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 support healthy economic growth are outlined below.
Responsibilities of Central Bank
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.
Process of creating money
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 the 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 for 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 says, $ 1,000B; cr = 0.8 and r =.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.
Tools of Monetary Policy
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, which in turn create money through their capability to extend credit. Bank credit boosts economic activities and helps to increase GDP, but at the same time, it increases inflation in the economy. This task is done through an Open Money market operation (OMO) by using two tools to achieve this target.
Sucking excessive money circulating in the economy through Mop-up. The central bank sells its bonds and securities to the financial sector and the general public by using a financial instrument called the repo.
Repo is just like borrowing; the central bank borrows at predetermined interest rates. It sells bonds and securities with a promise to buy them back at a predetermined time and interest rate. in this way, the bank clears excessive money circulating in the economy.
The open market operations
The State Bank of Pakistan (SBP), Pakistan’s central bank, conducts four types of open market operations (OMOs) to manage the country’s liquidity.
It is the procedure by which the central bank purchases or sells government assets on the open market. When the SBP seeks to expand the money supply, it buys government securities from commercial banks, injecting cash into the economy. When it wishes to reduce the money supply, it sells government securities, which removes cash from the economy. This tool is used to manage banking system liquidity and achieve specific economic goals.
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 only completed on time when compared to lending rates. The responsiveness of returns on investments was affected by a 100-basis point change in money market rates.
Banks and other financial institutions (FIs) create money by lending it to businesses with the money that members of the public deposit in them. The multiplier effect increases the number of bank deposits. The legal reserve requirement is one tactic used to control the amount of money in circulation. When the economy lacks liquidity, the nation’s central bank “injects” money by buying bonds and other assets.
The country’s central bank will either soak up excess money or suck it out of the economy. Mop-up by utilizing a financial instrument of the repo to sell bonds and securities to the public and financial industry.
The discount rate is another instrument that the CB employs. The interest rate at which FI and banks borrow money from the CB is this.
The main node in this picture is “Tools of Monetary Policy,” and it comprises five child nodes that reflect the various monetary policy tools in Pakistan: interest rates, open market operations, reserve requirements, discount rate, and moral suasion. The arrows indicate the connection between the main node and the child nodes.