Econ: Tools of Monetary Policy

     The Fed has a number of monetary tools available to change the money supply and interest rates to affect real output, employment, and price levels.

Open market operations are the most frequently used tool of monetary policy because of their flexibility and immediate effects. Open market operations are the Fed’s purchases and sales of government bonds with member banks and the public. When the Fed buys bonds from a bank, it creates reserves in the bank’s deposit with the Fed, which the bank can then lend to customers. When the Fed buys bonds from the public, it puts a check in the hand of the consumer, who can deposit the funds in his bank. The two transactions are slightly different in effect, because the bank can loan the full excess reserves resulting from its sale of bonds to the Fed, but the bank must keep the required reserves from the customer’s deposit, leading to a smaller increase in the money supply. In either case, the Fed increases the money supply when it buys bonds, and it reduces the money supply when it sells bonds.

The reserve requirement is the most powerful tool of monetary policy, so it is only rarely used. A change in the percentage of deposits the banks must hold in reserve directly impacts the bank’s ability to increase loans and, therefore, the money multiplier. If the Fed increases the reserve requirement, banks cannot loan as much and the money supply falls. A reduction in the reserve requirement increases the potential growth of the money supply.

A third important tool of monetary policy is the discount rate, which is the interest rate the Fed charges member banks for loans. A reduction in the discount rate encourages banks to borrow from the Fed and, in turn, increase loans to their customers. As a result, the money supply increases. An increase in the discount rate discourages banks from borrowing from the Fed, reducing loans and the money supply.