Macroeconomics – Monetary policy

Money policy is aimed at controlling the supply of money in the economy (Mankiw, 2002). In most countries, the monetary policy operations are rested with a government institution – the central bank – that enjoys some level of independence (Mankiw, 2002). Through such an institution, the government could use various tools to control the amount of money circulating in the economy. A policy that results in decreased monetary supplies is a contractionary monetary policy and that which increases monetary supplies in the economy an expansionary one (Mankiw, 2002).

Tools of monetary policy

The primary tool through which the central bank controls the supply of money is by open market operations which refer to the sale and purchase of government bonds in the market (Mankiw, 2002). To increase the amount of money in circulation, the central bank uses some of its monetary reserves to purchase government bonds from people who had previously bought them (Mankiw, 2002). To decrease the monetary supply, a reversal of this is made by selling some of the government stocks from its portfolio hence reducing the currency in the hands of the public (Mankiw, 2002).

Through the purchase of government bonds in the open market, the central bank forces the bank cash reserves to increase (Colander, 2008). Such increases in cash at the disposal of banks are used for lending purposes thus increasing the economy’s deposit base (Colander, 2008).  Such monetary policy approaches that lead to increased amounts of cash in circulation are expansionary in nature (Colander, 2008). These reduce the interest rates whereas increasing the incomes thus encouraging consumption and investment (Colander, 2008). Conversely sale of the governments bonds through open market operations, leads to the decrease of the money in circulation (Colander, 2008). This occurs since by selling such bonds the buyers will draw checks against their bankers whose reserve assets will decline on completion of the process (Colander, 2008). Such policy, a contractionary one, will lead to increased interest rates and decreased incomes thus adversely affecting consumption and investment (Colander, 2008).

Other tools for monetary policy application include the minimum reserve requirements and borrowing from the central bank at a discount rate. By increasing the reserves required to be maintained at the central bank, the amounts of money available for lending will decrease thus reducing the supply of money in the economy (Colander, 2008). The discount rate is the rate at which other banks borrow from the central bank (Colander, 2008). Increasing this rate will result into increased bank lending rates thus making the cost of capital more expensive and thus discourage borrowing (Colander, 2008). Through these ways the government aims to control the supply and demand for money so as to control for inflationary and deflationary trends.

monetary policy



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