Monetary policy mechanisms

Monetary policy mechanisms

Monetary Policy Mechanisms

The mechanisms of monetary policy are the tools that central banks have to carry out their monetary policies in order to achieve specific macroeconomic objectives.

The three main mechanisms of monetary policy are:

  • Vary the cash ratio : By increasing the legal cash ratio, the central bank decreases the funds available to lend money, decreasing the money supply. On the contrary, if the required cash ratio decreases, the money supply will increase. The lower the cash ratio, the higher the money multiplier.
  • Modify the interest rate for permanent facilities: Central banks offer permanent, credit or deposit facilities to other banks in the country at an official percentage to control market liquidity. It normally acts as a ceiling or floor for 1-day market interest rates.
  • Open market operations: There are several types of open market operations, each with different objectives:
    1. The most important are the main financing operations , in which case the central bank lends money (money injection) through auctions to credit institutions at the official money rate (making it cheaper). If you decide to lower this percentage, you will reduce the cost of money, facilitating credit and increasing the money supply.
    2. The central bank can also buy or sell financial assets in the market to introduce money into the market and increase its supply, through structural operations . For example, buying government bonds or corporate bonds. In this way, the central bank pays private agents, who can reinvest these amounts in the market or in other activities, increasing the supply of money in the economy.

When the money supply of an economy is increased, one of these consequences is mainly caused: increase in prices or economic growth. It may cause both situations at the same time, stimulating economic growth and raising prices. This is due to the quantity theory of money, which we can see summarized in this simple formula widely used in monetary policy, where it is easily observed how the money supply (money supply) affects prices (P) and real income or quantity of goods and services produced (Yr):

M x V = P x Yr

The "M" represents the money supply, which is the only thing the central bank can control, and "V" is the speed at which money circulates in the market. We must also know that P times Yr is equal to nominal GDP. A curious result of this formula is to observe how the nominal GDP of a country depends on the amount of money that there is in an economy multiplied by the speed at which that money moves, that is, the faster the money moves in a few people to others, the greater the wealth of a country.


Let’s imagine a country called Naranjalandia, in which the only products there are are 100 oranges worth € 2 each. We have discovered the speed at which money circulates is 1 and in total there are 200 one-euro coins (M = 200). If the Central Bank wanted prices to be lower, it would only have to reduce the money in the market. If you want the prices to be half, you will recall 100 coins. Since there are only 100 coins now, but there are still 100 oranges, each orange will have to be worth € 1.

Before tight monetary policy: 200 x 1 = 2 x 100
After: 100 x 1 = 1 x 100

The prices of the products have become worth € 1.

In reality, the problem with this specific monetary policy is that it can also cause the volume of income in a country to decrease, that is, to produce 90 oranges instead of 100 in the country.

Cash ratio effects

  • Central bank
  • Cash ratio
  • Offer shifts