Central Bank Influence: Monetary Policy and Its Effects
How Central Banks Influence the Money Supply
When a central bank (CB) grants a loan to a bank, the banking system has more reserves, and these additional reserves allow it to create more money. The CB can alter the money supply by changing the discount rate. An increase in the discount rate discourages banks from borrowing reserves from the CB. Therefore, a rise in the discount rate reduces the number of reserves in the banking system, which, in turn, reduces the money supply. However, a reduction in the discount rate encourages banks to borrow from the central bank, raises the number of reserves, and increases the money supply.
- Increased reserves lead to a decreased money supply and lower interest rates.
- Decreased reserves lead to an increased money supply and higher interest rates.
Changing the Reserve Ratio
The reserve ratio (or bank reserve ratio or legal reserves) indicates what percentage of deposits banks must keep in cash reserves or store without being able to use it to make loans. This is done to avoid risks. If the central bank decides to reduce this ratio, banks save less money and lend more, increasing the amount of money in circulation. If the ratio increases, the bank sets aside more money and cannot grant as many loans, decreasing the amount of money. This way, the CB can inject money into the market or remove it.
Open Market Operations
Open market operations refer to the operations that the CB conducts with public debt securities in the market. The open market policy is the purchase and sale of assets by the CB, including gold, foreign exchange, government bonds, and general fixed-income securities. When the monetary authority buys or sells securities, it changes the monetary base by varying the amount of the cash reserves of commercial banks, either creating an expansionary or contractionary effect. If the CB sells many titles from its portfolio, and citizens or banks buy them, the CB receives money from people, reducing the public’s money supply.
Effect on Interest Rates
When the CB buys or sells fixed-income securities or debt, it influences the price of such bonds and, consequently, the effective interest rate of those values. The purchase of securities by the central bank injects more liquidity into the system and is accompanied by a drop in interest rates.
Types of Monetary Policy
Monetary policy may be either expansionary or restrictive:
- Expansionary monetary policy: Used when the goal is to put more money into circulation.
- Restrictive monetary policy: Used when the target is to remove money from the market.
Expansionary Monetary Policy
When there is little money in circulation in the market, an expansionary monetary policy can be applied to increase the amount of money. This can be achieved by:
- Reducing the interest rate to make bank loans more attractive.
- Reducing the reserve requirement, allowing banks to lend more money with the same reserves.
- Buying government debt to provide money to the market.
Restrictive Monetary Policy
When there is excess money in circulation, a restrictive monetary policy can be applied to reduce the amount of money. This can be achieved by:
- Increasing the interest rate to make borrowing more expensive.
- Increasing the reserve requirement, leaving more money in the bank and less in circulation.
- Selling government debt to withdraw money from circulation in exchange for public debt.
Monetary Policy Transmission Mechanisms
The monetary transmission mechanism is the process through which variations in the money supply translate into changes in output, employment, prices, and inflation. The process in which the central bank acts to curb inflation is as follows:
- The CB takes steps to reduce bank reserves, such as selling bonds in the open market.
- Each reduction of bank reserves leads to a multiple contraction of deposits, reducing the money supply.
- The reduction of the money supply tends to raise interest rates and tighten credit conditions.
- Rising interest rates and declining wealth tend to reduce spending sensitive to interest rates, particularly investment.
- The tightening of monetary policy reduces aggregate demand, income, production, employment, and inflation.