How the Central Bank controls Money?

How the Central Bank controls Money?

Hello! Welcome to my first blog where we are going to learn about how a central bank of any country has sole controlling authority on money supply in the economy. This article is divided into 5 portions where we will first build a strong conceptual foundation and then go through the analytical portions.

The Concept of Central Bank

Central Bank is the sole and major authority of any country responsible for maintaining economic strength of the concerned economy. Here, Economy can be understood as a country. The first central bank of the world is Sveriges Riksbank, established in 1668 and it is the central bank of Sweden. Talking about the scope of activities of Central Bank, here are some of them:

  1. Issuance of Notes: In most of the countries, central bank is the sole authority entitled with the power of issuing currency i.e. notes and coins. The Central bank must keep reserves of gold, silver, or other valuable assets as the backup security of issued notes. It helps to gain people's confidence in the currency.

  2. Banker of the government: A Central bank makes and receives payments on the behalf of government and also records government transactions. It also participates in buying and selling of government securities.

  3. Banker of the Banks: Central bank has control over all the remaining banks and financial institutions of the economy and every bank has to keep a certain percentage of its total deposits with the central bank.

  4. Lender of the last resort: To understand in the easiest form, whenever any banks require emergency fund in the verge of bankruptcy, it can get such loans and financial help from the central bank which also helps to gain public confidence in the banking system.

  5. Control of Credit: A central bank controls the amount of credit to be injected in the economy through determination of interest rates and all the banks must follow such determined interest rates.

How money affects Economic activity?

Economic activities includes consumption, production, distribution and exchange.

  1. Consumption: Money allows individuals to buy goods and services, satisfying their needs and wants.

  2. Production: Money is used to pay for factors of production, facilitating the efficient organization of resources and large-scale production.

  3. Distribution: Money compensates individuals for their contributions to production, influencing income and purchasing power.

  4. Exchange: Money simplifies transactions, promoting the exchange of goods and services, specialization, and the division of labor.

The Concept of Liquidity

In macroeconomics, liquidity refers to the ease with which financial assets or instruments can be quickly converted into cash without causing a significant impact on their market value. Cash is the most liquid form of asset.
We often listen to the news or articles saying that there is more liquidity or less liquidity in the market. In simple terms, having more liquidity in economy means having more money and having less liquidity implies having less money in the economy.
This ,"Liquidity" is what central bank wishes to keep in control because having an optimum amount of liquidity is very essential for economic growth. While we will later learn on how central bank increases or decreases money supply(liquidity), lets first learn what happens when money supply is increased or decreased.

  1. When money supply is increased, there is more money in the hands of public due to which public(consumers) demand for more goods and services. Due to more demand, production also increases and so does investment. On the other hand, with increase in demand for goods and services, price of such goods and services also increase.

  2. When money supply is decreased, there is less money in the hands of the public, leading to a reduction in consumer demand for goods and services. The decrease in demand results in lower production and a decline in investment. Conversely, as demand for goods and services decreases, prices may experience downward pressure.

Expansionary and Contractionary Policy:

  1. Expansionary policy is when a government or central bank takes actions to boost the economy. This can include making it easier to borrow money (lowering interest rates), injecting more money into the system, or increasing government spending. The goal is to encourage people and businesses to spend more, invest, and create jobs, especially during economic downturns.

  2. Contractionary policy is when a government or central bank takes steps to slow down a fast-growing economy. They might do this by making it more expensive to borrow money (raising interest rates) or by reducing government spending. The goal is to prevent inflation and keep the economy from getting too hot.

Central Bank's tools to control liquidity (money supply)

  1. Open Market Operations:
    Under Open market operations (OMO), Central Bank controls liquidity by buying or selling government securities. When the central bank buys securities, it injects money into the banking system, increasing bank reserves. This boosts the overall money supply, encourages lending, and puts downward pressure on interest rates. Conversely, when the central bank sells securities, it withdraws money from the system, reducing liquidity.

  2. Discount Rate:
    The discount rate is the interest rate at which commercial banks can borrow money directly from the central bank. When the central bank raises the discount rate, it becomes more expensive for commercial banks to borrow money directly from the central bank. This encourages banks to lend less, reducing the overall money supply and liquidity. Conversely, lowering the discount rate makes borrowing cheaper, encouraging banks to lend more and increasing liquidity.

  3. Reserve Requirement (particularly CRR): CRR is the part of a bank's deposits it must keep as cash with the central bank. It controls lending: higher CRR limits loans, lower CRR boosts lending. If the CRR is higher, banks have to keep more money aside, making less money available for loans and reducing spending. If the CRR is lower, it has to keep less money in central bank and can lend more, which boosts spending.

  4. Term Auction Facility (TAF):
    The TAF is a lending program where the central bank auctions funds to commercial banks for a specified term.
    Commercial banks bid for a certain amount of funds at an interest rate set by the central bank.
    This mechanism helps address liquidity shortages in the banking system by providing banks with access to funds for a fixed period.

  5. Term Deposit Facility (TDF):
    The TDF is a facility that allows banks to place deposits with the central bank for a specific term.
    Banks can voluntarily choose to deposit funds with the central bank for a specified period, and in return, they earn interest.
    The TDF serves as a tool for the central bank to absorb excess liquidity from the banking system.

  6. Quantitative Easing (QE):
    It is a tool used by central banks to boost the economy. They create new money and use it to buy things like government bonds. This puts more money into the financial system, making it cheaper to borrow. The goal is to encourage spending and investment, helping the economy grow, especially during tough times.

  7. Overnight Liquidity Facility(OLF):
    It is like a short-term loan that banks can get from the central bank when they need quick money for just one night.

  8. Standing Liquidity Facility(SLF):
    It is a continuous arrangement where banks can always borrow money from the central bank whenever they face short-term money shortages.

  9. Repo/Repurchase Agreement:
    It is like a short-term loan between a bank and the central bank. The bank sells securities to the central bank with an agreement to buy them back later. It's a way for the bank to get quick cash when needed, and it helps manage liquidity in the financial system.

  10. Reverse Repo:
    Reverse repo is the opposite of repo. It's like a short-term investment where a bank lends money to the central bank by buying securities with an agreement to sell them back later. It's a way for the bank to earn some interest on excess cash, and it helps the central bank manage liquidity in the financial system.

By the use of above mentioned tools, a central bank controls liquidity position in the economy whereas there are even more tools beyond these.

Thank you for allocating time to read it upto here.
Don't forget to check other platforms of mine.