A Central Bank That Desires to Reduce Money Supply Can Do This

Central banks manage the economy by controlling the money supply. When inflation rises or the economy overheats, they take steps to reduce liquidity and slow spending to stabilize prices and maintain financial stability.

Several tools help achieve this by influencing how much money circulates within the banking system.

Reducing Liquidity Through Open Market Operations

One of the most direct ways to reduce the money supply is by selling government securities. When banks and financial institutions buy these bonds or Treasury bills, they use their reserves, pulling money out of circulation. With fewer reserves, banks issue fewer loans, slowing economic activity.

As lending tightens, borrowing becomes more expensive for businesses and consumers, reducing demand and curbing inflation. The impact depends on the scale and frequency of these operations. A small sale has a limited effect, while a sustained and aggressive approach can significantly contract liquidity. The Federal Reserve used this strategy extensively during its quantitative tightening phase, reducing its balance sheet by allowing bonds to mature without reinvestment and actively selling assets.

Raising the Reserve Requirement

A central bank can also restrict the money supply by increasing the reserve requirement—the percentage of deposits banks must hold rather than lend. Raising this requirement directly limits credit expansion, reducing money circulation.

Banks with lower excess reserves may need to cut lending or seek additional funding, pushing interest rates higher and making borrowing more difficult. This discourages consumer spending and business investment.

Central banks rarely adjust reserve requirements because even small changes have significant effects. In 2020, the Federal Reserve reduced the reserve requirement to zero for many institutions to encourage lending during the pandemic. Reversing this policy would force banks to hold more funds in reserve, reducing money available for lending.

Adjusting the Discount Rate

Altering the discount rate—the interest rate banks pay to borrow from the central bank—affects liquidity. A higher discount rate makes borrowing more expensive, discouraging banks from relying on central bank loans and leading to a contraction in available credit.

The effects extend beyond these institutions. The discount rate serves as a benchmark for other interest rates, including business loans and consumer credit. When borrowing costs rise, banks pass these costs onto customers, making mortgages, personal loans, and corporate debt more expensive. This discourages borrowing and spending, slowing economic activity and easing inflationary pressures.

Market expectations also play a role. If investors anticipate further rate hikes, they may shift toward safer assets like government bonds, tightening financial conditions before additional policy actions take effect.

Modifying Interest on Excess Reserves

The interest rate paid on excess reserves (IOER) influences how banks manage surplus funds. A higher IOER incentivizes banks to hold reserves rather than lend, reducing money circulation.

This also affects short-term interest rates. When banks are less willing to lend excess liquidity in interbank markets, rates such as the federal funds rate in the U.S. or the Euro Overnight Index Average (EONIA) in the eurozone tend to rise. This makes financing more expensive for corporations and individuals.

Limiting Access to Lending Facilities

Restricting access to central bank lending facilities tightens monetary conditions by making emergency liquidity less available. When access is limited or borrowing terms become less favorable, banks must rely more on private funding sources, increasing borrowing costs and reducing credit availability.

One approach is imposing stricter collateral requirements, requiring banks to pledge higher-quality assets or larger amounts to secure funding. This makes it harder for weaker institutions to obtain liquidity, forcing them to be more cautious with lending. Another method is shortening loan durations, requiring banks to repay borrowed funds more quickly.

In some cases, central banks discontinue lending programs introduced during financial crises or economic downturns. The Federal Reserve, for instance, phased out many emergency measures from the 2008 financial crisis and the COVID-19 pandemic once economic conditions stabilized. By withdrawing these facilities, central banks remove a source of liquidity, reinforcing tighter monetary policy and encouraging more disciplined credit conditions.