MacroeconomicsI_working_version (1)

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Chapter 13
Central banks have an important role in modern and highly developed countries. The main
function of the central bank is to control money supply and credit conditions in the
country. The central bank conducts national monetary policy, which should assist the
economy in achieving the potential output (its non-inflationary level) and full employment.
In addition to that fundamental objective, the central bank focuses on stabilising the price
level in the country. The central bank may increase money supply in the economy to
stimulate spending and investment during contraction of output. Conversely, it conducts
restrictive monetary policy to slow down inflation and rapid rise in spending. Thus, a
central bank may influence total output, employment and inflation by altering the supply of
money in the economy.
In fact, the central bank controls money supply by controlling the excess reserves held by
commercial banks. These reserves play the key role in the money-creation process of the
banking system in the economy 1 . In this chapter we will explain how altering money
supply influences the nation’s interest rates, aggregate demand, total output and
employment.
13.1. Tools of Monetary Policy
Figure 13.1 describes the relationship among the monetary policy instruments,
intermediate targets and ultimate objectives. There is a number of policy tools
(instruments) the central bank can use to influence the intermediate targets such as interest
rates, reserves, and the money supply). Controlling intermediate targets is, in fact, the way
to achieve the ultimate objectives (Stable prices, low unemployment and sustainable
growth in real output) in the economy.
• Open-market operations consist of dealing with government bonds by the central
bank in the open market. The central bank is buying bonds from, or selling bonds to,
commercial banks and the general public. The aim of such dealing in the open market is
raising or lowering commercial banks’ reserves. The open market operations are
considered to have the most stabilising effect in the variety of central bank’s policy
instruments.
• Reserve-requirements policy (the reserve ratio) influences the bank-system’s ability
to create new money by lending. This policy covers altering the legal reserve ratio
requirements on deposits in banks and other financial institutions due to controlling
money supply as an ultimate objective. Lowering the reserve ratio leads required
reserves to excess reserves and enhances the ability to create new money by lending
within the bank system. Raising the reserve ratio increases the amount of required
reserves bank must keep and thus banks lose excess reserves. This reduces the ability to
create new money by lending and hence supply of money decreases in the economy.
• Discount-rate policy allows the member banks borrow reserves from the central bank
at the discount rate (set by the central bank). The central bank, as “a lender of last
resort” provides funds to commercial banks, which reveal unexpected and immediate
needs for additional financing. This is the case, when the central bank provides shortterm
loans. The interest rate called the discount rate is the charge for the commercial
1 To examine money-creation process see chapter 7.