Instruments (Tools) of the monetary policy

1. The bank rate (discount rate) policy. The bank (discount) rate refers to the interest rate charged by      the Central bank on commercial banks.  This occurs when the commercial banks borrow cash from the Central bank as a lender of last resort. If the Central bank wants to reduce money supply, aggregate demand and to check on inflation, it increases the bank rate. Consequently, Commercial  banks  also  increase  the  interest  rate  charged  on  loans  to  their customers hence limiting money supply. If the Central bank wants to increase money supply, aggregate demand and to check on deflation, it reduces the Bank rate. Commercial banks also reduce their interest rates hence increased borrowing by customers.

Note.  Rediscount   Rate.  This  refers  to  the  interest  rate  charged  by  the  Central  bank  on commercial banks by buying short term securities from them at a discount.

2. Open Market Operations (OMO). This refers to the act of buying and selling of government securities (bonds and treasury bills) by the government through the Central bank. If the Central bank wants to reduce money supply and check on inflation, it sells government securities to the public (individuals). This leads to a fall It money supply.   However, if the aim is to increase money supply and to check on deflation, the central bank buys securities from the public.

Note.  Treasury Bills are short term financial assets which are used by the government when borrowing from the public.                                                                                     .

Bonds are long term financial assets which are used by the government when borrowing from the public.

3. Selective Credit Control (Credit squeeze). This is where  the  Central  bank  directs   or  instructs commercial   banks  to  give  credit  (loans)  to specific  sectors  of the  economy   for  example   giving loans  to priority  sectors  like agriculture.    This reduces the number of sectors getting loans hence reducing money supply in the economy.
4. Legal reserve requirement (Reserve requirement ratio). This refers to the percentage  of bank deposits   required   by law to be deposited   by commercial    banks   with the Central   bank.   The Central   bank   sets the minimum    amount   of bank   deposits   which   commercial    banks   should deposit with it. If the  central  bank  wants  to reduce  money  supply,  it increases   the  legal  reserve requirement   so that  commercial   banks  have  less  loanable   funds.  However,  if the  Central   bank wants  to increase  money   supply,   it reduces  the  legal  reserve   requirements    so  that  commercial banks  have more  loanable  funds.

5. Cash ratio (cash reserve). This refers to the fraction of  the  total bank deposits which remain in the Commercial   bank  in cash  form  to meet  the daily  requirements   of the customers   (depositors). In this case,  if the central  bank  wants  to reduce  money  supply,  it instructs  commercial   banks  to increase  the cash ratio.  However   if the central bank wants to increase money supply, it instructs commercial banks to reduce the cash ratio.

Note. Reserve ratio. This  refers  to the  fraction  of the  total  bank  deposits  that is not  lent  out  by the commercial   bank.  Liquidity ratio is the proportion   of Commercial bank assets that it keeps in liquid (cash) and near liquid (cash) form.

6. Moral suasion. This is where   the central bank persuades   and requests   commercial    banks   to follow   the general   monetary   policy.     In  periods   of  inflation,   the  central  bank  may  persuade commercial   banks  not  to  give  out  credit  and  in periods   of  depression   (deflation),   commercial banks  may be persuaded   to expand  credit  so as stimulate  economic  activity,
7. Special deposits (Supplementary reserve requirement). This is where the central bank instructs commercial    banks   to make   certain    deposits   over   and   above   the   minimum    legal   reserve requirement.      This reduces   the money   available   for lending   (loanable   funds)   in commercial banks hence reducing money supply.                   .
8. Margin requirements. In this case,  the commercial   bank  does not  lend up to the full amount  of the value  of the collateral   security,  but  it lends  some  amount  which  is lower.   The  central  bank may  direct  commercial   banks  to rise  or reduce  their  margin   requirements    in  order  to regulate money  supply.  A higher  margin  requirement   reduces  the  amount  of loans  given  by commercial banks  and  this  is done  in times  of  inflation.    A  lower  margin   requirement   raises  the  loanable funds  and  this  is  favourable   in  times  of  economic   depression   in order  to  stimulate   economic activity,
9. Currency reforms. This refers to the act of changing money by the government  from one form to another.    It is aimed at reducing   money supply and knowing   the amount   of money   in the economy.    It is normally   done  when  the  currency  has  totally  lost  value  due  to  high  levels  of inflation.