One of the main functions of the central bank is to control the amount of money in circulation by controlling the activities of the central banks. Monetary policy refers to the measures used by the central bank to control the supply of money in other to achieve some desired economic objectives. Such as the control of inflation, reduction in unemployed and so on.
Measures or Instruments of monetary policy.
1) OPEN MARKET OPERATION
In open market operations, the central bank may buy or sale securities through open market operations, payments for these securities (treasury bills and government bond) are made by cheques drawn on commercial banks and as a result the balances at the central bank fall. These balances are considered as cash and because banks must maintain the reserve ration. They have to reduce their deposits by calling loans from customers. This further result in a reduction in bank deposits and purchasing power.
When the central banks buy securities it draws cheques on itself. Most of this cheques would be paid into the commercial banks and the total deposits will increase. This then enables the banks to increase their advances to the customers thereby increasing money supply.
2) BANK RATE
The bank rate is the rate at which the central bank re-discount first class bills. It is essentially the interest rate that the central bank charges the commercial bank for borrowing. The bank rate is also known as the minimum lending rate. It affects the rate of interest charge by the commercial bank to their advances to the customers.
A rise in the bank results in an increase in the interest rate charge by the commercial bank for borrowing. All types borrowing becomes more expensive. The demand for loans is reduced and the supply for money is also reduced.
A fall in the bank rate results in a fall in the interest rate making borrowing expensive. Demand for loans increases lending to an increase in money supply.
3) RESERVE REQUIREMENTS
Commercial banks are required by law to keep a certain percentage of their deposit in cash (i.e cash ratio) of in liquid assets (liquidity ratio to meet the demand for cash by the public. The central bank can raise this reserve requirements to reduce credit creation and money supply. It can also lower the reserve requirement to reduce credit creation and money supply.
4) Special deposits:
The central bank can ask the commercial bank for special deposits in order to reduce their reserve. Special deposits are demanded from the commercial bank when the central bank considers that it is necessary to reduce the deposits of the commercial banks in order to reduce money supply. This ordering the commercial banks to deposit with the central banks and giving percentage of their total deposits.
The central bank may issue directives (instruction) to the commercial banks on the sectors of the economy where loans are to be given (i.e selective credit central) or the maximum amount of loans which commercial banks can give win a particular period of time.
6) MORAL SUASION
The central bank can recommend or appeal the commercial banks to limit their lending. This recommendations or suggestions on the lending policies of commercial banks are strictly followed by the banks.
This is a method of controlling money supply by converting short term securities into medium or long term securities. The central bank does this by lasing long term securities (e.g government long term bonds). And using the money to buy short term bonds e.g treasuring bills).