Central Bank Purchases Back Securities example essay topic

Monetary Policy is important tool used by the government and economists in order to manipulate the current economic situation as much as possible. For example since 1993, monetary policy in the UK has been used primarily to keep inflation below a rate set by the government. Monetary policy is the use of interest rates and the level of the money supply to manage the economy. Interest rates were always used to be set by the government, but the nowadays the control over interest rates has been passed to the Central Bank. The 'operational independence' of the Central Bank means that it can set targets for inflation and set interest rates at the level most appropriate to achieve those targets. The level is set at monthly meetings of the 'Monetary Policy Committee'.

A majority decision of the Committee is all that is required to change the level of interest rates. Using this policy, the central bank uses four techniques in order to control the Money supply. The first and the most commonly used are the open-market operations. This involves the purchase or sale by the central bank of government securities known as bonds or bills in the open market. If for example the central bank wishes to reduce the money supply, it sells more securities. When people buy these securities, they pay for them using cheques drawn on banks.

Thus banks' balances with the central bank are reduced. Banks will reduce advances (credit loans). Therefor this creates a multiple contraction of credit and hence of money supply. The effect will be limited if the extra securities are bills and if some are purchased by banks. The reduction in one liquid asset (balances with the central bank) will be offset to some extent by an increase in another liquid asset (bills), Open market operations are more likely to be effective in reducing the money supply, therefore, when conducted in the bond market. If on the other hand the central bank would like to increase the money supply, the central bank purchases back securities.

When people cash the central bank cheques into their banks, the banks' balances with the central bank will rise. Thus Credit creation can take place. The second type of controlling the money supply is the lending to the banks by the central bank. The central bank in most countries is prepared to provide extra money to banks through re discounting bills, gift repos or straight loans. If the central bank provides more money to banks in this way, they can use it as the basis for credit creation. Funding is also used for controlling money supply, however in this method it is not like the above two methods, it does not focus on controlling the monetary base.

An alternative is for the central bank to attempt to alter the overall liquidity position of the banks. An example of this approach is a change, by the central bank, in the balance of funding the national debt. Assume, for example, that the central bank wishes to reduce the money supply. It will issue more bonds and fewer bills, banks' balances with the central bank will be little effected, but to the extent that banks hold fewer bills, there will be a reduction in the amount of credit created. Funding is thus the conversion of one type of government debt into another. The final type is known as the variable minimum reserve ratios.

If banks are required to maintain a statutory minimum reserve ratio and if the central bank is free to alter this ratio, it can use it as a means of controlling the money supply. It does this by affecting not the monetary base, but the size of the bank multiplier. For example we assume that there are just two types of asset: cash and advances, and that banks are required to maintain a minimum 10 per cent cash ratio. The bank multiplier is thus 10.

Assume that banks' total assets are Lm 100 billion in advances. Now we must assume that the central bank raises minimum reserve ratio to 20 per cent. Banks still have Lm 10 billion cash reserves, and so they have to reduce their advances to Lm 40 billion giving total assets of 50 billion, of which the Lm 10 million cash is the required 20 per cent. The bank multiplier has been reduced to 5.