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 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 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 the 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 reserved 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
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.Conclusion; The open money market operation, Injection through reverse repoMop-up through repo
Long term liquidity management
Bai-Muajjal; Islamaic mode of deferred payment
When members of the public deposit money in a bank, banks, and financial institutions (FI) create money by lending it to businesses.
Bank deposits are amplified by the multiplier effect.
One strategy for regulating the money supply is the legal reserve requirement.
The country's central bank "injects" money when there is a shortage of liquidity in the economy by purchasing bonds and assets.
When there is too much money floating about in the economy, the central bank of the nation will mop it up or suck it.
Mop-up by selling bonds and securities to the financial sector and the general public by using a financial instrument of the repo.
Another, tool used by the CB is the discount rate. This is the interest rate at which banks and FI borrow from the CB.
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