• Varun Mittal

Monetary policy and its effects on money supply

In a previous article, I discussed how one of the monetary policy's tools - lowering the base/reserve rate – can impact interest rates in the economy. In this article, I will explain how it affects the money supply, in addition to many subsequent impacts that monetary policy can have.

The two primary methods available for central banks to use to influence money supply are Quantitative Easing (QE) and Quantitative Tightening (QT). QE is a term that many of you may have seen if you have read about the 2008 financial crisis. However, it sounds much more complicated than it is; all it means is that the central bank will increase or decrease the supply of money in the economy.

Quantitative Easing can get extremely complicated the more you get into it, so we will keep it simplistic. Effectively, the central bank would first create money on a spreadsheet. They would then use this money to go out and purchase government bonds that investors hold; most often, they would buy the bonds from banks. The bondholders will have the money from the bond and have extra liquidity, and as the central bank now holds those bonds, they do not require that the government pays it back. Thus, the amount of money in the economy increases. Often, the bonds bought are held by commercial banks; therefore, those banks now have a more significant number of funds and can reduce their interest rates. This leads to lower interest rates - the impact I explained in my last article, more consumer borrowing and spending, and potentially business spending if conditions are right.

Another method to increase the money supply would be to reduce the reserve requirement for commercial banks. The reserve requirement is a requirement by central banks stating that commercial banks must keep at least x% of their total assets in liquid cash for consumers. This is so that banks can hold a suitable amount of funds should consumers wish to withdraw funds – most often also done to prevent a bank run. By reducing the percentage that banks must hold, the central bank allows those commercial banks to lend out more money. Therefore, there would be more money in circulation around the economy.

Quantitative tightening works oppositely; the central bank could enforce that the government pays them the principal amount for their purchased bonds. Once they receive this money, they would then put it back into the spreadsheet and make money disappear. Of course, it is a lot more complicated than this, but this is called quantitative tightening to keep it simple. Increasing the reserve rate would also have the opposite effect; it would limit how much money the commercial banks could lend. The total quantity of money circulating in the economy has fallen.

Hopefully, this has been a quick guide as to how the government can influence the money supply. There are many different tools besides what has been mentioned here; the best way to further knowledge on this topic would be to look up monetarism. I plan to explain monetarism and the monetarist theory of inflation in my next article, so stay on the lookout for that.