- The central bank has different tools to control the money creation in the economy:
- Open Market Operations
- Minimum Reserve Requirements
- Changes in Central Bank Minimum Lending Rate
- Quantitative Easing
Open Market Operations
Open market operations work with the buying and selling of government bonds in the bond market.
Definition
Bond
Refers to a signed certificate, which represents a loan given by the bond holder to the borrower in exchange for regular interest payments and the promise to repay the full amount at a set future date.
- The buyer of the bond is the lender
- The seller of the bond is the borrower
- 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.
- This will increase the amount of money these commercial banks hold, which increases the amount of loans they can give.
- This in turn, increases the money supply and leads to decreasing interest rates.
- 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.
- 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.
We will discuss in depth how central banks change interest rates, and influence the supply and demand of money in the next section. For now, just understand the differences between the tools central bank have to carry out monetary policy.
Minimum Reserve Requirements
- As we already discussed in the last section:
- If the minimum reserve requirements are decreased by the central banks:
- The commercial banks reserves increase, increasing their lending ability.
- If the minimum reserve requirements are decreased by the central banks:
