How the Central Bank can fight a recession

In this post I would like to show you how a countries’ Central Bank can fight a recession.

Many believe a fiscal stimulus would be the thing to go for, but as I have shown in my first article about the US stimulus this has proven not to be the right answer to a recession. It was the Chicago School of Business economist Milton Friedman that proved the Central Bank is the one and only mechanism to fight a recession. Even though he won the Nobel Prize in the 1960s, governments tend to neglect his findings.

The Central Bank could use the following tools to get an economy back on its feet:

• Lower interest rates
• Decrease in banks’ reserve ratio
• Increase money supply

Lower interest rates

The economy can benefit from an increase in peoples’ consumption. Lower interest rates will both discourage saving and encourage borrowing. It would discourage saving because the returns on those savings would be very low, and it would encourage borrowing because the interest rate on borrowing is very low. Both would in their turn trigger spending.

Interest rates should not be below zero. This is because such a rate would make money worth more when someone is not saving it, effectively making spending a stupidity.

Decrease in banks’ reserve ratio

The Central Bank could decrease the banks’ reserve ratio regulation. When banks can keep lower reserves, they have more money available to lend. Companies in their turn would have more chance of landing the loans needed for their development.

Too low reserve ratios would be risky though, since they would not protect the bank from market fluctuations. When there is a “run” on the bank or many people take out their deposits the bank would not have enough liquidity to give back its deposits. Banks would then go bust, calling Lehman Brothers as an example.

In China banks have the benefit of having a shitload in deposits. Even though many loans are non-performing, there are enough deposits to cover them. Still, instead of their American counterparts these banks see their problems shifted towards the future.

Increase of money supply

When increasing the supply of money the Central Bank simply “creates” (supplies) more money that is brought into the market in the form of cheap loans to financial institutions.

A Central Bank should not “create” (supply) too much more money. When too much money gets into the market serious inflation could dispose of the money’s value. Decreasing the real value of money would then be the opposite of the effect that the Central Bank is aiming for.

Conclusion

I hope you now get an idea on how a government can best fight a recession. Hence, no taxpayers’ money would be spent to build sandcastles. ;-)