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.
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.
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.