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  • Writer's pictureLewis White

How Central Banks Control the Monetary Supply

As we learned about in the last post, the role of central banks is to keep inflation low and the economy strong by controlling the monetary supply.

They have three principal ways of doing this: the reserve requirement, open market operations, and the target interest rate. Let's examine these one-by-one.

First of all, we've got the reserve requirement. Commercial banks use funds deposited by their clients to make loans. But they need to hold a certain percentage of deposits in cash, and that percentage is set by the central bank. How does this affect the monetary supply? Essentially, the money a bank is holding in cash reserve is out of circulation. By increasing the size of the reserve, you reduce the monetary supply and keep inflation in check. But if the economy was weak, the central bank could reduce the reserve requirement and cause extra funds to be available for loans to create new economic activity.

One thing to keep in mind with the reserve requirement is that it's primary purpose is not the control of inflation, it is to maintain a stable financial system and protect depositors. Interest rates can theoretically be set anywhere so long as the economic conditions are appropriate. With the reserve requirement, if central banks drop the requirement too low they risk wide-scale collapse of the financial system. It can also be difficult for banks to adapt to changes in the reserve requirement. For those reasons, it is not the preferred fiscal policy tool.

The second tool central bankers have is open market operations. These transactions are where the central bank buys government bonds or another security from another, private, bank. This is the primary way that the central bank creates brand-new money. When the bank wants to boost economic growth and increase inflation, they buy bonds from their member banks. This makes extra money available to those banks to lend out. If the central bank is selling securities, they are taking money out of circulation and reducing inflation.

The third tool and the most relevant to real estate is the interest rate. If central banks are only policymakers, why are they called a bank? Well, they are a bank, except their clients are only other banks, the normal kind that you have a chequing account with. Among the services they provide to their member banks are loans, and the interest rate is the interest they charge on these loans. So when you hear the interest rate referred to on the news, they're talking about the interest that the central bank is charging on its loans to other banks. The reality is changes in the interest have a much wider impact because other financial institutions generally adjust their interest rates in unison with the central bank.

So how does changing the interest rate affect inflation and the economy? If the cost of borrowing is low, consumers and business can more easily obtain credit. This easy access to credit creates extra purchasing demand and boost the economy. At the same time, it also increases the amount of money in circulation and results in inflation. If interest rates are high, less people can afford credit and the monetary supply shrinks, cooling the economy and reducing inflation.

How does the interest rate affect the real estate market? That is a very complex question, but generally lower interest rates benefit the housing market. Homebuyers have easy access to credit and can afford larger mortgages, boosting buyer demand. Additionally, when interest rates are low the payoff on most investments goes down, making real estate more appealing as an investment. But when interest rates are high, it is more difficult to obtain credit and this reduces the number of people who can afford a high mortgage. Higher interest rates also make alternative investments more palatable, pulling money out of the real estate market.

Hopefully this discussion of financial policy has helped you to better understand the intricacies of the financial system. Check the blog out for other posts on topics related to the real estate market!

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