Role of Central Bank

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How does the Central Bank control bank lending?

Let us see how bank lending works and how it is controlled by the central bank of US, ie, Fed.

Banks are not ordinary intermediaries. Like non-banks, they also borrow, but they do not lend the deposits they acquire. They lend by crediting the borrower's account with a new deposit, and then if necessary borrowing the funds needed to meet the reserve ratio requirement. The accounts of other depositors remain intact and their deposits fully available for withdrawal. Thus a bank loan increases the total of bank deposits, which means an increase in the money supply. When the loan is paid off, the money supply decreases.

A net increase in bank lending results in a shortage of reserves needed by the banking system, which only the Fed can supply. In order to maintain control of the Fed funds rate, i.e. the interest rate on overnight loans between banks, the Fed must provide the funds as required. It does so by purchasing Treasury securities from the public.

Bank lending has no effect on a bank's own capital. But bank lending is limited by the capital ratio requirement set by the Fed. If a bank has sufficient capital, it can expand its balance sheet by issuing more loans. However if it is not holding excess reserves, it will have to acquire more in order to meet the reserve ratio requirement. Banks therefore actively seek new deposits. Of course they prefer deposits on which they pay no interest, like ordinary checking accounts. They also borrow from savers who open savings accounts and investors who buy their CDs.

Reference: http://wfhummel.cnchost.com/nonbanks.html

Does the Central Bank have a Monetary Policy?

Yes, each central bank has a monetary policy, which changes from time to time, depending on the economic situation and future outlook of a country.

Monetary policy is the process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates (such as the Federal reserve is doing right now to combat recession in US by lowering the interest rates), while contractionary policy has the goal of raising interest rates to combat inflation (or cool an otherwise overheated economy).

In practice all types of monetary policy involve modifying the amount of base currency in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

source: http://en.wikipedia.org/wiki/Monetary_policy

How does the Central Bank measure the money supply in the COUNTRY?

According to the IMF's manual, money supply is measured as the combined deposit liabilities of the banking system and the currency liabilities of the central bank, both held by households, firms, nonprofit institutions and all public sector entities outside of the central government. In this official or standard representation of money supply, there are three monetary aggregates delineated; M0, M1 and M2.

M0 includes only currency in the hands of the public, banks' statutory reserve deposits held at the central bank and banks' cash reserves. This aggregate represents the monetary liabilities of the central bank and is usually referred to as the monetary base or reserve money

The second aggregate M1, comprises currency held outside the banking system and the current account deposit liabilities of commercial banks held for ...