What Are the Three Main Tools of Monetary Policy?

Monetary policy involves actions taken by a nation’s central bank to manage the availability of money and credit within the economy, aiming to influence overall financial conditions and achieve specific economic objectives. A central bank uses monetary policy to promote a healthy and stable economy.

The overarching goals of monetary policy include maintaining price stability, fostering maximum sustainable employment, and ensuring moderate long-term interest rates. Price stability refers to keeping inflation low and predictable, which helps preserve the purchasing power of money over time. Maximizing employment means supporting conditions where people who want to work can find jobs. These objectives work together to create an environment conducive to economic growth and stability.

Open Market Operations

Open market operations (OMOs) are the primary and most frequently used tool of monetary policy. These operations involve the buying and selling of government securities, such as Treasury bonds, by the central bank in the open market with financial institutions. They influence the amount of money circulating in the banking system and the broader economy.

When the central bank aims to increase the money supply and stimulate economic activity, it purchases government securities from banks. This injects funds into the banking system, directly increasing bank reserves. With more reserves, banks have a greater capacity to extend loans to businesses and consumers. This increased lending expands the overall money supply and leads to a decrease in interest rates, including the federal funds rate, which is the rate banks charge each other for overnight loans. Lower borrowing costs encourage investment and spending.

Conversely, when the central bank seeks to reduce the money supply to curb inflation or cool down an overheating economy, it sells government securities to banks. These sales withdraw funds from the banking system, reducing bank reserves. With fewer reserves, banks have less money available to lend, which contracts the money supply. This action pushes interest rates higher, including the federal funds rate, making borrowing more expensive, and slowing economic activity. Open market operations are highly flexible and precise, allowing continuous adjustments to influence short-term interest rates and credit conditions.

The Discount Rate

The discount rate is the interest rate at which commercial banks borrow directly from the central bank. This occurs through the “discount window.” Though a monetary policy tool, it is less frequently used for routine money supply management than open market operations. It primarily serves as a backup source of liquidity for banks.

Banks prefer to borrow from each other in the federal funds market, where the rate is often lower than the discount rate. The discount window provides an alternative when a bank faces unexpected short-term liquidity needs or cannot obtain funds elsewhere. These loans are short-term, often overnight, and must be secured by acceptable collateral. The central bank acts as a “lender of last resort,” providing financial system stability during stress.

Changes in the discount rate also carry a significant signaling effect regarding the central bank’s monetary policy stance. A reduction in the discount rate can signal an accommodative policy, suggesting encouragement of lending and economic growth. Conversely, an increase can signal a restrictive policy, indicating a desire to tighten credit and slow economic activity. While direct borrowing volume may be low, the rate’s adjustment communicates the central bank’s intentions to the financial markets.

Reserve Requirements

Reserve requirements dictate the fraction of deposits commercial banks must hold in reserve, either as cash or as balances at the central bank, rather than lending out. These requirements directly impact the amount of money banks have available for lending. Historically, changes to reserve requirements could significantly influence the money supply.

If the central bank were to lower reserve requirements, banks would have more funds to lend. This would increase money available in the economy, encouraging spending and investment. Conversely, raising reserve requirements would reduce the funds banks could lend, contracting the money supply and increasing interest rates. Such adjustments directly affect banks’ lending capacity and the credit available in the economy.

This tool is rarely adjusted in modern monetary policy due to its disruptive effects on the banking system. Even small changes can have a widespread and significant impact on banks’ balance sheets and operations. Effective March 26, 2020, reserve requirement ratios for all U.S. depository institutions were reduced to zero percent. This measure supported credit flow to households and businesses during economic uncertainty from the COVID-19 pandemic. With a zero percent reserve requirement, this tool currently plays a minimal role in the day-to-day implementation of monetary policy.