How can central bank decreases money supply?

Central banks use several different methods to increase or decrease the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board—commonly referred to as the Fed—could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used, at least not in the United States.

The Federal Reserve Board, which is the governing body that manages the Federal Reserve System, oversees all domestic monetary policy. They are often referred to as the Central Bank of the United States. This means they are generally held responsible for controlling inflation and managing both short-term and long-term interest rates. They make these decisions to strengthen the economy, and controlling the money supply is an important tool they use.

Key Takeaways

• Central banks use several methods, called monetary policy, to increase or decrease the amount of money in the economy.
• The Fed can increase the money supply by lowering the reserve requirements for banks, which allows them to lend more money.
• Conversely, by raising the banks' reserve requirements, the Fed can decrease the size of the money supply.
• The Fed can also alter short-term interest rates by lowering (or raising) the discount rate that banks pay on short-term loans from the Fed.

Modifying Reserve Requirements

The Fed can influence the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy.

Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.

How Do Central Banks Inject Money Into The Economy?

Changing Short-Term Interest Rates

The Fed can also alter the money supply by changing short-term interest rates. By lowering (or raising) the discount rate that banks pay on short-term loans from the Federal Reserve Bank, the Fed is able to effectively increase (or decrease) the liquidity of money.

While the Fed can directly influence a market rise, it is more commonly held accountable for market downturns than it is lauded for upswings.

Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, and so the Fed must be careful not to lower interest rates too much for too long.

In the period following the 2008 economic crisis, the European Central Bank kept interest rates either at zero or below zero for too long, and it negatively impacted their economies and their ability to grow in a healthy way. Although it did not bury any countries in economic disaster, it has been considered by many to be a model of what not to do after a large-scale economic downturn.

Conducting Open Market Operations

Lastly, the Fed can affect the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.

Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system. Adjusting the federal funds rate is a heavily anticipated economic event.

If a nation’s economy were a human body, then its heart would be the central bank. And just as the heart works to pump life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money, and sometimes they need more.

The methods central banks use to control the quantity of money vary depending on the economic situation and power of the central bank. In the United States, the central bank is the Federal Reserve, often called the Fed. Other prominent central banks include the European Central Bank, Swiss National Bank, Bank of England, People’s Bank of China, and Bank of Japan.

Let's take a look at some of the common ways that central banks control the money supply—the amount of money in circulation throughout a country.

Key Takeaways

• To ensure a nation's economy remains healthy, its central bank regulates the amount of money in circulation.
• Influencing interest rates, printing money, and setting bank reserve requirements are all tools central banks use to control the money supply.
• Other tactics central banks use include open market operations and quantitative easing, which involve selling or buying up government bonds and securities.

Why the Quantity of Money Matters

The quantity of money circulating in an economy affects both micro- and macroeconomic trends. At the micro-level, a large supply of free and easy money means more spending by people and by businesses. Individuals have an easier time getting personal loans, car loans, or home mortgages; companies find it easier to secure financing, too.

At the macroeconomic level, the amount of money circulating in an economy affects things like gross domestic product, overall growth, interest rates, and unemployment rates. The central banks tend to control the quantity of money in circulation to achieve economic objectives and affect monetary policy.

Print Money

Once upon a time, nations pegged their currencies to a gold standard, which limited how much they could produce. But that ended by the mid-20th century, so now, central banks can increase the amount of money in circulation by simply printing it. They can print as much money as they want, though there are consequences for doing so. 

Merely printing more money doesn’t affect the economic output or production levels, so the money itself becomes less valuable. Since this can cause inflation, simply printing more money isn't the first choice of central banks.

Set the Reserve Requirement

One of the basic methods used by all central banks to control the quantity of money in an economy is the reserve requirement. As a rule, central banks mandate depository institutions (that is, commercial banks) to keep a certain amount of funds in reserve (stored in vaults or at the central bank) against the amount of deposits in their clients' accounts.

Thus, a certain amount of money is always kept back and never circulates. Say the central bank has set the reserve requirement at 9%. If a commercial bank has total deposits of $100 million, it must then set aside $9 million to satisfy the reserve requirement. It can put the remaining $91 million into circulation.

When the central bank wants more money circulating into the economy, it can reduce the reserve requirement. This means the bank can lend out more money. If it wants to reduce the amount of money in the economy, it can increase the reserve requirement. This means that banks have less money to lend out and will thus be pickier about issuing loans. 

Central banks periodically adjust the reserve ratios they impose on banks. In the United States (effective January 1, 2022), smaller depository institutions with net transaction accounts up to $32.4 million are exempt from maintaining a reserve. Mid-sized institutions with accounts ranging between $32.4 million and $640.6 million must set aside 3% of the liabilities as a reserve. Institutions with more than $640.6 million have a 10% reserve requirement.

On March 26, 2020, in response to coronavirus pandemic, the Fed reduced reserve requirement ratios to 0%—eliminating reserve requirements for all U.S. depository institutions, in other words.

Influence Interest Rates

In most cases, a central bank cannot directly set interest rates for loans such as mortgages, auto loans, or personal loans. However, the central bank does have certain tools to push interest rates towards desired levels. For example, the central bank holds the key to the policy rate—the rate at which commercial banks get to borrow from the central bank (in the United States, this is called the federal discount rate).

When banks get to borrow from the central bank at a lower rate, they pass these savings on by reducing the cost of loans to their customers. Lower interest rates tend to increase borrowing, and this means the quantity of money in circulation increases.

Engage in Open Market Operations

Central banks affect the quantity of money in circulation by buying or selling government securities through the process known as open market operations (OMO). When a central bank is looking to increase the quantity of money in circulation, it purchases government securities from commercial banks and institutions. This frees up bank assets: They now have more cash to loan. Central banks do this sort of spending a part of an expansionary or easing monetary policy, which brings down the interest rate in the economy.

The opposite happens in a case where money needs to be removed from the system. In the United States, the Federal Reserve uses open market operations to reach a targeted federal funds rate, the interest rate at which banks and institutions lend money to each other overnight. Each lending-borrowing pair negotiates their own rate, and the average of these is the federal funds rate. The federal funds rate, in turn, affects every other interest rate.Open market operations are a widely used instrument as they are flexible, easy to use, and effective.

Introduce a Quantitative Easing Program

In dire economic times, central banks can take open market operations a step further and institute a program of quantitative easing. Under quantitative easing, central banks create money and use it to buy up assets and securities such as government bonds. This money enters into the banking system as it is received as payment for the assets purchased by the central bank. The banks' reserves swell up by that amount, which encourages banks to give out more loans, it further helps to lower long-term interest rates and encourage investment.

After the financial crisis of 2007–2008, the Bank of England and the Federal Reserve launched quantitative easing programs. More recently, the European Central Bank and the Bank of Japan have also announced plans for quantitative easing.

The Bottom Line

Central banks work hard to ensure that a nation's economy remains healthy. One way central banks accomplish this aim is by controlling the amount of money circulating in the economy. Their tools include influencing interest rates, setting reserve requirements, and employing open market operation tactics, among other approaches. Having the right quantity of money in circulation is crucial to ensuring a stable and sustainable economy.

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