Question

How does monetary policy affect the supply of money?

I would love your personal answer and real world examples.

Answer 1

Money supply remains in hands of central banks for most of the nation hence, saying central banks regulate money supply would be appropriate.

The excess money supply results in inflation and shortages result in deflation. Central banks regulate money supply to control inflation and deflation both.

For decreasing the supply in the market central banks can do following things:

·      Central bank can issue new securities in market at higher rates and suck the liquidity in market

·      Central bank can increase the reserve requirement of banks so that the maximum money remains in banks high quality government assets and that would not allow commercials banks to lend more and finally that would tighten the supply of money

·      Central bank can increase money market rates so that money becomes costlier for borrowers and hence it will result in less demand for money in market.

The Central bank can adopt following measures to control inflation or to increase the inflation through monetary policies:

·      Central bank (Fed) can reduce the interest rates at which financial institutions borrow from the Fed. How this will impact? As interest rates are reduced the banks or financial institutions will be able to borrow at lower cost from Fed. Suppose, $ 1 Billion was earlier borrowed at 1% p.a which was equivalent to $ 10 million interest cost after reduction in interest rate same $ 1 Billion can be borrowed at 0.75% p.a hence, the cost of borrowing will become $ 7.5 million. Now, banks can go ahead and lend at lower cost to their clients. As client or borrower can borrow at lower cost they can spend more money at lesser cost. The flow of money will increase purchasing power of individuals. Purchasing power will chase the limited supply of goods and prices of goods would rise hence, inflation number will also rise

·      Central bank can relax the reserve requirements. Like Minimum Cash Reserve Ratios, ratio of mandatory holding of treasury bonds or government Securities by financial institutions and banks. This can indirectly improve the supply of money. The tight reserve requirements hold / contain the money supply in the market. The banks or financial institutions cannot lend these monies to their corporate or retail borrowers as reserve ratios are regulatory requirement. If Fed relaxes the financial institutions from restrictive reserve ratios then the natural supply of money will increase. The supply of more money improves the purchasing power of individuals hence the inflation numbers goes up

·      Central bank can go ahead and create the new currencies either electronically or by printing new currencies. New supply of money can be flown by purchase or buy back of existing government and treasury securities. This activity is broadly classified as quantitative easing. This method directly or indirectly increases the supply of currency in the market and helps improving the purchasing power of the individuals and ultimately results in inflation

Central bank can target the inflation number and accordingly it can increase the supply of money in tune to targeted inflation.