Econ: Monetary Policy Tools



Monetary policy consists of decisions made by a central bank about the amount of money in circulation and interest rates. In the United States, the Federal Reserve makes such decisions. The Fed controls monetary policy to help the economy grow steadily with full employment and stable prices.

The Fed can inject money into the economy or pull it out using open-market operations. The Fed’s open-market operation  involve buying and selling of government securities in the bond market. The securities can be Treasury bonds, notes, bills, or other government bonds. When the Fed adopts an easy-money policy, the Fed’s bond traders buys government securities. Every dollar the Fed pays for bonds increases the money supply. When the Fed adopts a tight-money policy, its bond traders sell securities in the bond market. The public pays for these bonds with cash or money taken out of banks. As the money goes out of circulation, the money supply shrinks. Additionally, banks end up with smaller deposits, they have less money to lend, which also slows the growth of the money supply.Open-market operations are relatively easy to carry out. They allow the Fed to make small adjustments in the money supply without new laws or banking regulations. For these reasons, the sale and purchase of securities is the monetary tool the Fed uses most to stabilize the economy.

Banks sometimes need to borrow money to keep their reserve requirement at the proper level. This might happen because a bank has made too many loans or it could be a result of an unexpectedly large withdrawals.Whatever the reason, banks can borrow money from the Fed to shore up their reserves. The interest rate on such loans is known as the discount rate. A low discount rate makes it less costly for banks to borrow from the Fed. Banks can then use that money to make loans to customers thereby expanding the money supply. Raising the discount rate has the opposite effect by discouraging banks from borrowing from the Fed. With money tight, banks make fewer loans, keeping the money supply in check.

The Fed’s least used monetary tool is the required reserve ratio. The Fed could expand or contract the money supply by adjusting the required reserve ratio. This ratio is the minimum percentage of deposits the banks must keep at all times.Lowering the ratio would allow banks to make more loans and create more money. Raising the reserve ratio would force banks to keep more cash in reserve and out of the money supply. This in turn would leave banks with less money to lend, slowing money creation. 

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