Monetary policy is the use of money supply by the appropriate authority (usually the central bank)  to achieve certain macroeconomic goals.

In other words, monetary policy is the central bank's policy relating to credit creation and money supply.

Monetary policy affects interest rate (the price of money) and the availability of credits.

Whenever there is a change in money supply, the interest rate change as well. 

A tight or contractionary monetary policy is used to reduce the money supply whereas a loose or expansionary monetary policy is used to increase the money supply.

Although monetary policy is affected by other factors, the control of the quantity of money supplied is considered to be the most important factor in monetary policy.

In any case, monetary policy is defined as the central bank's use of money supply or interest rate (which is the price of money) to influence economic activity in the policy.

Instruments Used In Monetary Policy

Honestly speaking, there are different instruments that the central bank used to achieve its monetary policies.

They include bank rate, reserve requirement, open market operation, consumer credit control, margin requirement, etc.

However, we can group these monetary policies into two broad headings: Quantitative or general method and quantitative or selective method

Quantitative Methods

These instruments seek to change the total amount of credits in the economy. Because they seek to change the amount of credit in the general economy, there are also called general methods. 

There are just three in number: Bank rate, open market operations, and reserve requirement.

1. Bank rate: This is the minimum rate at which a country's central bank lends to its commercial banks.

Because the central bank used to offer funding to commercial banks by rediscounting bills of exchange, the bank rate is also known as the discount rate.

The central bank can affect the credit creation of commercial banks by changing the bank rate.

Nowadays, bank credit accounts for a large portion of the money supply. Therefore, a change in bank rate will inadvertently affect commercial bank credit creation in the aggregate economy.

When the central bank increases the bank rate, the commercial banks are discouraged to borrow from the central bank.

Furthermore, an increase in bank rates will prompt commercial banks to increase their lending rate.

With higher lending rates, businessmen and industrialists will be discouraged from borrowing from the central bank. This would contract the money supply 

The reverse is also true. A fall in the bank rate will cause a reduction in commercial banks' lending rates. 

Because the lending rate is low, businessmen and industries will be encouraged to borrow more from commercial banks. This would result in an expansion in the money supply.

To summarize, there is an inverse relationship between bank rate and money supply. 

That is to say, an increase in bank rate reduces the money supply while a decrease in bank rate increases the monetary supply.

2. Reserve requirement: Banks are required by law to hold a certain percentage of cash as reserves against deposits. This is called reserve requirement or cash reserve ratio (CRR).

For example, If the cash reserve ratio is 5%, banks must hold €5,000 in reserves against €100,000 in deposits

You might ask: What happens to the remaining €95,000?

It's loaned out to businessmen and other deficient units of the economy.

What this means is that bank credit creation depends on the reserve requirement. 

So, if the central banks decide to increase the cash reserve ratio from 5% to 10%, it simply means that banks must hold 10,000 in reserves against €100,000 deposits. 

As a result, the maximum amount of money that banks can loan out decreases from €95,000 to €90,000. This eventually results in a reduction in the money supply

Conversely, if the central banks decide to decrease the money cash reserve ratio from 5% to 3%, banks must, therefore, hold €3,000 against a deposit of €100,000

As a result, the amount of money that banks can loan out increases from 95,000 to 97,000. This will eventually lead to an increase in the money supply.

To summarize, there is an inverse relationship between the cash reserve ratio and money supply.

That is, the money supply decreases the when cash reserve ratio increases and decreases when the cash reserve ratio increases.

However, it is important to note here that an increase in the cash reserve ratio will not have any effect on the money supply if banks are holding excess reserves.

3. Open market operation: This is simply the purchase and sales of securities by the central bank of a country.

Central banks influence the money supply when they purchase or sell securities.

When the central bank sells securities on the open market, it receives payment from a commercial bank in the form of a cheque.

As a result, the bank's cash balance with the central bank will be lower by the same amount.

And because the commercial bank's cash balance has been reduced, the commercial bank has to reduce its credit to meet its reserve requirement, thereby decreasing the money supply

In contrast, when the central bank buys securities in the open market, the central bank paid cash funds to the bank which increases the bank's cash reserve.

With an increased cash reserve, banks can now loan out more money thereby increasing the money supply.

To sum it up, the money supply increases when the central banks buy securities and decreases when the central bank sells securities.

Qualitative or Selective Methods

These seek to change the volume of a specific type of credit. The main aim of the selective method is to adjust the way credit is distributed or allocated among its various users.

Quantitative methods include margin requirement, control of consumer credits, and moral suasion.

1. Margin requirement: This is the difference between the market value of the security pledged as collateral for a loan and the loan amount itself.

For example, if the margin requirement is 20%, then a borrower must pledge security of €40,000 to obtain a loan of €32,000

So, if the central bank raises the margin requirement to 25%, then a borrower seeking a loan of 32,000 will be required to provide €42,667 in security.

As a result, businessmen are less likely to borrow from banks, reducing the demand for loans and the supply of money

For the same reason, a decrease in margin requirement would lead to an increase in the demand for loans and money supply.

To summarize, there is an inverse relationship between money supply and margin requirement. 

That is money supply increases when margin requirement falls and decreases when margin requirement.

2. Control of consumer credit: This is another method used by central banks to control monetary supply.

When the central banks want to increase the money supply, it increases the number of credits available for particular goods. 

To contract the money supply, the central bank decreases the number of credit facilities available to purchase a particular good.


3. Moral suasion: This refers to the central bank's informal methods of persuading banks to act in a way that is consistent with their monetary policies

It is the qualitative monetary policy used by the central bank to convince commercial banks to grant credit by the central bank's instruction.

Honestly speaking, moral suasion is a form of advice. It is devoid of any compulsion or coercion. 

It is important to note that moral suasion will succeed if the central banks are powerful enough to influence the banks without resorting to coercion.