Tools or Instruments of Monetary Policy

Money supply is best understood through the concept of Monetary Policy. Monetary policy can be defined as a deliberate move by government through the central bank to manipulate the supply, availability and cost of money in order to achieve the desired economic levels. The following are the various instruments/tools that commercial banks use in conjunction with the central bank to regulate the level of money supply. These instruments of monetary policy are also known as methods of credit control. They include:

1) The bank rate policy/bank interest rates

During inflation the Central Bank increases the commercial bank lending rates on loans making borrowing expensive; translating to reduced money supply and during deflation the rates are lowered thus promoting borrowing. Increased rates decrease the amount of currency in circulation while a decrease in rates increase the amount of money in circulation as in individuals are charged low interest rates

2) Open market operation

The open market operation (OMO) is another important monetary policy instrument. It refers to sale and purchase of securities in the stock market. During inflation the central bank sells government securities (treasury bills and bonds) to withdraw an amount of money from the general public and during deflation it buys back the securities to increase currency in circulation.

3) Reserve requirements/liquidiy ratio requirement

This credit control tool Central bank requires commercial banks to hold a certain proportion of total deposits in cash form to meet the needs of those customers who may wish to withdraw cash. Cash ratio=cash held/total deposit. If the central bank lowers this ratio then more money will be available for lending and the vice versa is true. This is meant to decrease or increase money in the commercial bank reserves.

4) Rationing of Credit

This instrument of controlling money supply is based on the size of loans a commercial bank is allowed by the central bank. When there is too much money in circulation, commercial banks may be required to lend money only to a certain limit determined by the Central Bank.

5) Margin Requirements

Central banks also use margin requirements to limit the amount of money that borrowers can access. The margin refers to the difference between a loan and a collateral security. If the margin is big, loans will be expensive thus the public will shy away from borrowing loans thus money supply will reduce and if the margin is small the loans will be cheap thus many people will be more willing to borrow loans, increasing money supply in the economy.

6) Restricting terms of hire purchase agreement and credit sales

Here the Central bank may encourage or discourage the purchase of commodities on installments. To discourage it, the payment period is decreased and deposit fraction raised to discourage buyers from buying on credit thus releasing some lump sum of money which they could be holding, and the vice versa is true.

7) Direct action, requests, moral persuasion and publicity

The Central Bank directs commercial banks to advance loans to a given amount. Directs the commercial banks to behave in a defined way i.e. expand or contract credit creation activities. Reports on financial matters related to commercial banks encourage banks to change their policies.

8) Compulsory deposit requirements:

The Central Bank may also require commercial banks to maintain certain amounts of deposits with it in special accounts whose money would stay frozen. This act has effect of reducing amount of money available to commercial banks for lending which implies a reduction in money supply. If the CBK wishes to increase supply of money, it may reduce/release the deposits to commercial banks.

9) Selective credit control

Central banks often give special instructions to commercial banks and other money lending instructions as to the type of sectors to give credit to and ones which credit should be restricted to.

10) Loans to banks and discount window

A central bank allows eligible institutions to borrow money from them usually to meet short term liquidity needs. When this happens, the amount of money in circulation will increase.

11) Gentlemen’s agreements:

The Gentlemen’s agreement is a voluntary agreement between central bank and banks aimed at improving monetary conditions in economy. In some countries, such agreements have been used between central bank and the largest commercial bank in an effort to lower spread on interest rates.

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