In all countries, there is a monetary authority called the Central Bank, which controls the amount of money in circulation or the money supply. When the economy is growing, people earn more and spend more, so the amount of money in circulation tends to rise, causing inflation. To tackle inflation, the Central Bank reduces the supply of money.
On the other hand, when we are in an economic crisis, people earn less and spend less, so the amount of money in circulation tends to go down, causing deflation. To head off deflation and to encourage higher spending, the Central Bank increases the money supply. In simple words, monetary policy refers to the actions taken by the Central Bank to regulate the money supply, in order to maintain economic stability.
When the Central Bank increases the money supply, we are talking about an expansionary monetary policy. When the Central Bank reduces the money supply, we are talking about a restrictive monetary policy. You may be wondering how the Central Bank can do that.
It is thanks to its three main instruments. 1. Discount rate 2.
Bank legal reserve or cash ratio 3. Open Market Operations The discount rate is the interest rate on loans that the Central Bank grants to commercial banks. To reduce the money supply, the Central Bank raises the discount rate.
In this way, money is more expensive for commercial banks and therefore for citizens. As a result, banks and citizens take on less debt and the money supply is reduced. If the Central Bank wants to increase the money supply, it simply lowers the discount rate to make loans cheap, increasing debt and money in circulation.
The bank legal reserve or cash coefficient is the percentage of money that a commercial bank must maintain as a liquid reserve, without being used for investments or loans. As you may have already deduced, the Central Bank reduces the legal reserve rate to increase the money supply, making banks able to lend and invest more money. And if the objective is to reduce the money supply, it simply increases the legal reserve rate to restrict the amount of money that banks can use.
Open Market Operations are the purchases and sales of public debt securities, carried out by the Central Bank. When you want to reduce the money supply, the Central Bank sells these titles. The money collected from the sale now remains in the hands of the Central Bank, that is, the Central Bank manages to extract money from the economy.
On the other hand, when you want to increase the money supply, the Central Bank buys these titles. In this way, the money used for the purchase remains in the hands of the economy, that is, the Central Bank manages to inject money into the economy. In short, thanks to monetary policies, the Central Bank can increase or reduce the money supply in the economy.
To increase the money supply, the Central Bank can lower the discount rate, lower the bank legal reserve rate, or buy debt securities. On the contrary, to reduce the money supply, the Central Bank can raise the discount rate, raise the bank legal reserve rate or sell debt securities. I hope this video has helped you understand it better.
Thank you very much.
