3.5.4 Tools of monetary policy (HL only) Notes

1. The central bank has different tools to control the money creation in the economy:
   1. Open Market Operations
   2. Minimum Reserve Requirements
   3. Changes in Central Bank Minimum Lending Rate
   4. Quantitative Easing

Open Market Operations

Open market operations work with the buying and selling of government bonds in the bond market.

1. If the central bank wants to lower the interest rates, it can increase the money supply in the economy by buying government bonds from the commercial banks.
   1. This will increase the amount of money these commercial banks hold, which increases the amount of loans they can give.
   2. This in turn, increases the money supply and leads to decreasing interest rates.
2. If the central bank wants to increase the interest rates, it should decrease the money supply in the economy, by selling government bonds to commercial banks.
   1. As commercial banks pay for these bonds, they will have less money to give out as loans which will decrease the money supply in the economy and hence will lead to higher interest rates.

Minimum Reserve Requirements

1. As we already discussed in the last section:
   1. If the minimum reserve requirements are decreased by the central banks:
      1. The commercial banks reserves increase, increasing their lending ability.
      2. The supply of money will increase as more money will be created.
   2. If the minimum reserve requirements are increased by the central banks:
      1. The commercial banks reserves decrease, decreasing their lending ability.
      2. The supply of money will decrease as less money will be created.

Changes in the central bank minimum lending rate

1. Central banks can also lend money to commercial banks, for which they charge interest rate, called minimum lending rate.
   1. When the central bank wants to increase the money supply, it lowers the minimum lending rate.
      1. This encourages commercial banks to borrow more money as it is more affordable, hence increasing the money supply.
   2. When the central bank wants to decrease the money supply, it raises the minimum lending rate.
      1. This discourages commercial banks from borrowing money as it is more expensive, hence decreasing the money supply.

Quantitative easing

1. Quantitative easing is a policy utilised when interest rates are already very low and cannot be reduced further.
2. This is where the central bank buys financial assets (like bonds and many other types) from the market, injecting money into the economy.
   1. Essentially, the central bank buys quantities of assets from commercial banks by creating electronic reserves for commercial banks.
   2. This increases commercial bank reserves, which increases the money supply and lowers interest rates as they can lend more.