Monetary policy tools

The federal bank controls the economy by regulating country’s interest rates, aggregate demand, and money supply

The three functions of money are acting as store of value to transfer purchasing power from present to future, medium of exchange between buyers and sellers and a unit of account.

Money supply can be categorized into three groups or classes: The M1 consists of traveler’s checks and currency owned by individuals and businesses, M2 includes M1 and savings, time, and other types of deposits. M3 includes M1 and large scale, term and time deposits.

The three monetary policy tools

  • Reserve requirements
  • Federal funds rate
  • Open market operations

Reserve requirements

  • When the fed wants to lower the money supply in the economy, it raises the reserve requirements.
  • Reserves are the amount of money that each commercial bank holds in their vault
  • When reserve requirements increase, the commercial banks are supposed to hold more money which reduces the amount available to lend to borrowers.
  • Fewer loans mean there will be a shortage of loans, and commercial banks are forced to raise interest rates, this decreases loans and eventually decreases the money supply. Less money means the prices of goods and services will go down as well.
  • On the other hand, if the fed wants to raise money supply in the economy, it will do the opposite by decreasing reserve requirements allowing the commercial banks to lend more money.

Federal funds rate

  • Fed funds rate is the interest rates the commercial banks pay for overnight borrowing.
  • When the federal funds rate decreases, commercial banks also charge lower interest rates and more loans are made accessible to the borrowers
  • If the government wants to increase the money supply in the economy, it will raise the federal funds rate so that the commercial banks can charge borrowers more interest rates, decreasing demand for loans.
  • This will eventually lower the aggregate demand while stabilizing the economy.

Open market operations

  • Open market operations refer to the sale and purchase of government securities and bonds to the commercial banks
  • If the government wants to decrease the money supply to avoid inflation, it will decrease reserves in commercial banks by selling securities.
  • The commercial banks will then charge high-interest rates due to a shortage and less money will be available in the vault to lend out to borrowers
  • If the fed wants to stimulate the economy by raising money supply and aggregate demand, it will do so by purchasing securities from the commercial banks.
  • This will increase money in the banks’ vaults, hence lowering interest rates, Borrowers will be able and willing to borrow more and hence an increased investment and aggregate demand.
  • The three tools are used by the fed to control the economy and avoid fluctuations between deflation and inflation


Reserve Requirement

  • Definition: The reserve requirement refers to the amount of money banks must keep on hand, either in their vaults or at the central bank, overnight.
  • Effect: A low reserve requirement allows banks to lend more, creating credit and promoting expansion.
  • Impact of High Requirement: A high reserve requirement is contractionary, limiting banks’ lending capacity, which can be challenging for smaller banks.
  • Central Bank Approach: Central banks rarely change the reserve requirement due to procedural complexities for member banks, especially small ones.

Open Market Operations

  • Definition: Open market operations involve central banks buying or selling securities from/to private banks.
  • Expansionary Action: Buying securities adds cash to bank reserves, facilitating more lending.
  • Contractionary Action: Selling securities reduces bank reserves, restricting lending.
  • Fed Funds Rate Management: The U.S. Federal Reserve uses open market operations to manage the fed funds rate, influencing banks’ borrowing behavior.

Quantitative Easing (QE)

  • Definition: QE involves purchasing long-term bonds to lower long-term interest rates.
  • Fed’s Strategy: The Fed used QE during the Great Recession and the 2020 recession to maintain low long-term interest rates.
  • Balance Sheet Impact: The Fed increased its holdings to over $7 trillion by 2020, allowing some securities to expire during economic improvement.

Discount Rate

  • Definition: The discount rate is the rate central banks charge member banks to borrow at the discount window.
  • Usage Dynamics: Banks turn to the discount window if unable to borrow from other banks, but its use carries a stigma, indicating financial trouble.

Interest Rate on Excess Reserves

  • Response to Crisis: Created in response to the 2008 financial crisis, central banks pay interest on excess reserves held by banks.
  • Lending Influence: The rate on excess reserves influences banks’ lending decisions; a lower rate encourages more lending, while a higher rate discourages it.

Impact Mechanism

  • Total Liquidity Influence: Central bank tools work by adjusting total liquidity, impacting the amount of capital available for investment or lending.
  • Beyond Money Supply: The influence extends beyond the money supply (M1 and M2) to include consumer spending and investment.

Other Tools

  • Inflation Targeting: Many central banks use inflation targeting, aiming for a 2% inflation rate to encourage current spending.
  • Crisis Response Tools: The Fed’s Main Street Lending Program and other crisis-response tools were introduced to combat the 2008 financial crisis and assist businesses during the COVID-19 pandemic.

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