Topic 12. Monetary policy

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Monetary policy is one of the main instruments of macroeconomics. It is based on the ability of the Central bank to control the money supply, which leads to changes in interest rates and the exchange rate, and therefore in the amount of investment, which influences directly the national output.

This method of controlling the economy centers on adjusting the amount of money in circulation in the economy and so the level of spending and economic activity.

The Central Bank attempts to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. The Central Bank has three instruments available to it in order to implement monetary policy:

• Controlling the money supply

• Controlling interest rates

• Managing the exchange rate

The aim of the authorities when controlling the money supply is to limit the amount borrowed, and hence spent, by businesses and individuals during a inflationary period. It is hoped in this way to limit the level of overall demand in the economy and thus to remove or reduce inflationary pressure. During a recession monetary policy is aimed at increasing the money supply to encourage spendings.

The three most important instruments available to affect the money supply are:

• open market operations,

• reserve requirements

• the discount rate.

Open Market Operations. Open market operations are the most important way of controlling the money supply. It refers to the Bank trading government bonds in the open market - that is when they are bought from and sold to commercial banks and individuals.

When the Bank sells government bonds in the open market, the Bank withdraws the money from population and reduces the money supply. When the Bank buys government bonds in the open market, it increases the amount of money in circulation and hence the money supply.

Reserve requirements are a percentage of commercial banks', and other depository institutions', demand deposit liabilities (i.e. chequing accounts) that must be kept on deposit at the Central Bank as a requirement of Banking Regulations. Though seldom used, this percentage may be changed by the Central Bank at any time, thereby affecting the money supply and credit conditions. If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks, and depository institutions, demand deposits to be held by the Central Bank, thus taking them out of supply. As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers. This type of action is only performed occasionally as it affects money supply in a major way. Altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply.

The Discount Rate.

The second instrument of monetary control available to the central bank is the discount rate.

The discount rate is the interest rate that the Bank charges when the commercial banks want to borrow money. Thus, by setting the discount rate at a penalty level in excess of the general level of interest rates, the Bank can induce commercial banks voluntarily to hold additional cash reserves. Since banks have to hold more cash as reserves, the money multiplier is reduced, less money can be created and the money supply is lower.