Question

What are the tools of monetary control used by central banks, such as the Bank of England, the European Central Bank? Why cannot central banks fully control the money supply

If the central bank wants to increase the money supply with outright open-market operations, what does it do?

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Answer 1

The Central Bank is established with the view of controlling the supply of money and giving directives on banking operations to commercial banks at large. These Banks directly control the supply and demand of money with the various tools that they possess.

The same are described as follows: -

1) Cash Reserve Ratio: -

Commercial banks require to keep a part of their deposits as security with the Federal Reserve which they have to maintain to continue operations. For example, if the cash reserve ratio is 10%, and a deposit of 100$ is made with the commercial banks, then only 90$ can be used by the bank to generate loans.

Now, supposing there is recession in the economy which at present is the scenario due to the Corona Virus Pandemic. The Federal Reserve then reduces the cash reserve requirements. As a result, the currency in circulation increases and people can get easier access to funds which increases the aggregate demand and the economy returns back to its normal position.

On the contrary, during an inflation cycle the exact opposite of this takes place.

2) Interest Rates: -

Interest Rates are another common way in which the Central Bank of a nation can impact the flow of currency in circulation. The Central Bank provides interest to commercial banks on the reserves they hold with the Central Banks. It also provides loans to commercial banks so that they can procure money and supply to loan takers as and when required by the bank.

For example, when there is inflation in the economy, the flow of money in such an economy is high. If the Central Bank then increases the interest rates on loans, the commercial banks then usually start charging higher interest rates from the customers as well. The resultant of which is that the aggregate demand in an economy contracts and the money in circulation is reduced.

3) Open Market Operations: -

Open market operations are when the central bank themselves chose to purchase or sell bonds of a certain value in the market. When the Federal Reserve purchases bonds, the sellers pay a price for the same and it reduces the supply of money by the same. On the contrary, if the federal reserve sells bonds, it gives payments to the seller and in return the monetary base expands.

Thus, during a recession cycle, the Central Bank purchases bonds and increases the supply of money as sellers receive the money and can then spend the same on various profit-making avenues. For example, if a bank receives this money it would give out more loans.

Why Central Banks cannot control the supply of money fully?

The central bank can only control the above-mentioned items which may or may not have a direct impact on the currency in circulation. This is because directly the bank cannot ask people not to save more money or lesser money and neither can it force banks to give away more loans.

It is up to the discretion of the banks, if or not they want to give away loans or not and also in case of people, it is up to them whether them want to or don’t want to save money as a result of interest rate changes.

This is the exact reason why it does not control the supply of money fully.

Please feel free to ask your doubts in the comments section.