With the Coronavirus ravaging the global economy, central banks have once upon called upon to save the it with policies such as interest rate cuts, quantitative easing, and helicopter money. But before getting into the more exotic policies, this post will cover how central banks control the money supply using interest rates.

How do central banks control the money that is circulating in the economy? Let’s make a distinction between two aspects of money. First, there is the price of money: the interest rate. Second, there is the total amount of money that is circulating in the economy: the quantity of money. The policies that central banks employ to control both the price and quantity of money is called: monetary policy. No surprise there. These days every time you open a financial newspaper, you will find many headlines concerning how central bankers conduct monetary policy. But what does that actually mean? What do central bankers do when they conduct monetary policy? The answer to this question is not as straightforward as you might think. So, let’s take a step back.

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What do central bankers target?

When asked whether central bankers target the price of money or the quantity of money, most people would say the quantity of money. However, this view is hopelessly outdated (if you don’t believe me, take it from the Federal Reserve Bank). Most modern central banks target the price of money: the interest rate. Having established this, there is yet another complication. Most of you who own money know that there is not one interest rate.

The interest rate that your money yields depends on the type of money that you own. The two forms of money that you might instinctively think about –coins and notes– do not pay any interest at all. Money in the bank –or bank deposits– this will accrue interest. However, this rate is set by your bank, not by the central bank. After all, you might be inclined to switch banks to get a more favourable interest rate.

Why banks follow the central bank rate

That being said, those of you following the news closely might have noticed that when central banks increase or decrease their interest rate, quickly your bank will follow suit. Why is that?

The reason is that the central bank is the bank of bankers. It provides the same services for banks as banks do for us. Central banks issue money that only banks can use. This money is usually called reserves. Reserves are very important to banks for two reasons. The first reason is that banks can exchange them for coins and notes with the central bank. The second reason is that banks can use reserves to pay each other. Banks need to pay each other in reserves whenever we are paying someone who has an account with a different bank than our own.

This gives the central bank some power over commercial banks. Banks that have too many reserves will try to increase their lending to the economy, to other banks or will need to hold them at the central bank. On the other hand, banks that do not have enough reserves will try to attract depositors, borrow from other banks or will need to borrow reserves the central bank.

There we have our answer to how the central bank controls the price of money: the interest rate. While central banks do not control all interest rates, they do control the most important rates. The rate at which banks can keep money at the central bank and the rate at which they can borrow from the central bank. Given that the other options for banks with too many reserves are lending to the economy, and to other banks, these rates will obviously be influenced by the rate at which they can keep their reserves at the central bank. If the central bank rate rises, the other two are likely to follow. Similarly, for banks that do not have enough reserves. They can borrow from the central bank at a certain rate. If that rate goes up, they might prefer to attract additional customers instead. This will drive up the interest rate on their savings accounts.

So, now we know about the price of money. But, what about the quantity of money?

How the central bank (hopes to) controls the quantity of money

If we reflect on the different types of money we have so far discussed: notes, coins, reserves and bank deposits, one thing stands out. Out of these types of money there are only three categories of money for which the central bank controls the quantity. What makes things even more interesting is that the central bank cannot control the amount of money created by commercial banks directly.

Indeed, as the last blog post covered, most money is created by commercial banks. Most central banks cannot control the amount they create directly. So, does that imply that modern central banks have no control over the money supply whatsoever? No, not quite. The reason is that there are multiple banks that compete with each other. If one bank starts lending too much, customers might doubt that they are good for their loans. At that point the they will first need loans from other banks and ultimately from the central bank.

As you might have guessed, this means that the central bank can –theoretically– influence the quantity of money by manipulating the price of money: the interest rate! If the interest rate that the central bank charges on these loans is very high, all other rates will be high too. Very high interest rates will attract only risky borrowers. As a consequence, banks might consider it too risky to lend too much.

Conversely, if the central bank interest rate is very low, commercial banks might feel confident to go on a lending spree. This is it! … decreasing or increasing the interest rate. That is what central bankers generally mean if they talk about monetary policy. By increasing the central bank interest rate, banks are discouraged from making loans and, in the process, they are discouraged from creating new money. Therefore, they call this monetary policy tightening. And, the other way around, by lowering the interest rate, the central bank encourages bank lending, increasing money creation. This is monetary policy loosening.

Now, you might be wondering. When does the central bank increase or decrease the interest rate? In other words, what is the goal of monetary policy?

What is the goal of monetary policy?

The answer is, for almost all central banks, to stabilize the general price level in the economy. To be more precise, to stabilize the change in the price level. Better known as inflation. Central bankers like stable inflation. So, it makes sense that most central banks use monetary policy to control inflation. This practice is what they call inflation targeting. Usually, they set an inflation target at 2%.

Why 2% you may ask? This number might seem a bit arbitrary. But, it was chosen for a reason. In general central bankers believe that a bit of inflation is good because it helps borrowers pay off their debt and because it motivates people to spend their money as it is getting worth less over time if you hold it.

To achieve their 2% target, central bankers will fiddle with the interest rate to get inflation near that target of 2%. When inflation is too high, central banks will often increase the interest rate and when inflation is too low, they will tend to lower interest rates. The general idea behind how is based on New-Keynesian theory and roughly works as follows.

The central bank believes that inflation depends on the level of unemployment in the economy. Low unemployment is believed to lead to inflation whereas high unemployment is believed to lead to deflation… Why is that?

Most central bankers believe that, if unemployment is really low, workers will demand higher wages. So, on average, wages will increase. Companies who see their profit levels shrink will then increase the prices that they charge for their goods. Because all companies will do it, the overall price level will rise. We call that inflation!

So, how does the interest rate matter for all of this? Well, the interest rate level determines how attractive it is for banks to lend out money. If banks are encouraged to lend more, this will boost investment and consumption which means the economy performing well and that unemployment is low. But, in this theory, if the economy is performing too well, with an extremely tight labour market, inflation is very likely to be above target.

If this is the case, the central bank should increase the interest rate. This will slow down lending, which will in turn slow down consumption and investment and cool down the labour market. Wages are now likely to stop increasing and so will prices. So, by increasing the interest rate, the central bank has cooled down the economy and prevented inflation from getting out of control.

In the opposite case, in which the economy is underperforming, unemployment is high, and inflation will tend to be too low. Maybe there is even deflation. The central bank, following their theory, should decrease interest rates. This will increase investment, consumption which will increase economic growth and inflation. That is the story that most central bankers have in mind when they determine whether the interest rate should go up or down.

Monetary policy in practice

In practice, as citizens of Europe, the U.S. and Japan have experienced over the last decade, it is questionable if this story is always true. In these regions central banks interest rates have been super low for a long time, but inflation has hardly moved.

Especially, the bank of Japan and the European central bank just don’t seem to get their respective inflation numbers to target. So, can central bankers really control the money supply and inflation by tinkering with the interest rate. There is really no scientific consensus on this. There is a lot more to it.

As a result of this uncertainty, central bankers have started to experiment with new monetary policies such as quantitative easing and helicopter money. These will be discussed in the next blog post.

Conclusion

But for now, this was it. Now, you know how the central bank controls the money supply. They do so indirectly and imperfectly, via the interest rate. Central banks do not control all interest rates. But, they do set the interest rate on which all other rates are based. By doing so they try to control the amount of money circulating in the economy indirectly by making it more or less attractive for commercial banks to lend. Most central bankers change the interest rate as they try to control inflation. They will increase the interest if they believe the economy is overheating. This will lower inflation. They decrease the interest rate to spur the economy to grow faster which will lead to increased inflation.

If you have any questions about it, or would like to discuss more about it, comment below, I will be down in the comment section and be happy to discuss or clarify.