The central bank commonly attempts to meet the goal of price stability by keeping inflation low, economic growth or exchange rate stability, or all of these together.
To meet up these expectations, central banks use the following equipment:
- Change in interest rates;
- Change in reserve requirements;
- Change in the accretion of foreign currency; and
- Capital control
When the central bank attempts to increase economic growth, it tries out the following policies-
- LOWERS INTEREST RATE:
It helps in reducing the cost of borrowing, that is, consumers and businesses can invest, as well as, consume more- this is good for growth. This further reduces the amount which the existing borrowers pay to service their debt. This frees them up to invest or to spend. But lower interest rates mean a weaker currency and this leads to inflation.
- LOWER RESERVE REQUIREMENTS:
It implies that for every deposit they hold, banks can provide more loans by increasing the amount of money available to be borrowed. This also results in inflation due to stronger growth.
- WEAKEN CURRENCY:
In order to devaluate domestic currency, the central banks print more money and purchase foreign currency. A weaker currency is an advantage of making exports more competitive. But the weaker currency is equal to inflation.
Now, when the central banks shot to reduce inflationary burden, they opt for these options-
- RAISE INTEREST RATES:
It exactly results opposite to lowering interest rates. Costs of borrowing increase and investment and consumption by businesses and consumers fall. This increases the amount of debt and the borrowers now have to cut down their investments and spending on other goods. With the declined growth, the inflation rate also lowers down. Moreover, a rise in interest rates boosts up the currency- reducing the inflationary burden on imports. All these will lead to slower growth and probably a stronger currency-lessening the export competition.
- RAISE RESERVE REQUIREMENTS:
Banks will decrease the money available for borrowing and will lend less. This will decelerate growth and inflation as well.
- STRENGTHEN CURRENCY:
Now, to strengthen the domestic currency, central banks have to sell off the foreign currency and buy back their own currency. A strong currency is inversely proportional to exports and it will reduce the cost of imports. This halts the steady economic growth due to expensive exports.
By exchanging rate stability, the banks affect the economy in the following ways-
- STRENGTHEN OR WEAKEN CURRENCY:
As discussed earlier, the banks buy or sell foreign currency to strengthen or weaken the domestic currency. Therefore, the banks are able to buy or sell currency anytime to stabilize the currency. In case the banks implement a wrong exchange rate, the consequences will be detrimental.
- IMPLEMENTATION OF CAPITAL CONTROLS:
The central banks hold enough power to reduce private individual’s ability to freely trade with foreign currency. They can curb the amount of money flowing in and out of the economy. This stops foreign investments to enter the country.
Central banks have another card, signaling. It means, when the central banks announce a particular goal or target, the market starts believing it, only if the former has credibility.
These are the different channels through which monetary policies affect the economy and are complementary because they operate simultaneously.