A monetary policy is a macroeconomic tool utilized by the government through its monetary authority to either expand or contract the economy. It is a measure for managing and stabilizing the economy often used alongside a fiscal policy. However, to be more specific, it involves a government-mandated monetary authority, such as a central bank or currency board, increasing or decreasing the monetary base or money supply to speed up or slow down the overall economy. Nevertheless, monetary policy has three specific instruments or tools. These are the reserve requirements, discount rates, and open market operations.
The Three Major Tools of Monetary Policy: How the Central Bank Controls the Money Supply and Influences Interest Rates
1. Reserve Requirement
One of the major tools of monetary policy is the reserve requirement. It is a mandate developed and implemented by the central bank that tells how much money commercial banks and other depository institutions are allowed to keep.
Note that banks generally operate by holding a portion of money deposited by their customers and handling out the rest as loans. This is fractional reserve banking. The central bank dictates through the reserve requirement what fraction of the deposits banks are allowed to keep. In other words, it influences the liquidity of banks because it dictates the quantity of cash available for lending.
Raising the reserve requirement effectively increases the availability of cash in banks. Doing so increases the overall money supply. With more cash on hand, these banks can easily hand out loans to their customers. Because they compete for customers, they can lower their interest rates to encourage people to borrow money from them.
Meanwhile, decreasing the reserve requirement decreases the availability of cash in commercial banks, as well as the overall money supply. This affects the capability of banks to hand out loans. In other words, increasing the reserve requirement encourages lending-borrowing activities and decreasing it discourages such activities in the economy.
2. The Discount Rate
The discount rate or discount window is another tool for controlling the money supply and commercial interest rates. Remember that the central bank is essentially the banker of commercial banks. It can extend loans to these banks or other depository institutions. The discount rate is the interest rate the central bank sets and uses to charge these institutional borrowers.
Changing the discount rate essentially influences the ability of commercial banks to hand out loans to their customers. For example, decreasing the discount rate would make it easier for these banks to borrow money from the central bank and thus, would make it easier for them to increase their liquidity and positively affect their capability to hand out loans to household and business customers.
A low discount rate encourages banks to loan more money to the central bank because it lowers the cost of borrowing. Because commercial banks compete for customers, they will naturally take advantage of inexpensive loans to increase their cash supply. Because they have more cash and they compete for customers, the tendency is for them to also lower their interest rates, thus encouraging lending-borrowing activities in the economy.
Increasing the discount rate, on the other hand, would make it hard for commercial banks to borrow money from the central bank and thus, would make it difficult for them to hand out loans to their customers. Interest rates for customers eventually increase, and the entire process discourages lending-borrowing activities.
3. Open Market Operations
Another tool of monetary policy is called open market operations. It involves the buying and selling of different financial instruments or securities such as government bonds and treasury bills. Although it is a commonly employed instrument, it is only applicable to countries with an established market for their respective government bonds.
Open market operations also influence the money supply. The objective of this monetary policy instrument is to either supply commercial banks with liquidity or take surplus liquidity from them, as well as to indirectly control the total money supply by manipulating the short-term interest rate and the supply base of money. A somewhat similar albeit unconventional measure is quantitative easing.
To understand further how open markets operations work, note that commercial banks have different means of increasing their liquidity or raising their available cash. One of the ways of doing so is to borrow money from the central bank by buying government bonds or treasury bills. Commercial banks prefer these financial instruments because they are less risky than stocks.
Whenever a central bank buys back their previously issued bonds from the banks, it is essentially handing them out cash. With cash on hand, these commercial banks have enough money supply to loan out. Furthermore, remember that the abundance of cash reserves naturally compels banks to lower their interest rates to compete for customers and encourage them to borrow money.
The Purpose of Monetary Policy: How Controlling the Money Supply and Interest Rates Influences Economic Expansion or Contraction
Monetary policy is a collective measure employed by a government and coursed through a monetary authority to influence aggregate demand and economic activity. Remember that the purpose of monetary policy is to control the money supply. It specific goals are to maintain GDP stability, achieve or maintain low unemployment, stabilizes prices or inflation rates, and to maintain exchange rates with other foreign currencies.
The monetary authority such as a central bank or currency board can either pursue an expansionary monetary policy or a contractionary monetary policy depending on the status of the economy. Both expansionary and contractionary routes involve controlling the money supply.
By controlling the money supply, monetary policy also indirectly manipulates the interest rates of commercial banks to either encourage lending and borrowing or discourage lending-borrowing activities in the economy. Note that if a monetary authority increases the money supply, banks will have plenty of money to loan out. The abundance of the money supply will compel these commercial banks to lower their interest rates to attract customers or borrowers.
It is important to highlight the fact that the central bank does not directly control commercial interest rates. The three tools of monetary policy only provide upward or downward pressure to other interest rates within the economy.
Encouraging lending and borrowing can lead to economic expansion. More funds available to the people means more opportunities for consumption via loans or credits, and business expansions and investments, thus leading to an increase in aggregate demand. On the other hand, discouraging lending-borrowing activities leads to economic contraction.
To understand further the role of monetary policy and its three tools, it is also important to reiterate that they often go alongside a fiscal policy under Keynesian economics. One of the fundamental principles of Keynesian economics is that the economy cannot regulate itself and as such, the government needs to intervene. Hence, from a Keynesian perspective, the government has two more options to choose from during periods of economic instability. These are fiscal policy and monetary policy.