Actions taken by the central bank to control the money supply to promote macroeconomic goals and to achieve sustainable growth. Orders or policies are drafted to reduce the supply of money in the economy or to pump in money when circumstances demand.
They are achieved by altering interest rates, reserve ratio, buying or selling government bonds, bank issues, regulating the foreign exchange rates, to control the amount of money circulating in the economy.
Lender of last report– is something when the economy is distressed and is afraid to issue loans the central bank lends money to the banks and in turn they provide loans. This is made with an agreement that the banks need to buy the issued securities at a higher rate or some time with no collateral the loan money is pumped into banks. This is highly dangerous when the loans default, and the government stands at the brink of bankruptcy.
Actions and reactions:
The actions of the committee are based on the various information gathered from the economy, inflation rate, unemployment rate, GDP, exchange rates and various other indicators determine the upcoming monetary policy. The ultimate aim of a monetary policy is to have a sustainable growth in GDP, reduce unemployment, curtail inflation, maintain a reasonable exchange rate.
Every government has a dual mandate, monetary policy to decrease unemployment rate and to have inflation under control (less than 3%). When new jobs to be made the economy should expand and the scale of production due to demand increase should happen. Monetary policy for inflation, In the case inflation will be higher as spending is relatively higher like capital expenditure, salary hike. At this time the central bank has to keep inflation under control and also to promote employment and controlled growth.
Types of monetary policy:
Expansionary monetary policy is used to improve the job availability eventually reducing the unemployment rate. The interest rates are reduced so money is available cheap of businesses and can invest to raise production which again supports employment. At this time the banks lend aggressively and businesses develop. Inflation should be in check to promote the objective of a sustainable economy. Since businesses expand inflation rates increase, the private sector will do well, and this kind of inflation doesn’t affect the market significantly. If the economy is growing at reasonable rate, it’s good for the market too.
Contractionary monetary policy is used to bring inflation under control because of which the businesses suffer to grow and normal people needs to spend more on products. This triggers unemployment rate and existing employees demand pay raise and hence the economy slows down as the major resource of the economy to grow is labor.
Tools used by the central bank:
- Quantitative easing is one where the central bank (CB) trades short and long term government bonds to reduce interest rates (which makes the market rate to lower and the cost of capital to be less for businesses) in the market and is injecting more money into the economy. The same way the central bank sells bonds to decrease the money flow as the banks are obligated to buy them, the cost of lending money becomes expensive as less money is available for lending. Buying bonds and securities by the central bank is called open market operations (OMO). In quantitative easing the CB generally buys the long term bond, with or without printing money (Money from reserves). When the interest rate of short term securities is approaching zero, no use in buying them. When QE fails the government can increase expenditure and reduce taxes (Fiscal policy), therefore QE is a combination of both MP and FP.
- Collateralization of the loans in excess is wanting more value to back the credit obligation. Increasing interest rates would decrease the volume of loans. This is contrary to a monetary policy. The opposite, demanding less collateral and the lending rates increase.
- Reserve ratio is another tool where the central bank mandates all the banks to maintain a certain portion of assets in the central reserve. With which the central bank spends on government projects and other expenditure and also an interest is paid in return (rate set by the central bank, lending to the reserve of the bank to reduce money in the economy). The main concern is not what the central bank is doing with it, the money available for lending has been decreased from the banks so to make profits with less amount, banks push lending rates which reduce borrowing.
- Unconventional method of increasing the T-bills and Mortgage Backed Securities in their balance sheet.
The monetary policy economics target the supply of money to attain controlled growth. All the above tools mentioned above are the ways, creating enticing products which an investor or an institution is willing to invest. The policy rates and how the people react to it depends on how much credibility the central bank has among the citizens. No policy will control or regulate the economy if people lose trust in the central bank.