Instruments of Monetary Policy

Monetary policy is a central government policy with respect to the quantity of money in the economy, the rate of interest and the exchange rate. Two basic types of monetary policy are contractionary (or tight) and expansionary (or easy/free/loose) policies. Expansionary monetary policy is a policy which expands (increases) the supply of money, whereas contractionary monetary policy is the one that contracts (decreases) the supply of a country's currency.

The main instrument used by a central bank to achieve its goals is the interest rate – also known as the discount rate or base rate. This is the rate at which the central bank is ready to lend to commercial banks. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. Let us look at how a rise in the discount rate affects the banking system and the financial markets.

Banks may wish to borrow if they feel that their level of reserves is too low. A rise in the discount rate makes it more costly for commercial banks to borrow from the central bank. If the cost of borrowing from the central bank goes up, commercial banks are less inclined to borrow from it. Since borrowing from the central bank is also a source of bank reserves, an increase in the interest rate and subsequent reduction in borrowing from the central bank puts the commercial banks in a situation where they have lower reserves than they planned to hold. In response, they will reduce their lending by increasing the rates they charge to households and firms. In practice, commercial banks react very quickly to increases in the discount rate.

Another instrument of monetary policy is open market operations, which involve the purchase or sale of government securities by the central bank. When the central bank buys treasury bills or government bonds from a commercial bank, it makes payment simply by increasing the amount of reserves in the account of the commercial bank. Thus, the central bank uses its monopoly power over money creation. As the level of reserves increases, the commercial banks realize that they have more reserves than they need for prudent operation. Therefore, they extend their lending to households and firms by lowering their interest rates. In contrast, when the central bank sells treasury bills or government bonds, the commercial bank will make the payment for the securities from the reserves it deposited at the commercial bank. After the transaction has been completed, the level of reserves will be lower than before, and hence the commercial banks will raise their interest rate to cut their credit to households and firms. In both cases, the change in the reserves translates into a change in the credit provided to firms and households.

Finally, the central bank also requires the commercial banks to hold a percentage of their deposits as reserves. These are called required reserves, and the percentage is known as the required reserve ratio. These reserves are meant to ensure some minimum level of prudence, even if not all commercial banks want to operate as prudently as they should. If the central bank increases the reserve ratio, then the actual reserves of the banks will fall short of the required ratio. Thus the banks will have to raise their interest rate to cut back on loans, and deposit the money freed up as reserves at the central bank. The opposite happens if the central bank decreases the required reserve ratio. Suddenly banks have more reserves than they want to hold, so they will lend the money instead of holding it at the central bank. So if the required reserve ratio increases, the commercial banks lending to households and firms falls. The opposite happens when the required reserve ratio decreases. It is important to point out that required reserve ratios are very stable – central banks do not like to change them too often.

The level of cash deposits and commercial banks' reserves held at the central bank plays an important role in transmitting the central bank's monetary policy to the banking sector and the financial markets. The cash in circulation and the reserves of private banks together are called the monetary base. As we have already said, the central bank has a monopoly over money creation, more precisely, over monetary base creation. The power of a central bank rests on its ability to control the monetary base.

Monetary policy is an effective tool for influencing the economy in the short run. But the trouble is that it is difficult to predict the length of time policies need to take effect. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Ex. 1. Match the words from A with their synonyms in B.

Ex. 2. Match the Russian word combinations with their English equivalents.

Ex. 3. Answer the questions:

1. How can monetary policy be defined?

2. What are contractionary and expansionary monetary policies?

3. What are the main instruments of monetary policy?

4. In what way does the rise in interest rate influence the lending provided by commercial banks?

5. What happens in the situation when the level of reserves in commercial banks increases?

6. Why does the central bank require the commercial banks to hold a percentage of their deposits as reserves?

7. What happens in the situation when the central bank increases/decreases the required reserve ratio?

8. What is the monetary base?

9. Why can monetary policy not be considered a magic wand (волшебная палочка) with which to manage the economy?