Economics » Financial Institutions » Creation of Money and Monetary Policy

Monetary Policy and Its Instruments

Monetary Policy

Monetary policy refers to the combination of measures designed to regulate the value, supply and cost of money in the economy in consonance with the expected level of economic activity. An expansionary monetary policy is that which is designed to increase money supply, while a contractionary or restrictive monetary policy is that which is intended to reduce money supply.

Instruments of Monetary Policy

The main instruments or tools of monetary policy vary between economies and over time. However, the main instruments of monetary policy are:

  1. Open Market Operations (OMO): This refers to the purchases and sales of securities in the open market by the Central Bank in order to achieve the desired level of money stock in the economy. To reduce money supply, the Central Bank will sell securities in the open market. Conversely, to increase money supply, it will require the purchase of government securities.
  2. Discount Rate: It is the minimum lending rate of the Central Bank at which it rediscounts bills and government securities, or the rate charged by the Central Bank on its loans to the commercial and merchant banks as a lender of last resort. It is used to regulate credit conditions and availability in the economy because other rates depend on it.
  3. Special Deposits: Sometimes, commercial and merchant banks are required by law to hold a non-interest bearing special deposit with the Central Bank to complement other contractionary monetary policy measures.
  4. Credit Ceiling: It is a directive by the Central Bank prescribing the growth rate of credit expansion by the commercial and merchant banks. This is to ensure stability in both the domestic and external sectors of the economy.
  5. Reserve Requirements: This refers to the proportion of the total deposit liabilities of the commercial and merchant banks which they are required by law to keep as reserve with the Central Bank. The reserve requirements (i.e. cash reserve ratio and liquidity ratio) will be increased to reduce money supply or reduced to increase money supply.
  6. Moral Suasion: It is the use of persuasion rather than compulsion by the Central Bank to get other financial institutions to adopt a pattern of behaviour that is favourable to effective conduct of the monetary policy.
  7. Selective Credit Control: It involves issuance of credit guidelines to commercial and merchant banks to direct their credit facilities to the so-called favoured or preferred sectors of the economy.

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