How Government controls the money supply?

Money supply includes all the notes and coins in circulation with the public plus the money with banks. It also includes the deposits in banks and building societies. The later is more significant supply of money and is usually the target of Governments monetary policy. The ways through which Government controls the money supply are:

Open market operations

Government usually sells treasury bills and bonds to raise money. Private individuals invest in these bonds and bills in order to get a healthy rate of interest. This reduces the deposits with banks and the money supply.

Variation of legal reserve requirements

Usually, the commercial banks have to maintain a certain percentage of their assets as deposit with the Central Bank. When the Central Bank wants to reduce money supply it will increase the limit of the deposit kept by the banks. The commercial banks are left with less money to lend to their customers.

How the supply of money affects the economy?

If the Government reduces the supply of money, banks and money lenders will find they have less money to lend to people and firms. This shortage of the supply of money will lead them to charge higher interest rate. Moreover, in order to obtain more money they will increase the interest rates to attract savers to put money in deposit accounts. All these actions will lead to lowering the aggregate demand and the prices will come down.

On the other hand, if the Government increases the supply of money to banks, they will lower the interest rates in order to encourage people and firms to borrow more. More individuals and firms will borrow thus boosting the aggregate demand and the output of the economy. But if the increase in supply is not calculated properly it can result in inflation.