How central banks control money

Central banks are the key organizations that control money supply. These organisations hold different names depending on their country: the Federal Reserve controls monetary policy in the United States, for the European Union it is the European Central Bank, and China’s is the People’s Bank of China.

Each central bank has different methods for controlling money. However, there are some standard tools all central banks use, and understanding these will give you a stronger understanding of how money supply is controlled.

What is money supply?

Money supply refers to the total amount of money that is in circulation within an economy. It includes both physical currency like paper notes and digital forms such as the value of your bank checking account.

Money supply does not include amounts in your savings account and liquid assets such as bonds. That money is technically not in circulation. If you were to transfer money from an asset or savings account into your checking account, you would increase money supply, albeit only slightly.

There are actually four different measurements of money supply. But to understand the role central banks play, you only need to focus on M1, which refers to the basic definition of money supply we’ve described.

All fiat currencies are backed by their issuing government. This means all currency included in money supply is recognised as legal tender and backed by governments and financial institutions.  

Why is money supply important?

Money supply is crucial when examining monetary policy because it’s what central banks attempt to manipulate in order to control the value of a currency. Money supply is thought to change depending on the ratio of savings to borrowing and the rate of change in GDP.

Money supply is known to have a direct relationship with interest rates:

• Lower interest rates encourage more people to take out loans for purchases and focus less on saving money. The larger money supply also means inflation may rise in response to the influx of spending
• Higher interest rates typically discourage people from borrowing and instead save money in banks, creating a smaller money supply. Because money is more scare, inflation typically lowers as well

From the relationships between money supply, interest rates and inflation, you can see why money supply becomes important for the central bank to stabilise its currency. When money supply changes, so do interest rates, GDP rates, unemployment rates, and the price of goods and services.

In a moment, we’ll cover how central banks control money supply with several economic tools to control inflation, balance the economy and ensure general financial stability.

How does money supply affect markets?

When central banks increase money supply, it can lead to lower interest rates. As covered above, lower interest rates encourage spending and the demand for stocks. High spending can also increase profit margins for businesses and increase stock prices.

Increasing money supply can also lead to high inflation. Many investors and traders use stocks and commodities as a hedge against inflation, creating another boost to those markets.

However, too much of an increase in money supply can weaken a country’s currency in foreign exchange markets. That’s because the weaker currency makes exports more competitive and lowers currency demand.

Of course, central banks control money supply in response to economic indicators like inflation and GDP growth, so it’s important to have a holistic understanding of current economic conditions. You can learn more about money supply, inflation and other economic tools and indicators in our free online Trading Academy.

How do central banks control money?

Central banks control money mainly by selling government securities and adjusting how readily commercial banks can lend and borrow money or sell government securities.

These tools are adjusted periodically throughout the year as central banks deem necessary. Changes are announced with the publication of economic policy, which occur several times throughout the year depending on the central bank.

Stay aware of all central bank announcement with our economic calendar, and keep reading for a breakdown of the key tools central banks use to control money supply including reserve requirements, interest rates, open market operations and quantitative easing.

1. Reserve requirements

Central banks periodically adjust the amount of money commercial banks must keep on hand against the number of deposits they hold. If the reserve requirement is 10%, commercial banks would be required to hold 10% of their deposits, while the other 90% can be used in banking operations like lending to individuals and businesses.

When the reserve requirement is increased, banks will have less money to lend out and as a result will be more scrupulous about who they loan money to. Fewer loans mean less economic activity such as buying houses, cars or business expenses. Raising the reserve requirement may be done to lower the amount of money moving through the economy.

Changing the reserve requirement is one of the fastest ways for a central bank to adjust money supply. For example, in late March 2020, the US Federal Reserve moved the requirement ratio to 0% in response to the covid pandemic. This in theory would encourage spending, or at least help offset the reduction in spending that occurred in response to the pandemic.

2. Interest rates

Central banks also control the rate at which they lend to commercial banks. While central banks do not control interest rates for loans given by those commercial banks, they can hope to influence it by adjusting the rates they use when lending to the commercial banks.

In theory, lower rates set by a central bank will cause commercial banks to also set lower rates and encourage more borrowing and spending. Higher rates set by the central bank will force commercial banks to increase their own rates, making it harder for people to qualify for loans or discouraging people from borrowing altogether.

3. Open market operations

A more direct way for central banks to influence money supply is through buying and selling government securities on the open market, known as open market operations. Open market operations can focus on either expanding money supply or contracting it.

By manipulating the reserves of commercial banks, central banks have another way to influence the interest rate at which banks lend each other money. A interest rate reduces money supply, as banks are less likely to borrow excess reserves for their own operations and instead hold on to what they have.

Expansionary open market operations

When looking to increase money supply, central banks will purchase government debt securities from commercial banks, providing those banks more cash to loan out. This injection of cash also allows banks to lower the federal funds rate and more easily loan excess reserves to other banks.

These government securities have different names depending on the country. For example, they’re called treasury securities in the US, GILTS in the UK and EU-bonds in the European Union.

Contractionary open market operations

When central banks want to decrease money supply and increase interest rates, they sell the treasury bills back to commercial banks. By buying back these securities, commercial banks reduce the amount of money in circulation. Contractionary operations are used to tamp down on high inflation or curb other economic distortions.

4. Quantitative easing

Quantitative easing is a strategy of ‘injecting’ money into the economy to lower borrowing rates and encourage spending and investment. It is similar to open market operations but often used only in economic crises when open market operations are deemed insufficient.  

To perform quantitative easing, the central bank creates digital money to buy longer-term government securities, corporate bonds and even company shares. This injects more money into the economy and reduces the risk spread between government bonds and other securities.

For example, by buying more ‘safe assets’ like bonds, the yield is decreased to the point where investors are encouraged to look at ‘riskier’ assets like shares. This is one way quantitative easing boosts the economy. Once the economy recovers. The central bank sells its assets and sterilises the virtual money from the sales, so no ‘new’ money is actually created.

Quantitative easing was first used by the Bank of Japan in 2001 following the nation’s real estate crash. Other countries’ central banks including the Bank of England, European Central Bank and the United States Federal Reserve have all used quantitative easing. Although the methods differ slightly for each economy.

Money supply in action

To give an example of how a central bank may manipulate money supply, let’s look at how the Bank of England might respond to a hypothetical situation in which economic growth is slowing down and unemployment is rising.

The Bank of England has several tools to stimulate economic activity and increase money supply:

1. Lower reserve requirements: The Bank of England lowers the reserve requirement for commercial banks, allowing them to lend out a larger portion of their deposits. This encourages banks to lend more money
2. Lower interest rates: The central bank decreases the benchmark interest rate, making borrowing cheaper for individuals and businesses. This encourages borrowing and spending, thus boosting economic activity
3. Open Market Purchase: The Bank of England buys government securities from the market. This injects money into the economy and provides banks with additional reserves, encouraging them to lend more to consumers and businesses
4. Quantitative Easing: In addition to the above measures, the Bank of England might decide to engage in quantitative easing by purchasing a significant amount of government bonds. These purchases further increases money supply and help lower long-term interest rates