Monetary Policy Tools
Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied.
Why not print a lot of money so everyone could be rich?
Simple answer, inflation.
The supply of money is controlled so that there would be price stability. Steady economic growth with low inflation. At the macroeconomic level, the amount of money circulating in an economy affects things like gross domestic product, overall growth, interest rates, and unemployment rates. At the micro-level, a large supply of free and easy money means more spending by people and by businesses. Individuals have an easier time getting goods and services thus there comes a problem of high demand but very limited supply thus inflation and in some cases Hyper inflation making a country's currency drop in value and valueless in some cases
Back to monetary policies, now you have some idea of what they aim to achieve. mainly price stability, steady economic growth and low unemployment rates.
Central banks have four main monetary policy tools:
1. The reserve requirement
2. Open market operations
3. Interest Rates
4. The discount rate
5. Interest on reserves.
1. The reserve requirement
The reserve requirement refers to the money banks must keep readily available. This money can either be kept in the Bank's own vault or in the central bank. A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit and more people are able to get loans thus increasing the money supply.
The opposite is true, The central bank can raise reserve requirements thus limiting the amount of money banks could give out in the form of loans. This causes a decrease in the Money supply.
However, Central banks rarely change the reserve requirement because it's difficult for member banks to modify their procedures especially the small banks.
2. Open market operations
Open market operations are when central banks buy or sell securities. These are bought from or sold to the country's private banks. These securities may include bonds, bills an others. When the central bank buys securities, it adds cash to the banks' reserves. That gives them more money to lend. That increases the money supply.
When the money supply is to be reduced the vice versa will happen, central bank will sell it's securities to banks thus reducing the amount they have available for lending.
3. Interest Rates
- The discount rate
- Interest on reserves.
I've combined these last three because they're all rates of interest just interest charged on different financial instruments.
Before I get to mention about the discount rate first I'll mention that there is also an interest rate set on the securities. The rates are raised when the government is selling it's securities to the banks to make them more lucrative to buy and to buy more. The rates are lowered when the central bank wants to buy bonds from the banks in order to make them unattractive to hold.
- The Discount Rate
Primarily this is the inter-bank lending rate. When commercial banks need money for the short term they do offer each other loans. The discount rate also means the interest rate set by the central bank that they should use for financial services they offer to their clients, the public. This is the rate on loans and deposits generally. when the central bank wants to reduce money supply they increase the rate thus discouraging borrowing and encouraging savings. The vice versa is true. To increase money supply the central bank would lower the rates thus encouraging borrowing and investing thus less money is kept in the banks in form of deposits.
- Interest on reserves
Central banks reward interest to banks that have excess reserves. To stimulate lending, the rate of interest is reduced thus making it less profitable for a commercial bank to hold excess reserves thus they give more loans & increase money supply. To reduce lending the central bank increases the rate of interest on these excess reserves thus making commercial banks less willing to lend money and more willing to hold larger reserves.
Conclusion
These monetary policies (there are more) work in sync and often in an economy all of them are employed constantly to keep the money supply stable and achieve both Macroeconomic and Microeconomic goals.
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