Instruments used by Central banks to control money supply
Liquid money is issued by the Central Bank on the basis of computation of estimated demand for
cash. Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives
of price stability (or low inflation rate), full employment, and growth in aggregate income. This is
necessary because money is a medium of exchange and changes in its demand relative to supply,
necessitate spending adjustments. To conduct monetary policy, some monetary variables which
the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-
in order to affect the goals which it does not control. The instruments of monetary policy used by
the Central Bank depend on the level of development of the economy, especially its financial
sector. The commonly used instruments are discussed below.
Reserve Requirement: The Central Bank may require commercial banks to hold a fraction (or a
combination) of their deposit liabilities (reserves) deposits with it. Fractional reserve limits the
amount of loans banks can make to the domestic economy and thus limit the supply of money. The
assumption is that commercial banks generally maintain a stable relationship between their reserve
holdings and the amount of credit they extend to the public.
Open Market Operations: The Central Bank buys or sells (on behalf of the government; the
Treasury) securities to the banking and non-banking public (that is in the open market). One such
security is Treasury Bills. When the Central Bank sells securities, it reduces the money supply and
when it buys (back) securities-by redeeming them-it increases the money supply to the commercial
banks, thus affecting the supply of money.
Interest Rate: The Central Bank lends to financially sound commercial banks at a most favourable
rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest
rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit,
the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply
of investment (which affects full employment and GDP).
Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest
rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available
savings is allocated and investment directed in particular directions.
Liquid money is issued by the Central Bank on the basis of computation of estimated demand for
cash. Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives
of price stability (or low inflation rate), full employment, and growth in aggregate income. This is
necessary because money is a medium of exchange and changes in its demand relative to supply,
necessitate spending adjustments. To conduct monetary policy, some monetary variables which
the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-
in order to affect the goals which it does not control. The instruments of monetary policy used by
the Central Bank depend on the level of development of the economy, especially its financial
sector. The commonly used instruments are discussed below.
Reserve Requirement: The Central Bank may require commercial banks to hold a fraction (or a
combination) of their deposit liabilities (reserves) deposits with it. Fractional reserve limits the
amount of loans banks can make to the domestic economy and thus limit the supply of money. The
assumption is that commercial banks generally maintain a stable relationship between their reserve
holdings and the amount of credit they extend to the public.
Open Market Operations: The Central Bank buys or sells (on behalf of the government; the
Treasury) securities to the banking and non-banking public (that is in the open market). One such
security is Treasury Bills. When the Central Bank sells securities, it reduces the money supply and
when it buys (back) securities-by redeeming them-it increases the money supply to the commercial
banks, thus affecting the supply of money.
Interest Rate: The Central Bank lends to financially sound commercial banks at a most favourable
rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest
rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit,
the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply
of investment (which affects full employment and GDP).
Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest
rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available
savings is allocated and investment directed in particular directions.
