In recent months, the global economic figures are mostly less than ideal. The market is worrying about global economic recession and is expecting the central banks to implement expansionary monetary policies to stimulate economies. Monetary policy refers to the ultimate economic goal of the central bank to achieve financial and price stability through controlling the liquidity money available in market and the interest rates. There are two types of monetary policy, which are expansionary monetary policy and contractionary monetary policy. The expansionary monetary policy aims to expand the economy by increasing the money supply in market. On the contrary, the contractionary monetary policy aims to lower the overheating risk by reducing the money supply in market. There are four main policy instruments for central bank to carry out monetary policy.
- Open Market Operation
Open market operations involve the purchase and sale of government bonds from and to commercial banks and/or designated market makers, with an aim to control the amount of money in the banking system. When the market is overheated, central bank may use contractionary monetary policy to lower the overheating risk through selling or stop reinvesting the maturing government bonds to/from the commercial banks. Conversely, when the economy turns down, central bank may buy government bonds from the commercial banks in order to increase the money supply in market.
In March 2019, the Federal Reserve announced plan to end balance sheet reduction in September. Balance sheet reduction refers to the action that Fed shrinks the balance sheet by selling bonds. It is a dovish measure to end the balance sheet reduction as it may increase the money supply in market.
- Reserve Requirement Ratio
With the aim to protect depositors from loss, commercial banks must keep/deposit a certain proportion of funds in banks or central banks for depositors’ withdrawal. This part of the capital cannot be used for lending or investment, called reserve fund. Central bank can control the money supply in the market by raising or lowering the reserve requirement ratio. When the central bank wishes to increase the money supply in the market, it can lower the reserve requirement ratio. This action may increase the disposable funds of commercial banks, and they will be more willing and may offer a more favourable rate to enterprises to borrow money. After the money creation process, money supply in market may increase in multiples. Conversely, the central bank can reduce the amount of money in market by raising the reserve requirement ratio.
In January 2019, the People’s Bank of China decided to cut the reserve requirement ratio by 1 percentage. This measure can reduce the liquidity fluctuation caused by the outflow of cash before the Chinese New Year. Moreover, the measure also increased the support of financial institutions that given to the small and micro enterprises and private enterprises.
- Policy Rate
Policy rate is the interest rate that a central bank sets and that it announces publicly is normally the rate at which it is willing to lend money to the commercial banks. When the policy rate is raised, the borrowing costs of commercial banks will rise. Therefore, the interest rate that commercial banks charged the public will also rise, then the money supply in market will fall. On the contrary, the central bank can increase the amount of liquidity money in market by lowering the policy rate.
- Money Printing
Printing banknotes is the most direct monetary policy. Central bank can increase the amount of liquidity money in market by printing banknotes, but the inflation problem is likely to be derived, which will reduce the purchasing power of the currency.
In conclusion, monetary policy is the measure that government uses to control the money supply in the market, so as to stabilize the commodity price and the economic growth. Fiscal policy is another kind of government policy that have the same objective with monetary policy, but with different measures. We will discuss the measures of fiscal policy in detail and compare the effectiveness of the two policies in the subsequent articles.