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Monetary Policy 101 #1

Monetary policy refers to actions to promote maximum employment, create stable prices, and sustain high economic growth. All these actions are held by a central bank. If we should sort of these objectives by their importance; Inflation, Unemployment but at the same time considering inflation, and long term interest rates. For the many central banks, this arrangement is the same but what are the main instruments to regulate money supply? Fed and many other central banks use three components which are open market operations, discount rate, and reserve requirements.

The open market operation aims to regulate the money supply and to do this, central banks purchase or sell their treasury securities on the market. When the securities are sold by the Central Bank, it increases the money supply but interest rates decrease. Thus, companies are encouraged to invest, and individuals promote to consume more so economic growth and GDP goes up. In contrast, when commercial banks buy bonds from the Central bank, their money stock goes down and the interest rate rises. However, it results in a decrease in economic growth and GDP.

A discount rate is the second instrument that has an effect of increasing the other interest rates in the economy because it represents the cost of borrowing and it influences the supply of money and credit in the economy. Increasing the discount rate discourages banks and it causes a slow economy because of the reducing liquidity. However, when they lower the discount rate, it will positively impact the borrowing and increase the liquidity and raise the growth of the economy.

Last but not least, the reserve requirement is one of the tools and it determines the amount of money that central bank members’ should keep for sudden withdrawals and they are not allowed to lend. Also, it is used to increase or decrease the money supply. As an example, assume a bank had $300 million deposits and it is required to hold %10. Under this condition, the bank cannot lend out $270 million, which intemperately increases bank credit and when central banks want to increase the amount of money in the economy, they lower the reserve requirements and it is enlarged banks’ credit and decreased the rates.

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