends to commercial banks as lender of last resort. To contract the money supply, the Bank raises the bank rate; commercial banks then raise their own lending rates, borrowing becomes dearer, loans fall and the money supply contracts. To expand the money supply, the Bank lowers the bank rate, making credit cheaper and encouraging borrowing.

(b) Four functions of the Central Bank of Nigeria.

• Issue of currency: it is the sole issuer of legal-tender notes and coins.
• Banker to the government: it keeps government accounts, receives revenue and makes payments on its behalf.
• Banker to and supervisor of commercial banks: it holds their reserves, acts as lender of last resort and regulates them.
• Control of money supply and credit: it conducts monetary policy through OMO, bank rate, reserve requirements, etc.
• Custodian of external reserves and management of the exchange rate.

Examination reminder: link each instrument to its direction: selling securities and raising the bank rate both reduce money supply; buying securities and cutting the rate both increase it.