One of the main tasks of central banks is controlling the money supply in the economy. However, because of fractional reserve banking, most of the currency in circulation is actually created by commercial banks. Therefore, central banks can only control the amount of money in the economy indirectly through what we call monetary policy. More specifically, they can resort to three main monetary policy tools to control the money supply: (1) open market operations, (2) the discount rate, and (3) reserve requirements. We will look at each of those tools in more detail below.
1) Open Market Operations
Open market operations are a means to control the money supply by buying or selling bonds on the bond market (i.e., open market) using newly created money. That means, the central banks create new money and exchange it for bonds on the open market to increase the amount of currency in circulation or vice versa.
To illustrate this, assume the Federal Reserve Bank (Fed) wants to increase the money supply in the US to prevent a recession. To do this, it can create new US dollars and buy existing bonds on the open market with the newly created cash. This puts the new dollars in circulation and thereby increases the money supply. Conversely, to reduce the money supply, the Fed can sell some of the bonds from its portfolio on the open market and thereby reduce the amount of USD in circulation.
These kinds of open market operations are sometimes also referred to as outright open market operations. The reason for this is that, unlike many other transactions central banks make in the open market (particularly repurchase or repo transactions), they don’t include an agreement to reverse the transaction at a later time.
2) Discount Rate
The discount rate describes a way to control the money supply by setting the interest rate and/or required collateral at which commercial banks can borrow money from the central bank. That means, the Fed can increase the cost of borrowing money for commercial banks which reduces the demand for new capital and vice versa.
For example, if the Federal Reserve wants to stimulate the economy by increasing the money supply, it can do so by lowering the discount rate. That allows commercial banks to borrow money more cheaply, which enables them to make more loans at lower rates. As a result, the amount of currency in circulation increases. Similarly, if the Federal Reserve wants to reduce inflation, it can increase the discount rate to make borrowing more expensive for commercial banks. This motivates them to make fewer loans at higher rates, which reduces the money supply.
Please note that the name of the discount rate differs across central banks. For instance, the European Central Bank (ECB) refers to it as the refinancing rate, and the Bank of England calls it the repo rate. However, despite the different names, they all describe the same interest rate.
3) Reserve Requirements
Reserve requirements are a means to control the money supply by setting a minimum amount of cash reserves all commercial banks must hold in relation to their deposits. That means, the central banks can increase the amount of cash commercial banks must keep in their vaults to decrease the amount of money in circulation and vice versa.
To give an example, let’s assume the Federal Reserve wants to improve the stability of the financial sector. It can do this by increasing the reserve requirements. This change forces commercial banks to keep a larger share of their customers’ deposits in their vaults, which reduces the money multiplier. As a result, the amount of money in circulation decreases. Meanwhile, if the Fed wanted to promote lending to stimulate the economy, it could reduce the reserve requirements to increase the money multiplier, which would lead to an increase in the money supply.
In reality, central banks rarely ever change reserve requirements. The reason for this is that frequent changes to these regulations would disrupt the banking system. However, after the financial crisis of 2008, the reserve requirements were increased significantly in many countries as a result of the so-called BASEL III agreement.
In a Nutshell
Central banks control the money supply in the economy through monetary policy. To do that, they can resort to three main monetary policy tools: open market operations, the discount rate, and reserve requirements. Open market operations are a means to control the money supply by buying or selling bonds on the open market using newly created money. The discount rate describes a way to control the money supply by setting the interest rate and/or required collateral at which commercial banks can borrow money from the central bank. And finally, reserve requirements are a means to control the money supply by setting a minimum amount of cash reserves all commercial banks must hold.