How the government uses the monetary tools to either expand or contract the money supply in the economy

Monetary policy is a policy that influences the economy through changes in the money supply and credit availability in the economy. This method of influencing the economy was adopted and put in practice as a result of the intervention of economists in trying to get a solution to the great depression that struck the economy of the United States and some western countries. Several schools of thought merged in their quest to solve the depression problem, among which was the classical economist, who believed in the markets ability to be self-regulating through the invisible hand (the pricing mechanism of the market). As the depression deepened, Lord Maynard Keynes was of the view that the economy does not work well on its own and needed to be guided by an active and efficient government. This led to the involvement of the government, in its quest to maintain economic stability, through the central bank adopts various measures to check money supply in the system .This is because, too much money could cause inflation whereas too little money could cause deflation and slow down economic activities. Monetary tools used by the central bank in doing this include the following: Open Market Operation (OMO); this involves the buying and selling of bonds in the open market (that is the public). To increase the money supply, the central bank buys bonds from the public. This makes money available to the public, part of which are deposited with the commercial banks thereby increasing their ability to grant loans. On the other hand, if the central bank wants to reduce money supply, the central bank sells bonds directly to the public. These are paid for by drawing cheques against commercial banks which then pays cash to the central bank and then reduce their holdings of currency. However, the effectiveness of this tool is dependent on the availability of short term securities, which can easily be converted into cash. And also when the commercial bank is a subsidiary to a foreign bank, it can rely on the parent bank for cash. Also, Discount Rate; this is the interest rate on monies (reserves) that commercial banks borrow from the central banks. To decrease money supply, the government may instruct commercial banks to adopt higher discount rates to discourage banks; from borrowing reserves from the central bank or borrow at the higher rates, and also lend out to their customers at very high rate. This discourages people from borrowing from the banks and hence reduces money creation. In other words, a decrease in the discount rate increases the quantity of reserves in the banking system since they can borrow from the central bank at lower interest rates. The effectiveness of

this measure is also limited by the availability of short-term securities and the size of the reserves the bank had before the higher rates are adopted. Moreover, another instrument used is the Reserves Requirements; these are regulations on deposits. With this tool, it is a proportion of the total deposits of each commercial bank which is mandatory by law on the banks to keep against possible demands or withdrawals. To decrease the amount of money in circulation, reserves requirements are increased (banks must hold more reserves) and can loan out less of each currency that is deposited. This decreases money supply in the economy. However, a decrease in reserves requirements means that banks must hold less reserve and therefore, can loan out more of each cedi that is deposited, and create more money as a result increase the money supply. Furthermore, Special Directives is also one of the instruments of money supply in the economy. The central bank may give qualitative directives (which sector of the economy credits of commercial banks should go) or quantitative directives (how much should go to individual sectors. If the government directs all credits to the agricultural (qualitative directives) sector, loans will be much easily accessible by farmers thereby restricting money supply to the advantage of farmers only. With the quantitative directives, the central bank may direct that 75% credits from banks should go to agricultural sector, 25% to the service sector, etc. Others include, Moral Suasion, where the central bankers meet with the commercial bankers to discuss the state and fate of the economy. But the commercial banks may or may not obey to the advice in which ever direction. And lastly, Special Deposits, in which the central bank asks the commercial banks to add up some amount of their excess reserves (amount available for granting loans) to the cash reserve (amount available for possible demand or withdrawals) in order to freeze some portion of the excess reserves to decrease lending and, money creation as well. In conclusion, the above measures are some of the means by which the government uses monetary tools in controlling (expanding or contracting) the supply of money in the economy.

REFERENCE

David C. Colander. Middlebury College Macroeconomics fifth Edition, Publisher, Gary Burke Robert h. Frank & Ben S. Bernanke Principles of Economics Second edition Henderson & Poole Principles of economics.