Central Banks and
Monetary Policy

Central Banks attempt to achieve economic stability by varying:

A. The quantity of money in circulation.

B. The cost and availability of credit, and

C. The composition of a country's national debt.

Central Banks have three instruments in order to implement monetary policy:

A. Open Market Operations:

The buying or selling of Government bonds by the Central Bank in the open market. If the Central Bank were to buy bonds, the effect would be to expand the money supply and hence lower interest rates, the opposite is true if bonds are sold.

B. Reserve Requirements:

A percentage of commercial banks' deposits are kept on deposit in the Central Bank. This is affecting the money supply and credit conditions.

If the reserve requirement percentage is increased, this would reduce the money supply by requiring a larger percentage of the banks deposits to be held by the Central Bank, thus taking them out of supply.

As a result, an increase in reserve requirements would increase interest rates, as less currency is available to borrowers.

C. The Discount Window:

Is where the commercial banks are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates. This enables the institutions to vary credit conditions, there by affecting the money supply.

By affecting the money supply, monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth. Without much debate, the effectiveness of monetary policy, its timing and its eventual impacts on the economy are very obvious.

Insights into monetary policy are very important to the investor since the availability of money and credit are key considerations in the pricing of an investment.

Of paramount importance is also the effect of the interest rates, because with higher interest rates people are less likely to apply for a loan.

High interest rates result in more people keeping their money in the bank rather than in the stock market. Why invest in the stock market when you can earn a good return in bonds and savings accounts with much less risk?

On the other hand, lower interest rates can spark the economy because people are encouraged to take out loans to buy goods and services.

Lowering the interest rates also means smaller returns from your bank, so you're more likely to put your money in the stock market instead.

In simple terms, if interest rates are high...

Stock prices generally go down and vice versa.