How Central Bank Control Money Supply To Stimulate Or Cool Down The Economy?

I have talked about how high inflation will damage the economy of a country. Now let’s talk about what the central bank can do to control inflation. In the context of US central bank (Federal Reserve), there are three primary tools:

Deposit Banks’ Reserve Requirement

The central bank has the power to instruct banks to keep a certain threshold of money in the reserve, and it must not be lent out. This will force banks not to get into excessive lending.

By maintaining the reserve, the banks will have lesser money to lent out and circulate.

Discount Window (Discount Rate)

Commercial banks are able to borrow money directly from the central bank, at an interest date which is known as discount rate. Commercial banks will then lend out the borrowed money at an even higher interest rate to make profit.

In times of high inflation, central bank might bring up the discount rate, and commercial banks will tend not to borrow the money since it is more expensive.

So with lesser money lent out to the public, less money will be in circulation and money supply can potentially be reduced and slow down inflation.

Open Market Operations

Lastly, the leading mechanism used by the central bank to control the most widely talk about interest rate (you always see this in the news) – Federal Funds Rate, which is how commercial banks based on to charge one another for overnight lending.

Why would commercial banks want to lend to one another? Very often commercial banks have insufficient money to make new investment or lending, and they will have to resort to borrow money from other commercial banks.

Central bank cannot force all the banks to stick to the same interest rate, as this would make the banking sector very non-productive and banks will not develop competitiveness to one another. What it does is by setting a target interest rate, and then influences every bank to adopt the interest rate by buying financial assets such as government bonds, foreign currency, gold and etc.

Let say when central bank announced that it will target to bring down the interest rate. It buys government bonds from the bond market and brings up the prices of government bonds, and brings down the interest rate on bonds. Commercial banks will find the yield on government bonds unattractive, and started cashing out the money.

Commercial banks will start lending out the money at a cheaper interest rate since there is more supply after selling out the government bonds.

So, when the central bank wants to bring up the interest rate, it will start selling the government bonds, bring down the prices of bonds, and bring up the interest rate of bonds. Commercial banks will find that the yield on bonds is now more attractive to invest, and start to bring up interest rate to curb lending, and put more of their money into government bonds.

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