The required reserve ratio and its effects

Central banks use the required reserve ratio (rr) as a monetary policy tool to influence the money supply by controlling how much commercial banks must hold in reserves.

The required reserve ratio

The required reserve ratio is the minimum percentage of customer deposits that commercial banks must keep as reserves, either in cash or as deposits with the central bank.

Effects of changing the required reserve ratio:

• Decreasing the ratio - Banks have more excess reserves to lend out, increasing money supply.
• Increasing the ratio - Banks must hold more reserves, reducing lending capacity and decreasing money supply.

This tool is rarely adjusted due to its abrupt effects on commercial banks' profitability.

The discount rate and how it influences money supply

The discount rate is another monetary policy instrument that central banks use to affect commercial banks' borrowing costs and, consequently, the overall money supply.

The discount rate

The discount rate, also known as the refinancing rate or base rate, is the interest rate charged by the central bank on short-term loans to commercial banks.

Effects of adjusting the discount rate:

• Lowering the rate - Banks can obtain additional reserves more cheaply, increasing lending and money supply.
• Raising the rate - Discourages banks from borrowing additional reserves, restricting money supply.

This tool is not frequently used as a regular tool but is employed during financial emergencies to ease pressure on banks with troubled loan portfolios.

Open market operations as a primary tool

Open market operations are the most commonly used monetary policy tool by central banks to adjust the money supply through transactions in government securities.

Open market operations

Open market operations involve the central bank buying or selling outstanding short-term government bonds (those maturing in less than a year) from or to commercial banks.

Effects of open market operations:

• Purchasing bonds - Bank reserves increase, allowing more lending and expanding money supply. For example, if a central bank purchases £400 million in bonds, it credits commercial banks' reserves, enabling them to increase lending.
• Selling bonds - Bank reserves decrease, forcing reduced lending and contracting money supply.

As the primary tool, open market operations allow for precise and gradual adjustments to liquidity in the banking system.

Quantitative easing for unconventional policy

Quantitative easing (QE) is an unconventional extension of open market operations, used when traditional tools are insufficient, particularly in low-interest-rate environments.

Quantitative easing

Quantitative easing involves large-scale purchases of longer-term financial assets by the central bank to inject liquidity into the economy. It was developed to address the zero lower bound (ZLB) problem, where interest rates approach zero.

Central banks, such as the Bank of England, the US Federal Reserve, the European Central Bank, and the Bank of Japan, implemented QE after the 2008-09 global financial crisis. It involves purchasing long-term (5-year or 10-year) government bonds, mortgage loans, and other financial assets. These purchases create large amounts of excess reserves, encouraging banks to lend more aggressively.

QE is typically reserved for severe economic downturns when standard monetary policy tools are ineffective.

Tools to increase or decrease money supply

Central banks employ a combination of tools to manage the money supply, aiming to achieve economic stability, control inflation, and support growth.

Tools for increasing money supply

These actions expand liquidity and encourage economic activity:

• Decrease the required reserve ratio.
• Decrease the discount rate.
• Buy short-term government bonds from commercial banks.
• Implement quantitative easing.

Tools for decreasing money supply

These measures restrict liquidity to curb inflation or cool an overheating economy:

• Increase the required reserve ratio.
• Increase the discount rate.
• Sell short-term government bonds to commercial banks.