What are the tools of monetary policy?

Monetary Policy Tools

Every central bank has four main monetary policy tools at its disposal to control the money supply and maintain price stability in the economy; however, most central banks have many more. The four primary tools and how they work together to maintain healthy economic growth are outlined below.

the tools of monetary policyThe central bank's principal task is to maintain price stability in the economy. Through credit, the financial sector has the potential to produce money. When the general public deposits money in a bank, banks and other financial institutions lend it to businesses while maintaining Cash Reserve requirements. For example, if you deposit $100 in a bank and the reserve requirement is 5%, the bank will be able to give out $95 in credit. This can also be expressed using the following formula:
1/LRR = 1/0.1 = 10 
As a result, the total amount of money created is-
Money is created by multiplying the initial deposit by 1/LRR, which is 100 * 10 = $1,000.

M = C + D This is the total money supply

B = C + R This is monetary base

Dividing Money supply by the monetary base we get,

M / B = C + D/ C+R Dividing right side by D, we get

M/B= (C/D + D/D) / (C/D + R/D)

C/D is cash to deposit ratio = cr

R/D is reserves to deposit ratio = rr

M / B = cr + 1 / cr + rr Therefore, cr + 1 / cr + rr is money multiplier (m)

M = [(cr + 1) / (cr + rr)] x B

M = m x B

If the monetary base of the country say, $ 1,000B; cr = 0.8 and rr=.01

m = (0.8 + 1) / (0.8 +0.1) = 2.0

and M= 2 x 1,000 = $2,000B

The LRR stands for Legal Reserve Requirement.
Where there is a credit crunch or shortage of liquidity in the economy, the Central bank of the country injects money through “Injection” by buying bonds and securities. In this way, the central bank provides liquidity to financial sectors or banks, who in return create money through their capability to extend credit. Bank credit boosts economic activities and helps to increase GDP but at the time increases inflation in the economy.

This task is done through an Open Money market operation (OMO) by using two tools to achieve this target,

1)  Sucking excessive money circulating in the economy through Mop-up. The central bank sells its bond and securities to the financial sector and the general public by using a financial instrument of the repo.

Repo is just like borrowing, the Central bank borrows at predetermined interest rates. It sells bonds & securities with a promise to buy back at a predetermined time and interest rate, in this way the bank clears excessive money circulating in the economy.

The open market operations 

The State Bank of Pakistan (SBP), Pakistan's central bank, conducts four types of open market operations (OMOs) to manage the country's liquidity.

OMO Process Flow

Changes in official interest rates have an immediate impact on money-market interest rates and, indirectly, bank lending and deposit rates. Several studies have found that new loan lending rates are more susceptible to changes in money market rates than existing loan lending rates. A 100-basis point change in KIBOR for various tenors leads to a 91 to 96 basis point change in new loan lending rates. The entire influence takes two to three months to manifest. Changes in money market rates to deposit rates are not only delayed but also incomplete when compared to lending rates. The responsiveness of returns on investments was affected by a 100 basis point change in money market rates.


For mobile phones, you can listen to the text voice by selecting the icon below this post.

Voice icon

On a PC, you can listen to the text voice by selecting the icon on the right-hand side.

Post a Comment

0 Comments

Research & Reviews: Quantitative and Qualitative research methods

... Verification: 0a33a83c7e367e3b