The money supply is controlled by the central
bank, therefore, if the money supply increases this will prompt an increase in
spending, thus resulting in positive growth in the economy. It uses the
discount rate, open market operation and reserve requirement to either contract
or expand the money supply.
When the central bank sells or purchases
government securities in an open market, this is known as open market
operation. When the central bank wants to contract or expand the quantity of
reserves and the money supply, it uses open market operations. The central bank
buys government securities by means of a check, upon clearance of the check,
the quantity of reserves that are in the system expands, which decreases the
interest rate making it easier for individuals and business entities to acquire
loans. Hence investment will increase, resulting in an increase in the money
supply and a boost in economic growth.
The total amount of deposits that is within
the bank and the money that is in circulation outside of the bank makes up the
money supply in an economy. In order to boost economic growth and stimulate
spending in an economy, the central bank can decrease its reserve requirement so
that the commercial banks can generate extra deposits by offering loans to
business entities and individuals. Hence, this will cause an increase in the
money supply which would result in a decrease in the interest rate and as a
result investment will increase, thus stimulating a boost in the economy.
When a commercial bank borrows money from the
central bank it pays an interest rate which is known as the discount rate.
There is an increase in the money supply when the amount of money borrowed by
the commercial bank increases. The money supply and the amount of money being borrowed
by the commercial bank can be influenced by the central bank through the
discount rates. Hence, when there is a decrease in the discount rate the
commercial bank will be motivated to borrow additional reserves thereby causing
an increase in the money supply. As a result, loans will be offered at a
decreased interest rate by the commercial bank causing it borrowers to increase
their level of consumption, leading to a boost in economic growth.