Implementing Monetary Policy

Central banks implement the monetary policy using a number of instruments. These affect the aggregate demand through the supply of money, cost of money, and credit availability. The three main tools central banks use to implement monetary policies are discussed below.

Bank Rate Variation Policies

Interest rate is the tool central banks mostly use to express their policy intentions to commercial banks, the entire financial system, and the economy in general. Normally, central banks only transact with commercial banks and other financial institutions. Therefore, when a central bank announces an interest rate, the announcement informs the public of the rate at which it is willing to lend to commercial banks. In the US, unexpected changes in the Fed funds rate are major market-moving events.

When the central bank wishes to reduce the amount of money in circulation within an economy, it could increase its interest rate (also known as policy rate or bank rate). When the interest rate is increased, commercial banks would have to reduce their lending rate because if they were to run short of funds, they would have to borrow from the central bank at the interest rate set by the central bank. Similarly, the central bank would reduce its interest rate if it wished to increase the money circulation within an economy.

Open Market Operations

Open market operations refer to cases where a central bank buys and sells securities in the money market. When there is a rise in price, the central bank sells securities. The commercial bank’s reserves are decreased and, therefore, they cannot be in a position to lend more to the business community. This leads to a decline in investments, and a further rise in prices is halted.

On the other hand, when recessionary forces get going in an economy, the central bank purchases securities, increasing the commercial banks’ reserves. Commercial banks then tend to lend more to businessmen and women who will, in turn, invest more.

Reserve Requirements

The law requires commercial banks to keep a certain percentage of their total deposits in the central bank as a reserve. When there is a rise in prices, the central bank raises the reserve ratios and, therefore, commercial banks are left with less money to lend to the business community.  Consequently, the volume of output, employment, and investment are adversely affected. Eventually, prices will fall. The opposite is also true.

Note that the higher the reserve requirement, the less the money commercial banks can create. Hence, if the central bank wants to reduce the money creation power of commercial banks, it could easily increase the commercial bank’s reserve requirements.

Question

Which of the following is an instrument used to implement monetary policy?

1. Lender of last resort.
2. Regulator of currency.
3. Open market operations.

Solution

The correct answer is C.

An open market operation is an instrument that the central bank uses to buy or sell securities to the public whenever there is too much rise or fall in prices.

B and C are incorrect. They are some of the roles of a central bank.