Instruments of Monetary Policy

This the Central Bank is able to do with the help of three instruments of monetary policy:

1. Open-market operations

2. Reserve requirements

3. Discount Rate.

I. Open-market Operations:

It is the deliberate sale and purchase of Government bonds by the Central Bank to the general public.

Working:

(i) During inflation:

Objective:

Increase the interest rate by decreasing the money supply.

Central Bank achieves this objective by selling bonds to the public

Result:

Public makes payment to the bank by withdrawing the amount from the commercial bank.

This will lead to a fall in the monetary base and thus decrease the money supply.

(ii) During deflation:

Objective:

Increase the money supply.

It therefore buys bonds from the public

Result:

Public deposit the money in the commercial bank.

The monetary base will increase and thus leading to an increase in the money supply.

II. Reserve Requirements:

Commercial banks have to maintain a minimum reserve-deposit ratio with the Central Bank.

Working:

If the Central Bank increases the Reserve-deposit ratio (rr), the money multiplier will decrease.

Reason:

Money multiplier =1 + cr/cr + rr

Result:

Money supply decreases.

Similarly if rr is lowered, money multiplier will increase and thus money supply will increase.

III. The Discount Rate:

(Commonly known as the Bank Rate)

It is the rate of interest at which the Central Bank gives loans to the Commercial banks.

When commercial banks are unable to meet the reserve requirements because of less reserves, it borrows from the Central Bank.

Working:

(i) If the Central Bank lends at low discount rate, the commercial banks can borrow more from the Central Bank.

Result:

Monetary base and the money supply will increase.

(ii) Similarly, if discount rate is high, borrowing will be less. Both Monetary base and the money supply will fall.

Note:

However, it is not essential that the Central Bank through its three tools will be able to regulate the money supply. For example, Central Bank cannot control the amount which the commercial banks can borrow. In such a situation, if banks borrow less, both the monetary base and the money supply will fall.