Everyone knows the classic saying: Money makes the world go ’round. The kicker is that it’s rooted in a lot of truth. But a couple of key questions arise. First, how does the supply of money affect economic growth? Second, what role do central banks play in that relationship? Let’s examine the role that money plays in our economy in this article. We’ll answer questions like, how do central banks act to oversee and govern the supply of money available? And how do these policies affect economic outcomes?

The Important Role of Central Banks

Money and our economy

Money actually serves several important functions in the economy.

For starters, money allows buyers and sellers to transact in goods and services without resorting to barter transactions that require, what economists call, a ‘double coincidence of wants.’

Secondly, money can also act as a reliable and trustworthy unit of account to help facilitate the recording of transactions. Additionally, it can act as a store of value for investment purposes.

Economists use several different methods to measure the amount of money available in the economy at any given point in time. Essentially, however, the supply of money is calculated as the value of all outstanding banknotes and coinage in circulation. They also count the value of all outstanding time deposits and money market securities that could easily and quickly be converted into cash.

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What is a central bank?

A central bank is a financial institution that’s responsible for regulating and overseeing a country’s monetary policy. Above all, they make sure that the country’s bank system doesn’t fail.

How do central banks work?

In Canada, the Bank of Canada’s mandate is to regulate the level of credit and currency available in the economy with the aim of facilitating low, stable, and predictable inflation. At the same time, the BoC promotes the country’s economic and financial welfare.

In order to accomplish their objectives or mandate, central banks typically have access to several tools to implement policy decisions.

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Functions of a central bank

One of these is the central bank’s official policy rate or discount rate. You might’ve noticed news headlines refer to this as its ‘key lending rate.’ After all, the cost of doing business is closely tied to the cost of borrowing money.

If a central bank wanted to stimulate economic activity, it could take action by lowering its official policy rate. This would make it cheaper for businesses and individuals to borrow money. If the central bank wanted to curb or slow the pace of economic activity? It could do so by raising its official policy rate.

A second tool that’s available to most central banks is the ability to buy and sell securities through open market operations.

Let’s say a central bank wanted to create more money to deposit into the economy. It could achieve this through buying securities in the open market.

On the other hand, perhaps they had the goal of removing money from the system (in order to slow the pace of economic growth). The central bank could sell securities in exchange for cash that would effectively be removed from circulation.

The third tool that central banks will typically have at their disposal? The ability to adjust the reserve requirements of the country’s commercial banks.

Banks are required to hold a certain ratio of their customer deposits in reserve. By lowering reserve requirements, central banks can stimulate demand by allowing commercial banks to lend out a greater proportion of their deposits.

Meanwhile, if it wanted to take money out of circulation, it could do so by raising its official reserve requirements.

Central banks and economic outcomes

Central banks regularly assess the level of activity taking place in the economy. Then, they will use the above tools to affect their desired monetary policies.

As explained in the above example, if the pace of economic growth was less than desired, a central bank may choose to buy securities through open market operations in order to stimulate demand.

This is an accommodative monetary policy — or ‘dovish’ policy. An accommodative policy allows the money supply to rise in line with the country’s Gross National Income. By making money less expensive to borrow, central banks end up encouraging spending — effectively boosting the economy.

And if central bankers feared that the economy was at risk of becoming overheated? They may elect to raise the official policy rate, curbing the borrowing activity of businesses and individuals. This is a restrictive — or ‘hawkish’ —monetary policy.

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What to do with central bank policies

Central bank policies are often nuanced and can be complex — even at the best of times. Official communications from central banks will often reveal important clues. Within these clues, you’ll find the forecast direction of an economy and stock market.

What can investors do with this information? At a minimum, investors should feel comfortable asking their wealth managers. As part of a regularly scheduled portfolio review, investors can ask about the current state of monetary policy, and whether it is accommodative or restrictive. They can also ask managers how this could change over the next six to twelve months.

These types of discussions can lead to a better, more complete understanding on the part of the investor — with respect not only to the outlook for the economy but to the assets in the investor’s portfolio as well.

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