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 uses to control the money supply are: 1. Open market operations: buying and selling government securities to inject or withdraw money from the economy. 2. Reserve requirements: adjusting the portion of bank deposits that must be held as reserves, influencing the amount of money available for lending. 3. Discount rate: the interest rate at which banks can borrow from the central bank, affecting the cost of borrowing and lending activity.

Step-by-step solution

1. Open Market Operations

Open market operations (OMOs) involve the buying and selling of government securities (bonds) by the central bank. When the central bank wants to increase the money supply, it buys government bonds from commercial banks and other financial institutions. This purchase injects money into the economy, thereby increasing the money supply. Conversely, when the central bank aims to reduce the money supply, it sells government bonds, which takes cash out of circulation.

2. Reserve Requirements

Reserve requirements refer to the portion of a bank's deposits that must be held as reserves, either in cash or in a central bank account, rather than being used for loans and other purposes. By adjusting the reserve requirements, central banks can influence the amount of money banks have available to lend, and thus the money supply. For example, a higher reserve requirement will leave banks with less money to lend, decreasing the money supply, while a lower reserve requirement will increase the amount of available funds for loans, increasing the money supply.

3. Discount Rate

The discount rate is the interest rate at which banks can borrow money from the central bank, typically on a short-term basis. The central bank can influence the money supply by adjusting the discount rate. If the central bank wants to increase the money supply, it can lower the discount rate, making it cheaper for banks to borrow and thereby encouraging them to lend more to their customers. Conversely, if the central bank wants to decrease the money supply, it can raise the discount rate, making borrowing more expensive and thus discouraging lending.