If a country's economy were a human body, so would its heartCentral bank. And just as the heart works to pump life-giving blood through the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money and sometimes more.
The methods that central banks use to control the money supply vary depending on the economic situation and the power of the central bank. In the United States this is the central bankFederal Reserve, often called Fed. Other prominent central banks includeThe European Central Bank, Swiss National Bank, Bank of England, People's Bank of China and Bank of Japan.
Let's look at some common ways that central banks control the money supply: the amount of money in circulation in a country.
Key learning points
- To ensure that a country's economy remains healthy, the central bank regulates the amount of money in circulation.
- Influencing interest rates, printing money, and setting bank reserve requirements are all tools that central banks use to control the money supply.
- Other tactics used by central banks include open market operations and quantitative easing, which involves selling or buying government bonds and securities.
Why the amount of money matters
The amount of money circulating in an economy influences both micro and macroeconomic trends. At the micro level there is a wide range of free andEasy moneymeans more costs for people and companies. Individuals find it easier to get personal loans, car loans or loansmortgage; companies also find it easier to obtain financing.
At the macroeconomic level, the amount of money circulating in an economy affects things like gross domestic product, overall growth, interest rates andunemployment rates. Central banks tend to control the amount of money in circulation to achieve economic goals and influencemonetary policy.
Print money
Once upon a time, countries pegged their currencies to itthe Gold standard, which limited the amount they could produce. But that ended in the mid-20th century, so now central banks can increase the amount of money in circulation simply by printing it. They can print as much money as they want, even if there are consequences.
Simply printing more money has no impact on economic output or production levels, making the money itself less valuable. Because this can cause inflation, simply printing more money is not the first choice of central banks.
Set the reserve requirement
One of the basic methods that all central banks use to control the amount of money in an economy isreserve requirement. As a rule, central banks give a mandateDepotinstitutions (i.e. commercial banks) keep a certain amount of money in reserve (in a safe deposit box or at the central bank) for the amount of deposits in their customers' accounts.
So a certain amount of money is always held back and never circulates. Let's say the central bank has set the reserve requirement at 9%. Like abusiness bankhas a total of $100 million in deposits, it must set aside $9 million to meet the reserve requirement. That could put the remaining $91 million into circulation.
If the central bank wants more money in circulation in the economy, it can lower the reserve requirement. This means that the bank can lend more money. If it wants to reduce the amount of money in the economy, it can increase the reserve requirement. This means that banks have less money to lend and will therefore be more selective in granting loans.
Central banks periodically adjust the reserve requirements they impose on banks. In the United States (effective January 1, 2022), smaller depositories with net transaction accounts up to $32.4 million are exempt from maintaining a reserve. Mid-sized institutions with accounts between $32.4 million and $640.6 million must set aside 3% of their liabilities as reserves. Institutions with more than $640.6 million have a 10% reserve requirement.
On March 26, 2020, in response to the coronavirus pandemic, the Fed reduced reserve requirements to 0% – in other words, eliminating reserve requirements for all U.S. depository institutions.
Affect the interest rate
In most cases, a central bank cannot directly set interest rates for loans such as mortgages, car loans or personal loans. However, the central bank has certain instruments at its disposal to push interest rates to the desired level. For example, the central bank holds the key to the policy rate – the interest rate at which commercial banks can borrow from the central bank (in the US this is calledfederal discount).
When banks can borrow from the central bank at a lower interest rate, they pass on these savings by lowering borrowing costs for their customers. Lower interest rates usually lead to more loans, which means the amount of money in circulation increases.
Participate in open market operations
Central banks influence the amount of money in circulation by buying or sellinggovernment bondsthrough the process known asopen market operations (OMO). When a central bank wants to increase the amount of money in circulation, it buys government bonds from commercial banks and institutions. This frees up bank assets: they now have more money to borrow. Central banks make this type of spending as part of an expansionary or accommodative monetary policy, which lowers interest rates in the economy.
The opposite happens in a case where money needs to be removed from the system. In the United States, the Federal Reserve uses open market operations to achieve a goalfederal funds rate, the interest rate at which banks and institutions lend each other money from one day to the next. Each pair of borrowers negotiates their own interest rate, and the average of these is the federal funds rate. The federal funds rate, in turn, influences all other interest rates.Open market operations are a widely used tool because they are flexible, user-friendly and efficient.
Introduce a quantitative easing program
In difficult economic times, central banks can go a step further with open market operations and launch a program of quantitative easing.quantitative easingCentral banks create money and use it to buy assets and securities such as government bonds. This money enters the banking system because it is received as payment for the assets purchased by the central bank. Banks' reserves rise by that amount, prompting banks to make more loans, further lowering long-term interest rates and encouraging investment.
After the financial crisis of 2007-2008bank of Englandand the Federal Reserve launched quantitative easing programs. Recently, the European Central Bank and the Bank of Japan also announced plans for quantitative easing.
In short
Central banks work hard to ensure that a country's economy remains healthy. One way central banks achieve this goal is by controlling the amount of money circulating in the economy. Their tools include influencing interest rates, setting reserve requirements, and using open market operations tactics. Having the right amount of money in circulation is essential for a stable and sustainable economy.
