Money supply takes place in the financial market. Equilibrium in the financial market exists at the interest rate where the quantity of money supplied is equal to quantity of money demanded. The quantity of money available is entirely controlled by the Central Bank. The money supply curve shows the quantity of money supplied at a given interest rate. Since the supply of money by the central bank is not affected by the level of interest rates, the money supply graph is illustrated as a vertical line. When the supply of money increases at a faster rate than the production of goods and services, inflation might occur. In order to correct inflation problems, the central bank takes action by decreasing the supply of money. There are certain ways to reduce money supply; however, the most favourable are Open market operations. This is because they are highly flexible, can be utilised with some precision and they are pretty well predictable. An Open market operation is the buying and selling of bonds by the central bank on open markets. These open market operations are used by the central bank to change the supply of money, which ultimately affects the interest rates. Open market operations can take in place in either expansionary or contractionary. An increase in money supply is referred to as expansionary, while a decrease in money supply is referred to as a contractionary open market operation. The most common way of reducing the supply of money is by means of contractionary open market operations where the central bank sells securities such as bonds to economic agents like firms, households and institutions. Figure 2.1 Contractionary Open Market OperationWhen people purchase these bonds, this implies an increase in the supply of bonds and the liquidity of money is reduced. A contractionary open market operation shifts the money supply curve to the left. As there is an increase in the supply of bonds, the price of bonds falls. Keeping in mind the inverse relationship between the price of bonds and the interest rate, as the price of bonds falls, we associate this to a higher interest rate. Leading to an increase in the interest rates, this implies a higher equilibrium interest rate at i2, as we move leftward along the money demand curve. This is due to the fact that as interest rates rise, there is less demand for money as people would find it more attractive to invest in bonds. Overall, a contraction in the money supply will decrease the supply of money, and results into a higher interest rate. Describe two monetary policy instruments which the central bank can utilize to undertake such a policy. Apart from open market operations, there are other instruments that central bank can utilize. These are • Changes in reserve requirement, and • Changes in discount rateChanges in the reserve requirements. Reserve requirements relate to an amount of cash, a bank is required to hold as a reserve. If the Fed increases the reserve requirement, it carries out contractionary policy, which lowers liquidity and slows down the economy. However, the central bank does not do this often because it can cause problems to the banking system. The reserve ratio leads to a higher money multiplier and therefore a higher level of supply for a given stock of central bank money supply. A higher interest rate is associated. Changes in discount rate. The discount rate is the rate at which commercial banks borrows from central bank to cover its requirements. Before doing so, banks can borrow reserves from each other through the ‘interbank market’. In practice the central bank holds the discount rate close to the rate of interbank market. The central bank handles monetary policy by applying interest rates’ targets on reserves.