Home > Macro, Monetary Policy, Money > Instruments of monetary policy

Instruments of monetary policy

The Central Bank has a few tools it can use to control the money supply.

The most well-known method in modern economies is open market operations. The Central Bank will hold a stock of illiquid assets like bonds. When it wants to decrease the supply of money in the economy, it will sell some of its bonds, when retail banks buy them, it simply deducts the value in cash from their reserve accounts at the Central Bank. That means those banks hold bonds where they used to have cash reserves, and the amount of high-powered money has fallen. Alternatively, if it wants to increase the amount of high-powered money, it can go to the markets and buy some bonds from retail banks. It pays for it by simply increasing the value of those banks’ reserve accounts held at the Central Bank, so bank reserves rise, and bank reserves are a component of high-powered money.

It can change the required reserve ratio, \theta, by forcing retail banks to hold a higher proportion of their liabilities to depositors in the form of reserves. This raises the money multiplier, \frac{1}{c+\theta (1-c)}. So it means any increase in high-powered money that the Central Bank introduces, will have a more magnified effect on the total amount of money in the economy. Not all countries have a legally required reserve ratio for banks.

As the Central Bank is the ‘lender of last resort‘ when banks are short on liquidity and need a short-term loan it can control the rate at which it charges interest to other banks. This will obviously have a knock on to banks’ market rates. If the Central Bank pushes up the rates at which it lends to other banks, they will charge their borrowers higher rates themselves. But if the Central Bank cuts its rates, other banks will take advantage of the ability to borrow cheaply from the Central Bank, by cutting their rates on lending to try and compete with each other for potential borrowers, who are all chasing the most competitive rates.

Categories: Macro, Monetary Policy, Money
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