How does the central bank control money supply?

Controlling the money supply is done via a number of mechanisms, remember as with any commodity, it is subject to the laws of supply and demand. Central banks can lower the money supply by issuing government bonds, people buy these bonds from the bank which removes their own money from the money supply, effectively reducing the amount of money in circulation. This will usually raise interest rates, because there is less money available while assuming demand is the same. The central bank can also buy foreign currency which will lower the money supply and increase interest rates. Additionally, it could print more money and increase the money supply as a result but this almost always results in inflation. There are other more intricate strategies that some central banks use, but in a nutshell that's pretty much it. Hope that helps.

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I agree with Mr. Serag's detailed answer. I personally think that central banks manipulates the money supply in the economy by using those different tactics. Sometimes such measures are not needed and they have negative ramifications on the economy but still central banks do it because of "special reasons" coming from the political leadership of the country as well as from other international financial institutions. 

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I agree with experts answers, thanks for the invitation. 

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Thanks for inviting , while Central Bank control by different tools  of Monetary Policy , like Bank Ratio, Reserve ratio , OMO ,Liquidity ratio etc

Why the Quantity of Money Matters

The quantity of money circulating in an economy affects both micro and macroeconomic trends. At the micro level, a large supply of free and easy money means more personal spending. Individuals also have an easier time getting loans such as personal loans, car loans, or home mortgages.

At the macroeconomic level, the amount of money circulating in an economy affects things like gross domestic product, overall growth, interest rates, and unemployment rates. The central banks tend to control the quantity of money in circulation to achieve economic objectives and effect the monetary policy. Through this article, we take a look at some of the common ways that central banks control the quantity of money in circulation.

1. Print More Money

As no economy is pegged to a gold standard, central banks can increase the amount of money in circulation by simply printing it. They can print as much money as they want, though there are consequences for doing so. Merely printing more money doesn’t affect the output or production levels, so the money itself becomes less valuable. Since this can cause inflation, simply printing more money isn't the first choice of central banks.

2. Set the Reserve Requirement

One of the basic methods used by all central banks to control the quantity of money in an economy is the reserve requirement. As a rule, central banks mandate depository institutions to keep a certain amount of funds in reserve against the amount of net transaction accounts. Thus a certain amount is kept in reserve and this does not enter circulation. Say the central bank has set the reserve requirement at 9 percent. If a commercial bank has total deposits of $100 million, it must then set aside $9 million to satisfy the reserve requirement. It can put the remaining $91 million into circulation.

When the central bank wants more money circulating into the economy, it can reduce the reserve requirement. This means the bank can lend out more money. If it wants to reduce the amount of money in the economy, it can increase the reserve requirement. This means that banks have less money to lend out and will thus be pickier about issuing loans.

In the United States (effective January 22, 2015), smaller depository institutions with net transaction accounts up to $14.5 million are exempt from maintaining a reserve. Mid-sized institutions with accounts ranging between $14.4 million and $103.5 million must set aside 3 percent of the liabilities as reserve. Depository institutions bigger than $103.6 million have a 10 percent reserve requirement.

3. Influence Interest Rates

In most cases, a central bank cannot directly set interest rates for loans such as mortgages, auto loans, or personal loans. However, the central bank does have certain tools to push interest rates towards desired levels. For example, the central bank holds the key to the policy rate—this is the rate at which commercial banks get to borrow from the central bank (in the United States, this is called the federal discount rate). When banks get to borrow from the central bank at a lower rate, they pass these savings on by reducing the cost of loans to its customers. Lower interest rates tend to increase borrowing and this means the quantity of money in circulation increases.

4. Engage in Open Market Operations

Central banks affect the quantity of money in circulation by buying or selling government securities through the process known as open market operations (OMO). When a central bank is looking to increase the quantity of money in circulation, it purchases government securities from commercial banks and institutions. This frees up bank assets—they now have more cash to loan. This is a part of an expansionary or easing monetary policy which brings down the interest rate in the economy. The opposite is done in case where money needs to taken out from the system. In the United States, the Federal Reserve uses open market operations to reach a targeted federal funds rate. The federal funds rate is the interest rate at which banks and institutions lend money to each other overnight. Each lending-borrowing pair negotiate their own rate and the average of these is the federal funds rate. The federal funds rate, in turn, affects every other interest rate. Open market operations are a widely used instrument as they are flexible, easy to use, and effective.

5. Introduce a Quantitative Easing Program

In dire economic times, central banks can take open market operations a step further and institute a program of quantitative easing. Under quantitative easing, central banks create money and use it to buy up assets and securities such as government bonds. This money enters into the banking system as it is received as payment for the assets purchased by the central bank. The bank reserves swell up by that amount, which encourages banks to give out more loans, it further helps to lower long-term interest rates and encourage investment. After the financial crisis of 2007-2008, the Bank of England and the Federal Reserve launched quantitative easing programs. More recently, the European Central Bank and the Bank of Japan have also announced plans for quantitative easing.

The Bottom Line

Central banks work hard to ensure that a nation's economy remains healthy. One way central banks do this is by controlling the amount of money circulating in the economy. They can do this by influencing interest rates, setting reserve requirements, and employing open market operation tactics, among other approaches. Having the right quantity of money in circulation is crucial to ensuring a healthy and sustainable economy.