Monetary Policy Tools and How They Work (2024)

Central bankshave four mainmonetary policy tools: the reserve requirement, open market operations, the discount rate, and interest on reserves. Most central banks also have a lot more tools at theirdisposal. Here arethe four primary tools and howthey work together to sustainhealthy economic growth.

Key Takeaways

Central banks have four primary monetary tools for managing the money supply.
These are the reserve requirement, open market operations, the discount rate, and interest on excess reserves.
These tools can either help expand or contract economic growth.
The Federal Reserve created powerful new tools to cope with modern recessions.

Reserve Requirement

Thereserve requirementrefers to the money banks must keep on hand overnight. They can either keep the reservein their vaults or at the central bank. Alow reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit.

A high reserve requirement is contractionary. It gives banks less money to lend. It's especially hard for small banksbecause they don't have as much to lendin the first place. That's why most central banks don't impose a reserve requirement on small banks. Centralbanks rarely changethe reserve requirement because it's difficultfor memberbanks to modify their procedures.

Open Market Operations

Open market operationsare when central banksbuyor sellsecurities. These are bought from or sold to the country'sprivate banks. When the central bank buys securities, it adds cash to the banks' reserves. That gives them more money to lend. When the central bank sells the securities, it places them on the banks' balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buyssecurities when it wantsan expansionary monetary policy. Itsells them when it executestight monetary policy.

Note

Thefed funds rateis the most well-known of the Fed'stools.

Quantitative easing(QE) is open market operations that purchase long-term bonds, which has the effect of lowering long-term interest rates. Before the GreatRecession, the Fed maintainedbetween $700 billion to $800 billion of Treasury notes on its balance sheet. It added or subtracted to affect policy, but kept it within that range.

In response to the recession, the Fed lowered the fed funds rate to its lowest level, a range of between 0% and 0.25%. This rate is the benchmark for all short-term interest rates. The Fed then needed to implement QEas a secondary tool, to keep long-term interest rates low. As a result, it increased holdings of Treasury notes and mortgage-backed securities to more than $4 trillionby 2014.

As the economy improved, it allowed these securities to expire, in the hopes of normalizing its balance sheet. When the 2020 recession hit, the Fed quickly restored QE. By May 2020, it increased its holdings to more than $7 trillion.

Discount Rate

Thediscount rateisthe rate that central bankscharge their member banks to borrow at itsdiscount window.Because it's higher than the fed funds rate, banks only use this if they can't borrow funds from other banks.

Using the discount window also has a stigma attached. The financial community assumes that any bank that uses the discount window is in trouble. Only a desperate bank that's been rejected by others would use the discount window.

Interest Rate on Excess Reserves

The fourth tool was created in response to the 2008 financial crisis. The Federal Reserve, the Bank of England, and the European Central Bank pay interest on any excess reserves held by banks. If the Fed wants banks to lend more, it lowers the rate paid on excess reserves. If it wants banks to lend less, it raises the rate.

Interest on reserves also supports the fed funds rate target. Banks won't lend fed funds for less than the rate they're receiving from the Fed for these reserves.

How These Tools Work

Central bank tools work byincreasing or decreasing totalliquidity. That’sthe amount ofcapitalavailable to invest or lend. It's also money and credit that consumers spend. It's technically more thanthemoney supply, known asM1 andM2. The M1 symbol denotescurrency and check deposits. M2 is money market funds,CDs,and savings accounts. Therefore, when people say that central bank tools affect the money supply, they are understatingthe impact.

Other Tools

Many central banks also use inflation targeting. They want consumers to believe prices will rise so that they are more likely to buy now rather than later. The most common inflation target is 2%. It's close enough to zero to avoid the painful effects of galloping inflation but high enough to ward off deflation.

In 2020, the Fed launched the Main Street Lending Program to assist small and medium-sized businesses affected by the COVID-19 pandemic.

Many of the Fed's other tools were created to combat the2008 financial crisis. These programs provided credit to banks to keep them from closing. The Fed also supported money market funds, credit card markets, and commercial paper.

Frequently Asked Questions (FAQs)

What monetary policy tool was introduced in 2008?

In response to the 2008 financial crisis, the Federal Reserve began paying interest on excess reserves held by banks. This allows the bank to influence lending trends by reducing rates (encouraging lending) or raising them (discouraging lending). The Bank of England began doing this in 2009. The European Central Bank has done it since 1999.

Which tool of monetary policy is used the least often?

Most monetary policy tools are always being used, and the strategies are simply adjusted as economic conditions change. There is always some level of reserve requirement, reserves earn interest, and discount rates always apply. One exception is quantitative easing—when the economy is doing well, there isn't a reason for the Federal Reserve to purchase any long-term bonds.