Question

What are the 3 major instruments that central banks can use to control money supply? Explain each one.

Answer 1

Central banks have three major monetary policy tools: open market operations, the discount rate, and the reserve requirement

Open Market Operations- Open market operations is when central banks buys or sells securities.These are purchased from or sold to private banks in the country. As central bank purchases securities it adds cash to the reserves of the banks. That allows them to lend more money. As central bank sells the securities it places them on the balance sheets of the banks and reduces their cash holdings. The bank now has to lend less. When a central bank wants an expansionary monetary policy, it buys securities. When it executes a contractionary monetary policy, it sells them.

Reserve Requirement- The Reserve Requirement refers to the money banks must be kept on hand overnight. They can keep the reserve either in their vaults, or at the central bank. A requisite low reserve allows banks to lend more of their deposits. It is expansionary in that it generates credit. A demand for high reserves is contractionary. It is giving less money to lend to the banks. It's especially difficult for small banks, because they don't have as much to lend first. That's why most central banks don't require small banks to make reserves. Central banks rarely change the reserve requirement, because member banks have difficulty modifying their procedures

Discount Rate- The third tool is discount rate. It is the rate at which central banks charge its members to borrow at their window of discount. As it is higher than the rate of fed funds, banks only do this when they can not borrow funds from other banks. There's also a stigma attached to using the discount window. The financial community assumes any bank using the discount window will be in trouble. Only a desperate bank which others have refused will use the discount window.