We are going to continue with the study of the role of central banks,

now it is the turn of monetary control.

To this aim, we shall describe the central bank's tools to control
the monetary supply. We have already discussed some characteristics
of commercial banks, the nature of fractional-reserve
banking system and some of the rules of central banks.
We have also said that one of the responsibilities of a central
bank is to regulate the money supply. We will see later in this lecture
that when prices are too high, a recommended policy is
to reduce the money supply.
Or, when there is a danger of a recession, the recommended policy is
to expand the money supply. But the process of money creation
is controlled not only by the central bank but also by commercial
banks; hence, we need to understand what are the tools that the former does
have to change money supply. Usually three main tools of monetary
control are described: the first one is based on exchanging
government bonds and is called an open market operation;
the second one is based on the central bank lending money to
commercial banks and the third one is related with the legal
reserve requirements that the central bank imposes
to commercial banks. The first one consists in the implementation
of open market operations. Open market operations are based
on buying or selling government bonds, also called sovereign
bonds. So, to understand and open market operation, it is important
to describe what is a government bond and how the government borrows
money. When we analysed public savings in lecture 2, we have said
that, when taxes are not enough to pay the public purchase of goods
and services, the government borrows money.
In other words, if T is smaller than G, the government runs a deficit
ans it must borrow the money it needs. So, the public deficit of
a year,  is equal to the amount of money that the government borrows
from other sectors of the economy.
What are the mechanisms that the public sector uses to borrow
money? The most usual is to sell government bonds.
A government bond is a debt certificates issued by the government.
These bonds are usually associated to medium or long-term debt.
For instance, this bond for the United States government was issued
in 1976 and has to be repaid in 1986.
So, it is a ten-years government bond.
There are government bonds with different maturities but, of course,
there are always less liquid than cash.
So, when the public sector wants to borrow some money it sells
bonds to households, firms and commercial banks.
In exchange, the government receives money that is
used to cover the deficit. Then, the public and commercial banks
have always some stock of government bonds.
And there is a secondary market for these bonds which are traded
very frequently. Hence, in any time, the central bank can trade government
bonds with the public or the commercial banks.
Now we may come back to the tools of monetary control and
the open market operations. Open market operations consist
in the central bank buying or selling sovereign bonds
from or to commercial banks or to the public.
Every time that the central bank buys government bonds to the
public or commercial banks, it is exchanging money for bonds.
It is giving a liquid asset to the public or commercial banks
(cash) and taking out a less liquid asset
(bond). After receiving the cash, the public increases the deposits
and the process of multiplication takes place;
the money supply increases. On the other direction, if the central
bank wants to reduce the money supply, it sells  government bonds
to the public or commercial banks. To pay the bonds, they use
their cash or deposits and, therefore, the total reserves of
the commercial banks and the deposits are reduced
and the money supply shrinks. The second mechanism through which
the central bank changes the money supply is by lending money
to commercial banks. If the central bank lends some more money
to commercial banks, they expand their reserves,
have more room for lending money to the public and the process
of money multiplication is set in motion.
When commercial banks borrow money from the central bank, they
have to pay an interest rate called the discount rate.
This is a very specific interest rate charged by the central
bank to commercial banks. So, when the central bank
wants to lend more money to commercial banks, it reduces the
discount rate a and makes more profitable for commercial banks to
borrow money. With this extra money, commercial banks can increase
their reserves and therefore, expand the money supply.
When the central bank wants to reduce the money supply, it increases
the discount rate, induces the commercial banks to borrow less money
and reduces their reserves. The third one,
probably the less important today, is the adjustment of the legal
reserve requirements. One of the regulations that central banks
introduce in the banking system is a minimum share of reserves
for each deposited quantity of money. To reduce the money supply,
the central bank can increase the reserve requirements and induce
those commercial banks which are close to the legal minimum
to increase their reserve ratio. The increase in the reserve
ratio implies a reduction in the multiplier.
For a given level of reserves, a smaller multiplier implies a reduction
in the money supply. This mechanism is only rarely implemented
because, among others things, it is not very useful for increasing the
money supply.  The legal reserve requirement is a legal minimum, so,
reducing this  legal minimum does not necessary
imply that banks change your effective ratio.
They can still keep their old ratio and comply with the new minimum.