Monetary policy refers to the actions taken by a central bank to control the supply of money in an economy and achieve specific economic goals. The central bank uses a variety of tools and instruments to influence the money supply and interest rates, such as open market operations, reserve requirements, and interest rate targeting. These instruments are used to manage inflation, promote economic growth, and maintain financial stability. The choice and use of these instruments can have significant impacts on the overall health of an economy. Understanding the different instruments of monetary policy and how they are used is crucial for understanding the overall functioning of an economy and the role of the central bank in managing it.
Table of Contents
What are the 6 Tools of Monetary Policy?
The instruments of monetary policy are the tools that the central bank uses to influence the money supply in an economy. The main tool is interest rates, which the central bank can use to encourage or discourage borrowing and spending. Other tools include reserve requirements, which dictate how much banks must hold in reserve, and open market operations, which involve buying and selling government securities to influence the money supply.
There are six tools of monetary policy:
#1. Open Market Operations
#2. Reserve Requirements
#3. Discount Rate
#4. Marginal Lending Facility
#5. Standing Facilities
#6. Moral Suasion
Each tool has its own strengths and weaknesses, which can be used to help stabilize the economy in different ways. Let’s take a closer look at each one:
#1. Open Market Operations
Open market operations (OMO) is a monetary policy tool used by central banks to control the money supply and interest rates in an economy. In Bangladesh, the central bank, Bangladesh Bank (BB), uses OMO to implement monetary policy and achieve its economic objectives.
The basic principle of OMO is that a central bank can buy or sell government securities in the open market, which in turn affects the money supply and interest rates. When the central bank buys government securities, it injects money into the economy and decreases interest rates. When the central bank sells government securities, it withdraws money from the economy and increases interest rates.
In Bangladesh, Bangladesh Bank (BB) uses OMO to influence the money supply and interest rates in the economy. The central bank conducts OMO by buying or selling government securities such as Treasury bills and bonds in the open market.
For example, if the BB wants to decrease interest rates and increase the money supply, it will buy government securities from commercial banks, which will inject money into the economy and decrease interest rates. This is an example of expansionary monetary policy.
On the other hand, If the BB wants to decrease the money supply and increase interest rates, it will sell government securities to commercial banks, which will withdraw money from the economy and increase interest rates. This is an example of contractionary monetary policy.
OMO is a flexible and powerful monetary policy tool that allows the central bank to quickly respond to changing economic conditions. The central bank can conduct OMO on a regular basis or as needed, depending on the economic situation of the country.
It’s worth mentioning that the Bangladesh Bank also uses other monetary policy tools such as changing the cash reserve ratio, changing the policy rate and other monetary tools to achieve its monetary policy goals.
#2. Reserve Requirements
Reserve requirements refer to the amount of money that commercial banks are required to hold in reserve with the central bank. Central banks use reserve requirements as a tool to control the money supply and implement monetary policy.
In Bangladesh, the central bank, Bangladesh Bank (BB), has the authority to set reserve requirements for commercial banks. The BB can increase or decrease reserve requirements as a means to implement monetary policy.
For example, if the BB increases reserve requirements, commercial banks will be required to hold more money in reserve with the central bank, which will decrease the amount of money available for lending. This can be used as a tool to slow down economic growth and curb inflation.
On the other hand, if the BB decreases reserve requirements, commercial banks will be required to hold less money in reserve with the central bank, which will increase the amount of money available for lending. This can be used as a tool to stimulate economic growth and promote investment.
In Bangladesh, the reserve requirement is currently set at 4.50% of net demand and time liabilities (NDTL) for scheduled banks and 6.50% for non-scheduled banks. The central bank may change the reserve requirement depending on the economic situation of the country.
For example, in 2019, the central bank of Bangladesh decreased the reserve requirement from 6% to 5.5% to encourage banks to lend more and increase credit flow. This was done to tackle the economic slowdown caused by the political unrest.
It’s worth noting that the effect of reserve requirement in monetary policy is usually limited, as banks can find other ways to increase their money supply, like borrowing from other banks or tapping international markets.
#3. Discount Rate
The discount rate, also known as the policy rate, is the interest rate at which commercial banks can borrow money from the central bank. Central banks use the discount rate as a tool for implementing monetary policy by adjusting it to influence the money supply and economic activity.
In Bangladesh, the central bank, Bangladesh Bank, uses the discount rate as one of its main tools for implementing monetary policy. The bank adjusts the discount rate to control inflation and stabilize the exchange rate.
For example, in order to curb inflation, Bangladesh Bank may increase the discount rate, making it more expensive for commercial banks to borrow money. This can decrease the amount of money available for lending, which can slow down economic growth and reduce inflationary pressures.
On the other hand, in order to promote economic growth, Bangladesh Bank may decrease the discount rate, making it cheaper for commercial banks to borrow money. This can increase the amount of money available for lending, which can stimulate economic growth.
In the recent time, Bangladesh Bank has been decreasing the discount rate to stimulate the economic growth during the COVID-19 pandemic. In 2020, the bank lowered the discount rate from 5.75% to 5.50% and later to 5.25% to provide liquidity to the banks and to revive the economic activities.
It’s worth noting that the discount rate is not the only monetary policy tool used by the Bangladesh Bank, it also uses other tools like open market operations and statutory liquidity ratio to achieve its monetary policy objectives.
#4. Marginal Lending Facility
In Bangladesh, the marginal lending facility (MLF) is a monetary policy tool used by the central bank, Bangladesh Bank, to provide short-term liquidity to commercial banks. The MLF is a lending facility provided to commercial banks at a rate higher than the policy rate (repo rate) to meet their short-term liquidity needs. The purpose of the MLF is to provide a safety net for commercial banks to ensure they have access to adequate liquidity in order to meet their obligations and avoid default.
Here’s how it works:
- When a commercial bank is facing a shortage of liquidity and is unable to borrow from the inter-bank market, it can borrow from Bangladesh Bank through the MLF.
- The commercial bank will pledge its eligible securities, such as government bonds, as collateral for the loan.
- The loan is provided at a rate higher than the policy rate (repo rate) and is usually for a short-term, typically overnight.
- The commercial bank is required to repay the loan with interest on the next working day.
The Bangladesh Bank uses the MLF as a monetary policy tool to control the money supply and stabilize the financial market. For example, during times of economic slowdown, it can lower the MLF rate to encourage banks to borrow and increase lending to businesses and individuals, thus stimulating economic growth.
On the other hand, when the inflation rate is high, the central bank may increase the MLF rate to discourage borrowing and reduce the money supply to curb inflation.
An example of when Bangladesh Bank used this tool was in the year 2020, when the Covid-19 pandemic caused a severe liquidity crunch in the banking sector. To help the banks overcome this, Bangladesh Bank introduced a repo-based lending facility, which was similar to MLF, to provide short-term liquidity to the banks. This helped to stabilize the banking sector and support economic activity during the crisis.
#5. Standing Facilities
Bangladesh Bank, the central bank of Bangladesh, uses standing facilities as a monetary policy tool to manage the money supply and control inflation in the economy.
Standing facilities refer to the mechanism through which commercial banks can borrow or lend funds to the central bank on a short-term basis. The central bank sets the interest rate for these transactions, which is known as the policy rate or the discount rate.
For example, if the central bank wants to decrease the money supply and curb inflation, it can raise the policy rate, making it more expensive for commercial banks to borrow from the central bank. As a result, commercial banks will have less money to lend to consumers and businesses, slowing down economic activity.
On the other hand, if the central bank wants to increase the money supply and stimulate economic growth, it can lower the policy rate, making it cheaper for commercial banks to borrow from the central bank. As a result, commercial banks will have more money to lend to consumers and businesses, increasing economic activity.
#6. Moral Suasion
Moral suasion is a non-coercive method of influencing the behavior of economic agents, such as banks and other financial institutions. In Bangladesh, the Bangladesh Bank (BB) uses moral suasion as a tool in its monetary policy to guide the behavior of banks and other financial institutions in line with the overall economic goals of the country.
One example of the use of moral suasion in Bangladesh is the BB’s guidance on loan disbursement. The BB often issues circulars and guidelines to banks instructing them to prioritize lending to certain sectors, such as agriculture or small and medium enterprises (SMEs), in order to promote economic growth and development. Banks are encouraged to comply with these guidelines through persuasive language and appeals to their social responsibilities, rather than through direct penalties or fines.
Another example is the use of moral suasion in managing liquidity in the banking system. The BB may use open market operations or other monetary tools to influence the supply of money in the economy. However, it also uses moral suasion to encourage banks to maintain appropriate levels of cash reserves or to discourage them from engaging in speculative or high-risk activities. This is done by issuing guidelines and circulars that advise banks on prudent risk management practices and remind them of their role in maintaining financial stability.
Moral suasion is an important tool for the BB in managing monetary policy in Bangladesh. By using persuasive language and appealing to banks’ social responsibilities, the BB can guide the behavior of financial institutions in line with overall economic goals, such as promoting growth and stability.
What is the Key Instrument of Monetary Policy?
Monetary policy is the process by which a central bank, such as the Bangladesh Bank, controls the supply of money in an economy. The key instrument of monetary policy is open market operations. Open market operations are purchases or sales of government securities in the open market by the central bank.
These operations affect the level of reserves in the banking system and influence the interest rates charged on loans.
Conclusion
In conclusion, monetary policy is a crucial tool for managing the economy and achieving macroeconomic goals. Central banks, such as the Bangladesh Bank (BB), use a variety of instruments to implement monetary policy, including open market operations, reserve requirements, discount rate and interest on reserves, moral suasion and forward guidance. Each instrument has its own advantages and limitations, and central banks often use a combination of these tools to achieve their desired outcomes. The effectiveness of monetary policy depends on various factors such as the structure of the economy, the level of inflation, and the effectiveness of fiscal policy. Central banks need to continuously monitor the economy and adjust their monetary policy accordingly to ensure stable growth and price stability.