Monetary Instruments for Increasing or Decreasing Money Supply (Research Paper Sample)

Macroeconomics
By [Name]
Course
Professor’s Name
Institution
Location of Institution
Date
Question one
Over the past years, the European Central Bank has adopted various monetary policies to keep the inflation rate in the Euro area below or close to 2%. The focus of the monetary policies adopted by ECB to achieve price stability is usually on the medium term. (Pavlík, 2012) Among the various monetary tools that the ECB used to stabilize price include the open market operations, the minimum reserve requirement and/or unconventional monetary instruments such as quantitative easing (Drometer, Siemsen and Watzka, 2013). All these monetary instruments can either increase or decrease the money supply depending on the prevailing economic condition in the Euro area.
The open market operations involves buying and selling of financial instruments by ECB held by commercial banks in an effort to regulate the money supply (Drometer, Siemsen and Watzka, 2013). When the supply of money is high, loans are readily available to consumers and businesses and this in turn increases the demand of goods and services. As aggregate demand increases the general price of good and services rises and this can cause the inflation rate to rise (Drometer, Siemsen and Watzka, 2013). To keep the inflation rate below the 2% in the Euro area, the European central Bank expands its open market operation by selling treasury securities to the commercial banks to reduce amount of money in circulation. As the money supply drops, loans becomes more expensive due to increasing interest rates.
The Open Market Operations adopted by the ECB is broken down into four operations namely the long-term refinancing, the main refinancing operation, the structural operation and the Fine-tuning operations (Pavlík, 2012). All these operations play a crucial role in adjusting the interest rates and managing the liquidity conditions of the banking sector in the Euro area. The ECB mainly relies on the Main Refinancing Operations as its main monetary policy instrument (Pavlík, 2012). This policy instrument allows commercial banks within the Euro area to borrow money from the ECB for a week and in turn provide an asset as collateral that guarantee the payment. Over the past years, the ECB has been setting the main refinancing operation rate every six weeks to stabilize the prices in the Euro area (Drometer, Siemsen and Watzka, 2013). This policy instrument is responsible for the bulk liquidity in the banking sector. During recessions, the ECB has continuously reduced the main refinancing operation rate to maintain the inflation rate below or close to its target of 2%. When the rate is low, there is a high amount of money circulating in the banking system.
Figure 1: the ECB Main Refinancing Operation rate (Pavlík, 2012).
The minimum reserve requirement is also an important monetary policy instruments widely applied by the ECB to