THE CENTRAL BANK
Managing the
monetary system
By raising or lowering its reserve
rate of interest, a central bank can
influence the size of commercial
banks’ reserves, and thus their
borrowing and lending rates and
the amount of money in circulation.
This affects spending, and inflation,
because when interest rates are
lower, saving is less and borrowing
more attractive, and when interest
rates are higher, the opposite is true.Increasing money in circulation
Open market operations: buying bonds
The central bank buys bonds on the open market using newly created
reserves. Investors’ deposits from the sale increase the amount of reserve
money in the open market, which leads to a lowering of the short-term rate.❯❯Secondary market The forum in
which investors buy and sell bonds
issued by the government.
❯❯Inflation A general increase in
prices and fall in the purchasing
value of money.
❯❯The spread The difference
between the cheapest and the
most expensive interest rate.❯❯Credit guidance A form of
cheaper lending by the central
bank that is designed to meet wider
government objectives such as
boosting key industries.
❯❯Reserve ratio The percentage of
depositors’ balances that a bank
must keep as cash. The reserve ratio
is set by the central bank.NEED TO KNOW
Central bank creates money
and buys bondsLower interest rates make central
bank loans more affordable$$$$$
$Investors deposit their
payments in commercial banksCommercial banks’
reserves increaseCommercial banks’
reserves increaseLower interest
rates paidLower interest rates make
loans more affordableLower interest rates make
loans more affordableMore money
circulatesMore money
circulates$$Lowering the reserve (base) rate of interest
The central bank can cut the reserve rate of interest to make it cheaper
for commercial banks to borrow from its reserves. The idea is that the
commercial banks will then in turn reduce their interest rates to the public.$$
$Central bank Investors in Commercial banks General public Money supply
government bondsCentral bank Commercial banks General public Money supplyUS_102-103_How_CB_dictates.indd 102 13/10/2016 16:18