If a nation’s economy were a human body, then its heart would be the central bank. And just as the heart works to pump life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money, and sometimes they need more. In this article, we’ll discuss how central banks control the quantity of money in circulation. (For related reading, see: What Are Central Banks?)
The methods central banks use to control the quantity of money vary depending on the economic situation and power of the central bank. In the United States, the central bank is the Federal Reserve, often called the Fed. Other prominent central banks include the European Central Bank, Swiss National Bank, Bank of England, People’s Bank of China, and Bank of Japan. (Related reading, see: Get To Know The Major Central Banks).
Why the Quantity of Money Matters
The quantity of money circulating in an economy affects both micro and macroeconomic trends. At the micro level, a large supply of free and easy money means more personal spending. Individuals also have an easier time getting loans such as personal loans, car loans, or home mortgages.
At the macroeconomic level, the amount of money circulating in an economy affects things like gross domestic product, overall growth, interest rates, and unemployment rates. The central banks tend to control the quantity of money in circulation to achieve economic objectives and affect monetary policy. Through this article, we take a look at some of the common ways that central banks control the quantity of money in circulation.
1. Print More Money
As no economy is pegged to a gold standard, central banks can increase the amount of money in circulation by simply printing it. They can print as much money as they want, though there are consequences for doing so. Merely printing more money doesn’t affect the output or production levels, so the money itself becomes less valuable. Since this can cause inflation, simply printing more money isn't the first choice of central banks.
2. Set the Reserve Requirement
One of the basic methods used by all central banks to control the quantity of money in an economy is the reserve requirement. As a rule, central banks mandate depository institutions to keep a certain amount of funds in reserve against the amount of net transaction accounts. Thus a certain amount is kept in reserve, and this does not enter circulation. Say the central bank has set the reserve requirement at 9%. If a commercial bank has total deposits of $100 million, it must then set aside $9 million to satisfy the reserve requirement. It can put the remaining $91 million into circulation.
When the central bank wants more money circulating into the economy, it can reduce the reserve requirement. This means the bank can lend out more money. If it wants to reduce the amount of money in the economy, it can increase the reserve requirement. This means that banks have less money to lend out and will thus be pickier about issuing loans.
In the United States (effective January 19, 2017), smaller depository institutions with net transaction accounts up to $15.5 million are exempt from maintaining a reserve. Mid-sized institutions with accounts ranging between $15.5 million and $115.1 million must set aside 3% of the liabilities as reserve. Depository institutions bigger than $115.1 million have a 10% reserve requirement.
3. Influence Interest Rates
In most cases, a central bank cannot directly set interest rates for loans such as mortgages, auto loans, or personal loans. However, the central bank does have certain tools to push interest rates towards desired levels. For example, the central bank holds the key to the policy rate—this is the rate at which commercial banks get to borrow from the central bank (in the United States, this is called the federal discount rate). When banks get to borrow from the central bank at a lower rate, they pass these savings on by reducing the cost of loans to its customers. Lower interest rates tend to increase borrowing, and this means the quantity of money in circulation increases.
4. Engage in Open Market Operations
Central banks affect the quantity of money in circulation by buying or selling government securities through the process known as open market operations (OMO). When a central bank is looking to increase the quantity of money in circulation, it purchases government securities from commercial banks and institutions. This frees up bank assets—they now have more cash to loan. This is a part of an expansionary or easing monetary policy which brings down the interest rate in the economy. The opposite is done in a case where money needs to taken out from the system. In the United States, the Federal Reserve uses open market operations to reach a targeted federal funds rate. The federal funds rate is the interest rate at which banks and institutions lend money to each other overnight. Each lending-borrowing pair negotiates their own rate, and the average of these is the federal funds rate. The federal funds rate, in turn, affects every other interest rate. Open market operations are a widely used instrument as they are flexible, easy to use, and effective.
5. Introduce a Quantitative Easing Program
In dire economic times, central banks can take open market operations a step further and institute a program of quantitative easing. Under quantitative easing, central banks create money and use it to buy up assets and securities such as government bonds. This money enters into the banking system as it is received as payment for the assets purchased by the central bank. The bank reserves swell up by that amount, which encourages banks to give out more loans, it further helps to lower long-term interest rates and encourage investment. After the financial crisis of 2007-2008, the Bank of England and the Federal Reserve launched quantitative easing programs. More recently, the European Central Bank and the Bank of Japan have also announced plans for quantitative easing.
The Bottom Line
Central banks work hard to ensure that a nation's economy remains healthy. One way central banks do this is by controlling the amount of money circulating in the economy. They can do this by influencing interest rates, setting reserve requirements, and employing open market operation tactics, among other approaches. Having the right quantity of money in circulation is crucial to ensuring a healthy and sustainable economy.