Monetary Policy Tools and How They Work

Four Tools Banks Use to Control the World Economy

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Central banks have four main monetary 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 their disposal. Here are the four primary tools and how they work together to sustain healthy economic growth.

Reserve Requirement

The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank. A low 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 banks because they don't have as much to lend in the first place. That's why most central banks don't impose a reserve requirement on small banks. Central banks rarely change the reserve requirement because it's difficult for member banks to modify their procedures.

Open Market Operations

Open market operations are when central banks buy or sell securities. These are bought from or sold to the country's private 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 buys securities when it wants expansionary monetary policy. It sells them when it executes contractionary monetary policy.

The U.S. Federal Reserve uses open market operations to manage the fed funds rate. Here's how the fed funds rate works. If a bank can't meet the reserve requirement, it borrows from another bank that has excess cash. The amount borrowed is called fed funds. The interest rate it pays is the fed funds rate. The Federal Open Market Committee (FOMC) sets a target for the fed funds rate at its meetings. It uses open market operations to encourage banks to meet the target.

The fed funds rate is the most well-known of the Fed's tools.

Quantitative easing (QE) is open market operations that purchase long-term bonds, which has the effect of lowering long-term interest rates. Before the Great Recession, the Fed maintained between $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 QE as 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 trillion by 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

The discount rate is the rate that central banks charge their member banks to borrow at its discount 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 by increasing or decreasing total liquidity. That’s the amount of capital available to invest or lend. It's also money and credit that consumers spend. It's technically more than the money supply, known as M1 and M2. The M1 symbol denotes currency 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 understating the 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 the 2008 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.

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.