Monetary tools used by central banks to control the money supply

By | April 20, 2014

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1. Question 1 Money supply

1.1 Monetary tools used by central banks to control the money supply

Monetary tools are widely utilized by the governments to achieve their monetary policy objectives through ultimate impacts on the supply and demand of the money among the market (Centralbank.org.bz 2010). Since the demand for the money is determined in the market subject to a number of factors, it is believed that governments tend to use policies more frequently to influence the supply of the money through the usage of different direct and indirect monetary tools. What is more different government due to the different financial and political systems could have various monetary tools to be used with different preference levels. For example the Federal Reserve System which controls the U. S. money supply usually uses the following monetary tools tools to influence the money supply: changes in the reserve requirement, open-market transactions that control the amount of reserves held by banks and changing the discount rate that would affects the amount of reserves banks borrow from the Federal Reserve Banks (Salvatore & Diulio 2003, p.68). Below we will talk about some usual tools that are used by different central banks.

1.1.1 Changes in the reserve requirement ratio

Reserve requirement is a central bank regulation that sets the minimum reserves every commercial bank needs to hold (Saunders & Cornett 2007). Rather than imposing a defined volume of money to be held by the commercial bank, many governments and central banks prefer to define a reserve requirement to be adhered by the commercial banks. Through adjustments in the reserves requirement ratio, the central banks would be enabled to alter the commercial banks’ liquidity situation and hence credit supply in the market (Axilrod & Wallich 1989). Take China as an example. in December of 2008 when the financial crisis deepened its influence over the Chinese economy, China’s central bank, i.e. the People’s Bank of China, had reduced the reserve requirement ratio by 1% point among the large commercial banks while this digit became 2% points among the smaller sized banks (Xinhuanet.com 2008) to increase the credit supply in the economy.

1.1.2 Open market transactions

Open market transactions could be defined as the utilization of primary issues of securities via auctions of central bank or government deposits with the objectives of central bank to affect monetary situations in the markets (Mehran 1996, p.47). Take the United States as an instance: one of the three most frequent monetary techniques to increase the monetary supply is through making open market purchasing to expand monetary supply. When the US Federal Reserve wants to increase the money supply, it will usually get the target achieved by making open-market purchase of the government bonds to increase the deposits of the banks (D’Souza 2008, p.51).

1.1.3 Adjustments of discount rate in short term loans

The official discount rate is the rate at which the Central Bank lends to commercial banks (Fernando 2011, p.560). Many governments’ central banks such as the US Federal Reserve will use the discount rate adjustment to discount rate of the short term loads that the commercial banks have from the central banks which enable the central banks to effectively increase or decrease the liquidity hence the supply of the banks.

1.1.4 Interest rate

The interest rate in a market will significantly influence the supply of the money in the market. For example, in China, the interest rate is determined directly by the The Peoples’ Bank of China Monetary Policy Committee, and this will affect the money supply in the market largely. For example, when the interest rate increases, people will tend to deposit more money in the bank which increases the volume that the commercial banks could supply to the market.