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Control of the Money Supply (M-ss) : Reserve Ratio, Discount Rate, Open Market

Operation

In economics, money supply is the total amount of monetary asset available in an economy at a
specific time. However if supply of money is not carefully controlled, it can have a negative
effect on economic growth. If there is excess supply of money then the result will be inflation
whereas tight control over money may cause depression and unemployment. So, monetary policy
is implemented by central bank to control total money supply.

Graphically, the supply curve for money illustrate the quantity of money supplied at a given
interest rate. Supply curve for money is vertical because it does not depend on interest rate rather
it is decided by central bank.

Three important tools to control money supply:


1. Reserve Ratio
Fed regulations that require banks to hold a minimum reserve-deposit ratio. Reserve
requirement affect rr and m: If Fed reduces reserve requirements, then banks can make more
loans and “create” more money from each deposit.
2. Discount Ratio
Banks may borrow from the Fed. The interest rate they pay the Fed is the discount rate.
Bank borrowing from the Fed leads to an increase in the money supply. The higher the
discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.
In practice, the Fed does not often use the discount rate to control the money supply. The
discount rate cannot be used to control the money supply with great precision, because its
effects on banks demand for reserves are uncertain. Moral suasion is the pressure exerted by
the Fed on member banks to discourage them from borrowing heavily from the Fed.
3. Open Market Operation (OMO)
OMO is a monetary policy tool in which central bank buy and sell bonds to regulate the
money supply in the economy. Security trading is one of the quickest and most effective way
to control economic activity. Open market purchase: If central bank want to increase the
money supply it purchase government securities due to this amount of cash with commercial
bank and people increase. Its done to control recession (expansionay policy). Open market
selling: If central bank wants to reduce money supply it sells government securities to
commercial bank and people which will reduce the cash with commercial bank.This will
decrease the number of loans whereas people’s demand for goods and services shrinks.. Its
done to control inflation (contractionary policy).

Source:
N. Gregory Mankiw. 2016. Principles of Economics (Eight Edition)