Similar to a fiscal policy, a monetary policy is a macroeconomic tool used by the government through its monetary authority to manage and stabilize the economy, particularly to either expand the economy or contract it. 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.
By controlling the money supply, monetary policy also influences or 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 such as a central bank increases the money supply, banks will have plenty of money to loan out. The abundance of the money supply will force these commercial banks to lower their interest rates to win out customers or more specifically, borrowers.
Encouraging lending and borrowing can lead to economic expansion. Making 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. Discouraging lending-borrowing activities leads to economic contraction.
Monetary authorities have used several monetary policy instruments to control the money supply. Also known as tools of monetary policy, the three major instruments 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. By definition, a reserve requirement is a mandate developed and implemented by the central bank that tells how much money commercial banks are allowed to keep.
As a further backgrounder, whenever customers deposit money, their banks hold a portion of these deposits and loans the rest out. The process is called fractional reserve banking, and the central bank dictates through the reserve requirement what fraction of the deposits banks are allowed to keep. In other words, the reserve requirement influences the quantity of cash available in commercial banks, thus influencing their liquidity.
Raising the reserve requirement effectively increases the availability of cash in commercial 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, interest rates subsequently go down to encourage people to borrow money.
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 is another tool or instrument of monetary policy used by central banks to influence the liquidity or the availability of cash of commercial banks and thus, influence the interest rates these banks give to their customers or borrowers. Remember that commercial banks buy bonds from a central bank to raise cash. Buying bonds from the central bank is akin to borrowing money. The central bank is essentially the banker of commercial banks. The discount rate is the interest rate the central bank uses to charge these banks.
Changing the discount rate influences the ability of commercial banks to hand out loans to their customers. As an 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 or raise their available cash.
A low discount rate encourages commercial banks to borrow more money to the central bank. Because these banks compete for customers or borrowers, they will naturally borrow money from the central bank so that they will have more cash needed to hand out loans. The overall abundance of money supply in commercial banks leads to a decrease in interest rates as banks try to attract and win borrowers. In turn, the entire process encourages 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 treasury bills. Note that this is the most commonly employed policy instrument but is only applicable to countries with an established market for their respective government bonds.
It is important to note that open market operations are also one of the collective ways governments control the money supply. The primary purposes of this monetary policy tool are to either supply commercial banks with liquidity or take surplus liquidity from these banks, and indirectly control the total money supply by manipulating the short-term interest rate and the supply base of money.
To illustrate further how open markets operations work, note that commercial banks have different ways of increasing their liquidity or raising their available cash. Remember that 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 money supply compels banks to lower their interest rates as they compete for customers and encourage them to borrow money from them.