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 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.
Central banks have various tools to control the money supply in an economy. One such tool is the adjustment of reserve requirements. By reducing the reserve requirement, central banks can increase the amount of money circulating in the economy. Conversely, increasing the reserve requirement can decrease the money supply. This is because banks have less money to lend out, leading to more selective lending practices.
Reserve requirement adjustments by central banks are not arbitrary. In the United States, as of 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. For institutions with more than $640.6 million, a 10% reserve requirement is imposed. In response to the coronavirus pandemic on March 26, 2020, the Federal Reserve reduced reserve requirement ratios to 0%, effectively eliminating reserve requirements for all U.S. depository institutions. Central banks also influence interest rates, although they cannot directly set rates for specific loans like mortgages or auto loans. They control the policy rate, which is the rate at which commercial banks can borrow from the central bank. In the United States, this is known as the federal discount rate. When banks borrow at a lower rate, they can reduce the cost of loans to their customers, which can increase borrowing and the quantity of money in circulation. Open market operations (OMO) are another method by which central banks affect the money supply. By purchasing government securities, central banks increase the cash available for banks to lend, which can lower interest rates and stimulate the economy. This is part of an expansionary monetary policy. Conversely, when money needs to be removed from the system, central banks sell government securities, which reduces the cash available for lending. In the United States, the Federal Reserve uses OMO to target the federal funds rate, the interest rate at which banks lend to each other overnight. This rate influences all other interest rates in the economy. In extreme economic conditions, central banks may implement a quantitative easing program, taking open market operations further by purchasing large quantities of government securities to increase the money supply. This is done to stimulate economic growth during periods of economic downturn.Quantitative easing is a monetary policy tool used by central banks to stimulate the economy. Under this policy, central banks create money and use it to buy assets such as government bonds. This newly created money enters the banking system as payment for the assets purchased, increasing banks’ reserves and encouraging them to extend more loans.
Lowering long-term interest rates and promoting investment are key objectives of quantitative easing. After the financial crisis of 2007-2008, the Bank of England and the Federal Reserve initiated such programs. More recently, the European Central Bank and the Bank of Japan have also announced their plans for quantitative easing. The primary goal of central banks is to maintain a healthy national economy. They achieve this by controlling the money supply in circulation. Their toolkit includes influencing interest rates, setting reserve requirements, and conducting open market operations. Ensuring the right amount of money in circulation is vital for a stable and sustainable economy.
