How Central Banks Control the Supply of Money

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.

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.

Let's take a look at some of the common ways that central banks control the money supply—the amount of money in circulation throughout a country.

Key Takeaways

  • To ensure a nation's economy remains healthy, its central bank regulates the amount of money in circulation.
  • Influencing interest rates, printing money, and setting bank reserve requirements are all tools central banks use to control the money supply.
  • Other tactics central banks use include open market operations and quantitative easing, which involve selling or buying up government bonds and securities.

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 spending by people and by businesses. Individuals have an easier time getting personal loans, car loans, or home mortgages; companies find it easier to secure financing, too.

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.

Print Money

Once upon a time, nations pegged their currencies to a gold standard, which limited how much they could produce. But that ended by the mid-20th century, so now, 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 economic 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.

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 (that is, commercial banks) to keep a certain amount of funds in reserve (stored in vaults or at the central bank) against the amount of deposits in their clients' accounts.

Thus, a certain amount of money is always kept back and never circulates. 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. 

Central banks periodically adjust the reserve ratios they impose on banks. In the United States (effective January 1, 2022), smaller depository institutions with net transaction accounts up to $32.4 million are exempt from maintaining a reserve. Mid-sized institutions with accounts ranging between $32.4 million and $640.6 million must set aside 3% of the liabilities as a reserve. Institutions with more than $640.6 million have a 10% reserve requirement.

On March 26, 2020, in response to coronavirus pandemic, the Fed reduced reserve requirement ratios to 0%—eliminating reserve requirements for all U.S. depository institutions, in other words.

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—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 their customers. Lower interest rates tend to increase borrowing, and this means the quantity of money in circulation increases.

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. Central banks do this sort of spending a part of an expansionary or easing monetary policy, which brings down the interest rate in the economy.

The opposite happens in a case where money needs to be removed from the system. In the United States, the Federal Reserve uses open market operations to reach a targeted federal funds rate, 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.

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 banks' 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 accomplish this aim is by controlling the amount of money circulating in the economy. Their tools include 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 stable and sustainable economy.

Article Sources
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  1. Board of Governors of the Federal Reserve System. "Reserve Requirements."

  2. Board of Governors of the Federal Reserve System. "Federal Reserve Actions to Support the Flow of Credit to Households and Businesses."

  3. Board of Governors of the Federal Reserve System. "The Discount Window and Discount Rate."

  4. Federal Reserve Bank of St. Louis. "Federal Funds Rate."

  5. Bank of England. "What Is Quantitative Easing?"

  6. Federal Reserve Bank of St. Louis. "Quantitative Easing: How Well Does This Tool Work?"

  7. European Central Bank. "How Quantitative Easing Works."

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