Question

List the three traditional tools that a central bank has for controlling the money supply.

Short answer

The three traditional tools that a central bank has for controlling the money supply are: 1. Open Market Operations (OMO) - buying and selling of government securities in the open market to impact the money supply. 2. Reserve Requirements - setting the minimum amount of funds a commercial bank must hold in reserve against its deposit liabilities, thus influencing lending capacity and money supply. 3. Discount Rate - adjusting the interest rate at which commercial banks can borrow funds from the central bank, impacting their lending and the money supply.

Step-by-step solution

1. Open Market Operations (OMO)

Open Market Operations (OMO) are the buying and selling of government securities in the open market by a central bank. The central bank aims at increasing or decreasing the money supply through these transactions. When the central bank purchases government securities, it injects money into the banking system which increases the money supply. Conversely, when the central bank sells government securities, it takes money out of the banking system, leading to a decrease in the money supply.

2. Reserve Requirements

Reserve Requirements are the minimum amount of funds that a commercial bank must hold in reserve against its deposit liabilities. By adjusting the reserve requirement ratios, central banks can control the amount of money a bank can lend, thus influencing the money supply. An increase in reserve requirements means banks must hold more funds in reserve, which reduces their lending capacity and thus the money supply in the economy. A decrease in reserve requirements allows banks to lend more money, thereby increasing the money supply.

3. Discount Rate

The Discount Rate is the interest rate at which commercial banks can borrow funds from the central bank, usually on a short term basis. By adjusting the discount rate, the central bank can influence the cost of borrowing for commercial banks, which in turn impacts the money supply. When the central bank raises the discount rate, it becomes more expensive for commercial banks to borrow funds from the central bank, which leads to a reduction in their lending and, consequently, a decrease in the money supply. Lowering the discount rate has the opposite effect, encouraging banks to borrow more and ultimately increase the money supply.