Principles of Economics/Monetary Policy

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There are four major components to Monetary policy, the decision of how much money is to be made available to the economy. All of them are controlled in part by the Central Bank:

Setting the required reserve ratio[edit]

Banks can only lend out a (albeit large) portion of the deposits consumers make to them. A few percentage points are generally required to be held on hand so that consumers making withdrawals will be able to get their money and to prevent infinite money multipliers perpetuated by unscrupulous and risky banking procedures. The Required Reserve Ratio (r) limits the amount of money available in the economy by preventing banks from creating more money than the Central Bank desires.

Setting the discount window lending rate[edit]

The Discount Window Lending Rate is the rate at which the Central Bank makes loans exclusively to other registered banks in times of financial and banking instability. Use of the discount window is generally frowned down upon by the general populace and any banks using it (without the backing of moral suasion, see below) will suddenly find stock shares plummetting due to a greatly reduced confidence due to a historical savings-and-loans crisis involving weak banks using the discount window. The discount window's rate is determined by the Central Bank; an announcement of an increase in the rate would mean fewer banks obtaining money through that means, less money for the economy, and shrinkage, while an announcement of a decrease in the rate would pump more money into the economy.

Open market operations[edit]

The Central Bank may also buy and sell securities to and from the public and banks in what is known as Open market operations. If it buys securities, its money is entered into the economy, hence allowing for more transactions to be made. If it sells securities, it takes money out of the economy, slowing it down.

Moral suasion[edit]

This method involves encouraging people to take certain actions that have certain effects on the economy. This is generally the one with the least determinate effect and is heavily laden sociologically.