Saudi Electronic UniversityECON 201

The main tools the central bank has is money supply, how does the central bank use this tool (how does the central bank change money in circulation)? Central bank uses this tool through purchasing and selling, how?

Answer:

The bank uses money supply as a tool to control the aggregate output in the economy. To impact the money supply it performs open market operations. Open market operations is the buying and selling of bonds by the central bank with the object of changing the money supply in the economy. When the bank buys bonds from the open market, it pays money to the investors, so this operation increases the money supply in the economy. Similarly when the bank sells the bonds in the open market then it takes money from the people and given them bonds, so this operation decreases the money supply in the economy. 

There are other methods also like reserve requirements, discount rates, etc to change the money supply in the economy. They work similarly to open market operations.

How do purchasing and selling by central bank works:

When the bank sells the bonds in the open market, it decreases the money supply in the market. When the money supply decreases people are left with less amount of money to spend (their liquidity falls). So the aggregate output will fall in the economy. Similarly when the bank buys the bonds from the open market the money supply increases in the economy that means that people have more money to spend on goods and services (because they have more liquidity). So the aggregate output will rise in the economy.